Incentive-Based Compensation Arrangements, 37669-37838 [2016-11788]

Download as PDF Vol. 81 Friday, No. 112 June 10, 2016 Part II Department of the Treasury Office of the Comptroller of the Currency 12 CFR Part 42 Federal Reserve System 12 CFR Part 236 Federal Deposit Insurance Corporation 12 CFR Part 372 National Credit Union Administration 12 CFR Parts 741 and 751 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Housing Finance Agency 12 CFR Part 1232 Securities and Exchange Commission 17 CFR Parts 240, 275, and 303 Incentive-Based Compensation Arrangements; Proposed Rule VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 PO 00000 Frm 00001 Fmt 4717 Sfmt 4717 E:\FR\FM\10JNP2.SGM 10JNP2 37670 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules Act). Section 956 generally requires that the Agencies jointly issue regulations or Office of the Comptroller of the guidelines: (1) Prohibiting incentiveCurrency based payment arrangements that the Agencies determine encourage 12 CFR Part 42 inappropriate risks by certain financial institutions by providing excessive [Docket No. OCC–2011–0001] compensation or that could lead to material financial loss; and (2) requiring RIN 1557–AD39 those financial institutions to disclose FEDERAL RESERVE SYSTEM information concerning incentive-based compensation arrangements to the 12 CFR Part 236 appropriate Federal regulator. DATES: Comments must be received by [Docket No. R–1536] July 22, 2016. RIN 7100 AE–50 ADDRESSES: Although the Agencies will jointly review the comments submitted, FEDERAL DEPOSIT INSURANCE it would facilitate review of the CORPORATION comments if interested parties send comments to the Agency that is the 12 CFR Part 372 appropriate Federal regulator, as RIN 3064–AD86 defined in section 956(e) of the DoddFrank Act, for the type of covered NATIONAL CREDIT UNION institution addressed in the comments. ADMINISTRATION Commenters are encouraged to use the title ‘‘Incentive-based Compensation 12 CFR Parts 741 and 751 Arrangements’’ to facilitate the organization and distribution of RIN 3133–AE48 comments among the Agencies. Interested parties are invited to submit FEDERAL HOUSING FINANCE written comments to: AGENCY Office of the Comptroller of the Currency: Because paper mail in the 12 CFR Part 1232 Washington, DC area and at the OCC is RIN 2590–AA42 subject to delay, commenters are encouraged to submit comments by the SECURITIES AND EXCHANGE Federal eRulemaking Portal or email, if COMMISSION possible. Please use the title ‘‘Incentivebased Compensation Arrangements’’ to 17 CFR Parts 240, 275, and 303 facilitate the organization and distribution of the comments. You may [Release No. 34–77776; IA–4383; File No. S7–07–16] submit comments by any of the following methods: RIN 3235–AL06 • Federal eRulemaking Portal— Regulations.gov: Go to Incentive-Based Compensation www.regulations.gov. Enter ‘‘Docket ID Arrangements OCC–2011–0001’’ in the Search Box and AGENCY: Office of the Comptroller of the click ‘‘Search.’’ Click on ‘‘Comment Currency, Treasury (OCC); Board of Now’’ to submit public comments. Governors of the Federal Reserve • Click on the ‘‘Help’’ tab on the System (Board); Federal Deposit Regulations.govhome page to get Insurance Corporation (FDIC); Federal information on using Regulations.gov, Housing Finance Agency (FHFA); including instructions for submitting National Credit Union Administration public comments. (NCUA); and U.S. Securities and • Email: regs.comments@ Exchange Commission (SEC). occ.treas.gov. • Mail: Legislative and Regulatory ACTION: Notice of proposed rulemaking Activities Division, Office of the and request for comment. Comptroller of the Currency, 400 7th SUMMARY: The OCC, Board, FDIC, FHFA, Street SW., Suite 3E–218, Mail Stop NCUA, and SEC (the Agencies) are 9W–11, Washington, DC 20219. seeking comment on a joint proposed • Fax: (571) 465–4326. rule (the proposed rule) to revise the • Hand Delivery/Courier: 400 7th proposed rule the Agencies published in Street SW., Suite 3E–218, Mail Stop the Federal Register on April 14, 2011, 9W–11, Washington, DC 20219. Instructions: You must include and to implement section 956 of the ‘‘OCC’’ as the agency name and ‘‘Docket Dodd-Frank Wall Street Reform and ID OCC–2011–0001’’ in your comment. Consumer Protection Act (Dodd-Frank mstockstill on DSK3G9T082PROD with PROPOSALS2 DEPARTMENT OF THE TREASURY VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 PO 00000 Frm 00002 Fmt 4701 Sfmt 4702 In general, OCC will enter all comments received into the docket and publish them on the Regulations.gov Web site without change, including any business or personal information that you provide such as name and address information, email addresses, or phone numbers. Comments received, including attachments and other supporting materials, are part of the public record and subject to public disclosure. Do not enclose any information in your comment or supporting materials that you consider confidential or inappropriate for public disclosure. You may review comments and other related materials that pertain to this proposed rule by any of the following methods: • Viewing Comments Electronically: Go to www.regulations.gov. Enter ‘‘Docket ID OCC–2011–0001’’ in the Search box and click ‘‘Search.’’ Click on ‘‘Open Docket Folder’’ on the right side of the screen and then ‘‘Comments.’’ Comments can be filtered by clicking on ‘‘View All’’ and then using the filtering tools on the left side of the screen. • Click on the ‘‘Help’’ tab on the Regulations.gov home page to get information on using Regulations.gov. Supporting materials may be viewed by clicking on ‘‘Open Docket Folder’’ and then clicking on ‘‘Supporting Documents.’’ The docket may be viewed after the close of the comment period in the same manner as during the comment period. • Viewing Comments Personally: You may personally inspect and photocopy comments at the OCC, 400 7th Street SW., Washington, DC. For security reasons, the OCC requires that visitors make an appointment to inspect comments. You may do so by calling (202) 649–6700 or, for persons who are deaf or hard of hearing, TTY, (202) 649– 5597. Upon arrival, visitors will be required to present valid governmentissued photo identification and to submit to security screening in order to inspect and photocopy comments. Board of Governors of the Federal Reserve System: You may submit comments, identified by Docket No. 1536 and RIN No. 7100 AE–50, by any of the following methods: • Agency Web site: https:// www.federalreserve.gov. Follow the instructions for submitting comments at https://www.federalreserve.gov/ generalinfo/foia/ProposedRegs.cfm. • Federal eRulemaking Portal: https:// www.regulations.gov. Follow the instructions for submitting comments. • Email: regs.comments@ federalreserve.gov. Include the docket number and RIN number in the subject line of the message. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules • Fax: (202) 452–3819 or (202) 452– 3102. • Mail: Address to Robert deV. Frierson, Secretary, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue NW., Washington, DC 20551. All public comments will be made available on the Board’s Web site at https://www.federalreserve.gov/ generalinfo/foia/ProposedRegs.cfm as submitted, unless modified for technical reasons. Accordingly, comments will not be edited to remove any identifying or contact information. Public comments may also be viewed electronically or in paper form in Room 3515, 1801 K Street NW. (between 18th and 19th Streets NW.), Washington, DC 20006 between 9:00 a.m. and 5:00 p.m. on weekdays. Federal Deposit Insurance Corporation: You may submit comments, identified by RIN 3064– AD86, by any of the following methods: • Agency Web site: https:// www.FDIC.gov/regulations/laws/ federal/propose.html. Follow instructions for submitting comments on the Agency Web site. • Email: Comments@FDIC.gov. Include the RIN 3064–AD86 on the subject line of the message. • Mail: Robert E. Feldman, Executive Secretary, Attention: Comments, Federal Deposit Insurance Corporation, 550 17th Street NW., Washington, DC 20429. • Hand Delivery: Comments may be hand delivered to the guard station at the rear of the 550 17th Street Building (located on F Street) on business days between 7:00 a.m. and 5:00 p.m. • Public Inspection: All comments received, including any personal information provided, will be posted generally without change to https:// www.fdic.gov/regulations/laws/federal. Federal Housing Finance Agency: You may submit your written comments on the proposed rulemaking, identified by RIN number, by any of the following methods: • Agency Web site: www.fhfa.gov/ open-for-comment-or-input. • Federal eRulemaking Portal: https:// www.regulations.gov. Follow the instructions for submitting comments. If you submit your comment to the Federal eRulemaking Portal, please also send it by email to FHFA at RegComments@fhfa.gov to ensure timely receipt by the Agency. Please include ‘‘RIN 2590–AA42’’ in the subject line of the message. • Hand Delivery/Courier: The hand delivery address is: Alfred M. Pollard, General Counsel, Attention: Comments/ RIN 2590–AA42, Federal Housing Finance Agency, Eighth Floor, 400 7th VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 Street SW., Washington, DC 20219. The package should be delivered at the 7th Street entrance Guard Desk, First Floor, on business days between 9 a.m. and 5 p.m. • U.S. Mail, United Parcel Service, Federal Express, or Other Mail Service: The mailing address for comments is: Alfred M. Pollard, General Counsel, Attention: Comments/RIN 2590–AA42, Federal Housing Finance Agency, 400 7th Street SW., Washington, DC 20219. Please note that all mail sent to FHFA via U.S. Mail is routed through a national irradiation facility, a process that may delay delivery by approximately two weeks. All comments received by the deadline will be posted without change for public inspection on the FHFA Web site at https://www.fhfa.gov, and will include any personal information provided, such as name, address (mailing and email), and telephone numbers. Copies of all comments timely received will be available for public inspection and copying at the address above on government-business days between the hours of 10:00 a.m. and 3:00 p.m. To make an appointment to inspect comments please call the Office of General Counsel at (202) 649–3804. National Credit Union Administration: You may submit comments by any of the following methods (please send comments by one method only): • Federal eRulemaking Portal: https:// www.regulations.gov. Follow the instructions for submitting comments. • Agency Web site: https:// www.ncua.gov. Follow the instructions for submitting comments. • Email: Address to regcomments@ ncua.gov. Include ‘‘[Your name] Comments on ‘‘Notice of Proposed Rulemaking for Incentive-based Compensation Arrangements’’ in the email subject line. • Fax: (703) 518–6319. Use the subject line described above for email. • Mail: Address to Gerard S. Poliquin, Secretary of the Board, National Credit Union Administration, 1775 Duke Street, Alexandria, Virginia 22314– 3428. • Hand Delivery/Courier: Same as mail address. • Public Inspection: All public comments are available on the agency’s Web site at https://www.ncua.gov/Legal/ Regs/Pages/PropRegs.aspx as submitted, except when not possible for technical reasons. Public comments will not be edited to remove any identifying or contact information. Paper copies of comments may be inspected in NCUA’s law library at 1775 Duke Street, Alexandria, Virginia 22314, by PO 00000 Frm 00003 Fmt 4701 Sfmt 4702 37671 appointment weekdays between 9:00 a.m. and 3:00 p.m. To make an appointment, call (703) 518–6546 or send an email to OGCMail@ncua.gov. Securities and Exchange Commission: You may submit comments by the following method: Electronic Comments • Use the SEC’s Internet comment form (https://www.sec.gov/rules/ proposed.shtml); • Send an email to rule-comments@ sec.gov. Please include File Number S7– 07–16 on the subject line; or • Use the Federal eRulemaking Portal (https://www.regulations.gov). Follow the instructions for submitting comments. Paper Comments • Send paper comments in triplicate to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549. All submissions should refer to File Number S7–07–16. This file number should be included on the subject line if email is used. To help us process and review your comments more efficiently, please use only one method. The SEC will post all comments on the SEC’s Internet Web site (https://www.sec.gov/ rules/proposed.shtml). Comments are also available for Web site viewing and printing in the SEC’s Public Reference Room, 100 F Street NE., Washington, DC 20549 on official business days between the hours of 10:00 a.m. and 3:00 p.m. All comments received will be posted without change; the SEC does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. Studies, memoranda or other substantive items may be added by the SEC or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any such materials will be made available on the SEC’s Web site. To ensure direct electronic receipt of such notifications, sign up through the ‘‘Stay Connected’’ option at www.sec.gov to receive notifications by email. FOR FURTHER INFORMATION CONTACT: OCC: Patrick T. Tierney, Assistant Director, Alison MacDonald, Senior Attorney, and Melissa Lisenbee, Attorney, Legislative and Regulatory Activities, (202) 649–5490, and Judi McCormick, Analyst, Operational Risk Policy, (202) 649–6415, Office of the Comptroller of the Currency, 400 7th Street SW., Washington, DC 20219. Board: Teresa Scott, Manager, (202) 973–6114, Meg Donovan, Senior Supervisory Financial Analyst, (202) E:\FR\FM\10JNP2.SGM 10JNP2 37672 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules 872–7542, or Joe Maldonado, Supervisory Financial Analyst, (202) 973–7341, Division of Banking Supervision and Regulation; or Laurie Schaffer, Associate General Counsel, (202) 452–2272, Michael Waldron, Special Counsel, (202) 452–2798, Gillian Burgess, Counsel, (202) 736– 5564, Flora Ahn, Counsel, (202) 452– 2317, or Steve Bowne, Senior Attorney, (202) 452–3900, Legal Division, Board of Governors of the Federal Reserve System, 20th and C Streets NW., Washington, DC 20551. FDIC: Rae-Ann Miller, Associate Director, Risk Management Policy, Division of Risk Management Supervision (202) 898–3898, Catherine Topping, Counsel, Legal Division, (202) 898–3975, and Nefretete Smith, Counsel, Legal Division, (202) 898– 6851. FHFA: Mary Pat Fox, Manager, Executive Compensation Branch, (202) 649–3215; or Lindsay Simmons, Assistant General Counsel, (202) 649– 3066, Federal Housing Finance Agency, 400 7th Street SW., Washington, DC 20219. The telephone number for the Telecommunications Device for the Hearing Impaired is (800) 877–8339. NCUA: Vickie Apperson, Program Officer, and Jeffrey Marshall, Program Officer, Office of Examination & Insurance, (703) 518–6360; or Elizabeth Wirick, Senior Staff Attorney, Office of General Counsel, (703) 518–6540, National Credit Union Administration, 1775 Duke Street, Alexandria, Virginia 22314. SEC: Raymond A. Lombardo, Branch Chief, Kevin D. Schopp, Special Counsel, Division of Trading & Markets, (202) 551–5777 or tradingandmarkets@ sec.gov; Sirimal R. Mukerjee, Senior Counsel, Melissa R. Harke, Branch Chief, Division of Investment Management, (202) 551–6787 or IARules@SEC.gov, U.S. Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549. SUPPLEMENTARY INFORMATION: mstockstill on DSK3G9T082PROD with PROPOSALS2 Table of Contents I. Introduction A. Background B. Supervisory Experience C. Overview of the 2011 Proposed Rule and Public Comment D. International Developments E. Overview of the Proposed Rule II. Section-by-Section Description of the Proposed Rule § ll.1 Authority, Scope and Initial Applicability § ll.2 Definitions Definitions Pertaining to Covered Institutions Consolidation VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 Level 1, Level 2, and Level 3 Covered Institutions Definitions Pertaining to Covered Persons Relative Compensation Test Exposure Test Exposure Test at Certain Affiliates Dollar Threshold Test Other Definitions Relationship Between Defined Terms § ll.3 Applicability (a) When Average Total Consolidated Assets Increase (b) When Total Consolidated Assets Decrease (c) Compliance of Covered Institutions That Are Subsidiaries of Covered Institutions § ll.4 Requirements and Prohibitions Applicable to All Covered Institutions (a) In General (b) Excessive Compensation (c) Material Financial Loss (d) Performance Measures (e) Board of Directors (f) Disclosure and Recordkeeping Requirements and (g) Rule of Construction § ll.5 Additional Disclosure and Recordkeeping Requirements for Level 1 and Level 2 Covered Institutions § ll.6 Reservation of Authority for Level 3 Covered Institutions § ll.7 Deferral, Forfeiture and Downward Adjustment, and Clawback Requirements for Level 1 and Level 2 Covered Institutions § ll.7(a) Deferral § ll.7(a)(1) and § ll.7(a)(2) Minimum Deferral Amounts and Deferral Periods for Qualifying Incentive-Based Compensation and Incentive-Based Compensation Awarded Under a LongTerm Incentive Plan Pro Rata Vesting Acceleration of Payments Qualifying Incentive-Based Compensation and Incentive-Based Compensation Awarded Under a Long-Term Incentive Plan § ll.7(a)(3) Adjustments of Deferred Qualifying Incentive-Based Compensation and Deferred Long-Term Incentive Plan Compensation Amounts § ll.7(a)(4) Composition of Deferred Qualifying Incentive-Based Compensation and Deferred Long-Term Incentive Plan Compensation for Level 1 and Level 2 Covered Institutions Cash and Equity-Like Instruments Options § ll.7(b) Forfeiture and Downward Adjustment § ll.7(b)(1) Compensation at Risk § ll.7(b)(2) Events Triggering Forfeiture and Downward Adjustment Review § ll.7(b)(3) Senior Executive Officers and Significant Risk-Takers Affected by Forfeiture and Downward Adjustment § ll.7(b)(4) Determining Forfeiture and Downward Adjustment Amounts § ll.7(c) Clawback § ll.8 Additional Prohibitions for Level 1 and Level 2 Covered Institutions § ll.8(a) Hedging § ll.8(b) Maximum Incentive-Based Compensation Opportunity PO 00000 Frm 00004 Fmt 4701 Sfmt 4702 § ll.8(c) Relative Performance Measures § ll.8(d) Volume-Driven Incentive-Based Compensation § ll.9 Risk Management and Controls Requirements for Level 1 and Level 2 Covered Institutions § ll.10 Governance Requirements for Level 1 and Level 2 Covered Institutions § ll.11 Policies and Procedures Requirements for Level 1 and Level 2 Covered Institutions § ll.12 Indirect Actions § ll.13 Enforcement § ll.14 NCUA and FHFA Covered Institutions in Conservatorship, Receivership, or Liquidation SEC Amendment to Exchange Act Rule 17a–4 SEC Amendment to Investment Advisers Act Rule 204–2 III. Appendix to the Supplementary Information: Example Incentive-Based Compensation Arrangement and Forfeiture and Downward Adjustment Review Ms. Ledger: Senior Executive Officer at Level 2 Covered Institution Balance Award of Incentive-Based Compensation for Performance Periods Ending December 31, 2024 Vesting Schedule Use of Options in Deferred Incentive-Based Compensation Other Requirements Specific to Ms. Ledger’s Incentive-Based Compensation Arrangement Risk Management and Controls and Governance Recordkeeping Mr. Ticker: Forfeiture and Downward Adjustment Review IV. Request for Comments V. Regulatory Analysis A. Regulatory Flexibility Act B. Paperwork Reduction Act C. The Treasury and General Government Appropriations Act, 1999—Assessment of Federal Regulations and Policies on Families D. Riegle Community Development and Regulatory Improvement Act of 1994 E. Solicitation of Comments on Use of Plain Language F. OCC Unfunded Mandates Reform Act of 1995 Determination G. Differences Between the Federal Home Loan Banks and the Enterprises H. NCUA Executive Order 13132 Determination I. SEC Economic Analysis J. Small Business Regulatory Enforcement Fairness Act List of Subjects I. Introduction Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the ‘‘Dodd-Frank Act’’ or the ‘‘Act’’) 1 requires the Agencies to jointly prescribe regulations or guidelines with respect to incentive-based compensation practices at certain financial institutions (referred to as ‘‘covered financial 1 Public E:\FR\FM\10JNP2.SGM Law 111–203, 124 Stat. 1376 (2010). 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 institutions’’).2 Specifically, section 956 of the Dodd-Frank Act (‘‘section 956’’) requires that the Agencies prohibit any types of incentive-based compensation 3 arrangements, or any feature of any such arrangements, that the Agencies determine encourage inappropriate risks by a covered financial institution: (1) By providing an executive officer, employee, director, or principal shareholder of the covered financial institution with excessive compensation, fees, or benefits; or (2) that could lead to material financial loss to the covered financial institution. Under the Act, a covered financial institution also must disclose to its appropriate Federal regulator the structure of its incentive-based compensation arrangements sufficient to determine whether the structure provides excessive compensation, fees, or benefits or could lead to material financial loss to the institution. The Dodd-Frank Act does not require a covered financial institution to report the actual compensation of particular individuals. The Act defines ‘‘covered financial institution’’ to include any of the following types of institutions that have $1 billion or more in assets: (A) A depository institution or depository institution holding company, as such terms are defined in section 3 of the Federal Deposit Insurance Act (‘‘FDIA’’) (12 U.S.C. 1813); (B) a broker-dealer registered under section 15 of the Securities Exchange Act of 1934 (15 U.S.C. 78o); (C) a credit union, as described in section 19(b)(1)(A)(iv) of the Federal Reserve Act; (D) an investment adviser, as such term is defined in section 202(a)(11) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–2(a)(11)); (E) the Federal National Mortgage Association (Fannie Mae); (F) the Federal Home Loan Mortgage Corporation (Freddie Mac); and (G) any other financial institution that the appropriate Federal regulators, jointly, by rule, determine should be treated as a covered financial institution for these purposes. The Act also requires that any compensation standards adopted under section 956 be comparable to the safety and soundness standards applicable to insured depository institutions under 2 12 U.S.C. 5641. 956(b) uses the term ‘‘incentive-based payment arrangement.’’ It appears that Congress used the terms ‘‘incentive-based payment arrangement’’ and ‘‘incentive-based compensation arrangement’’ interchangeably. The Agencies have chosen to use the term ‘‘incentive-based compensation arrangement’’ throughout the proposed rule and this SUPPLEMENTARY INFORMATION section for the sake of clarity. 3 Section VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 section 39 of the FDIA 4 and that the Agencies take the compensation standards described in section 39 of the FDIA into consideration in establishing compensation standards under section 956.5 As explained in greater detail below, the standards established by the proposed rule are comparable to the standards established under section 39 of the FDIA. In April 2011, the Agencies published a joint notice of proposed rulemaking that proposed to implement section 956 (2011 Proposed Rule).6 Since the 2011 Proposed Rule was published, incentive-based compensation practices have evolved in the financial services industry. The Board, the OCC, and the FDIC have gained experience in applying guidance on incentive-based compensation,7 FHFA has gained supervisory experience in applying compensation-related rules 8 adopted under the authority of the Safety and Soundness Act,9 and foreign jurisdictions have adopted incentivebased compensation remuneration codes, regulations, and guidance.10 In 4 12 U.S.C. 1831p–1. The OCC, Board, and FDIC (collectively, the ‘‘Federal Banking Agencies’’) each have adopted guidelines implementing the compensation-related and other safety and soundness standards in section 39 of the FDIA. See Interagency Guidelines Establishing Standards for Safety and Soundness (the ‘‘Federal Banking Agency Safety and Soundness Guidelines’’), 12 CFR part 30, Appendix A (OCC); 12 CFR part 208, Appendix D–1 (Board); 12 CFR part 364, Appendix A (FDIC). 5 12 U.S.C. 1831p–1(c). 6 76 FR 21170 (April 14, 2011). 7 OCC, Board, FDIC, and Office of Thrift Supervision, ‘‘Guidance on Sound Incentive Compensation Policies’’ (‘‘2010 Federal Banking Agency Guidance’’), 75 FR 36395 (June 25, 2010). 8 These include the Executive Compensation Rule (12 CFR part 1230), the Golden Parachute Payments Rule (12 CFR part 1231), and the Federal Home Loan Bank Directors’ Compensation and Expenses Rule (12 CFR part 1261 subpart C). 9 The Safety and Soundness Act means the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, as amended (12 U.S.C. 4501 et seq.). 12 CFR 1201.1. 10 See, e.g., the European Union, Directive 2013/ 36/EU (effective January 1, 2014); United Kingdom Prudential Regulation Authority (‘‘PRA’’) and Financial Conduct Authority (‘‘FCA’’), ‘‘PRA PS12/ 15/FCA PS15/16: Strengthening the Alignment of Risk and Reward: New Remuneration Rules’’ (June 25, 2015) (‘‘UK Remuneration Rules’’), available at https://www.bankofengland.co.uk/pra/Documents/ publications/ps/2015/ps1215.pdf; Australian Prudential Regulation Authority (‘‘APRA’’), Prudential Practice Guide SPG 511—Remuneration (November 2013), available at https:// www.apra.gov.au/Super/Documents/PrudentialPractice-Guide-SPG-511-Remuneration.pdf; Canada, The Office of the Superintendent of Financial Institutions (‘‘OSFI’’) Corporate Governance Guidelines (January 2013) (‘‘OSFI Corporate Governance Guidelines’’), available at https:// www.osfi-bsif.gc.ca/eng/fi-if/rg-ro/gdn-ort/gl-ld/ pages/cg_guideline.aspx and Supervisory Framework (December 2010) (‘‘OSFI Supervisory Framework’’), available at https://www.osfibsif.gc.ca/Eng/Docs/sframew.pdf; Switzerland, PO 00000 Frm 00005 Fmt 4701 Sfmt 4702 37673 light of these developments and the comments received on the 2011 Proposed Rule, the Agencies are publishing a new proposed rule to implement section 956. The first part of this SUPPLEMENTARY INFORMATION section provides background information on the proposed rule, including a summary of the 2011 Proposed Rule and areas in which the proposed rule differs from the 2011 Proposed Rule. The second part contains a section-by-section description of the proposed rule.11 To help explain how the requirements of the proposed rule would work in practice, the Appendix to this SUPPLEMENTARY INFORMATION section sets out an example of an incentive-based compensation arrangement for a hypothetical senior executive officer at a hypothetical large banking organization and an example of how a forfeiture and downward adjustment review might be conducted for a senior manager at a hypothetical large banking organization. For ease of reference, the proposed rules of the Agencies are referenced in this SUPPLEMENTARY INFORMATION section using a common designation of section ll.1 to section ll.14 (excluding the title and part designations for each agency). Each agency would codify its rule, if adopted, within its respective title of the Code of Federal Regulations.12 A. Background Incentive-based compensation arrangements are critical tools in the management of financial institutions. These arrangements serve several important objectives, including attracting and retaining skilled staff and promoting better performance of the institution and individual employees. Well-structured incentive-based compensation arrangements can promote the health of a financial institution by aligning the interests of executives and employees with those of Financial Market Supervisory Authority (‘‘FINMA’’), 2010/01 FINMA Circular on Remuneration Schemes (October 2009) (‘‘FINMA Remuneration Circular’’), available at https:// www.finma.ch/en/documentation/circulars/ #Order=2. 11 This section-by-section description also includes certain examples of how the proposed rule would work in practice. These examples are intended solely for purposes of illustration and do not cover every aspect of the proposed rule. They are provided as an aid to understanding the proposed rule and do not carry the force and effect of law or regulation. 12 Specifically, the Agencies propose to codify the rules as follows: 12 CFR part 42 (OCC); 12 CFR part 236 (the Board); 12 CFR part 372 (FDIC); 17 CFR part 303 (SEC); 12 CFR parts 741 and 751 (NCUA); and 12 CFR part 1232 (FHFA). E:\FR\FM\10JNP2.SGM 10JNP2 37674 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 the institution’s shareholders and other stakeholders. At the same time, poorly structured incentive-based compensation arrangements can provide executives and employees with incentives to take inappropriate risks that are not consistent with the longterm health of the institution and, in turn, the long-term health of the U.S. economy. Larger financial institutions in particular are interconnected with one another and with many other companies and markets, which can mean that any negative impact from inappropriate risk-taking can have broader consequences. The risk of these negative externalities may not be fully taken into account in incentive-based compensation arrangements, even arrangements that otherwise align the interests of shareholders and other stakeholders with those of executives and employees. There is evidence that flawed incentive-based compensation practices in the financial industry were one of many factors contributing to the financial crisis that began in 2007. Some compensation arrangements rewarded employees—including non-executive personnel like traders with large position limits, underwriters, and loan officers—for increasing an institution’s revenue or short-term profit without sufficient recognition of the risks the employees’ activities posed to the institutions, and therefore potentially to the broader financial system.13 Traders with large position limits, underwriters, and loan officers are three examples of non-executive personnel who had the ability to expose an institution to material amounts of risk. Significant losses caused by actions of individual traders or trading groups occurred at some of the largest financial institutions during and after the financial crisis.14 13 See, e.g., Financial Crisis Inquiry Commission, ‘‘Financial Crisis Inquiry Report’’ (January 2011), at 209, 279, 291, 343, available at https:// www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPOFCIC.pdf; Senior Supervisors Group, ‘‘Observations on Risk Management Practices during the Recent Market Turbulence’’ (March 6, 2008), available at https://www.newyorkfed.org/medialibrary/media/ newsevents/news/banking/2008/SSG_Risk_Mgt_ doc_final.pdf. 14 A large financial institution suffered losses in 2012 from trading by an investment office in its synthetic credit portfolio. These losses amounted to approximately $5.8 billion, which was approximately 3.6 percent of the holding company’s tier 1 capital. https://www.sec.gov/Archives/edgar/ data/19617/000001961713000221/0000019617-13000221-index.htm Form 10–K 2013, Pages 69 and 118. In 2007, a proprietary trading group at another large institution caused losses of an estimated $7.8 billion (approximately 25 percent of the firm’s total stockholder’s equity). https:// www.morganstanley.com/about-us-ir/shareholder/ 10k113008/10k1108.pdf Form 10–K 2008, Pages 45 and 108. Between 2005 and 2008, one futures trader VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 Of particular note were incentivebased compensation arrangements for employees in a position to expose the institution to substantial risk that failed to align the employees’ interests with those of the institution. For example, some institutions gave loan officers incentives to write a large amount of loans or gave traders incentives to generate high levels of trading revenues, without sufficient regard for the risks associated with those activities. The revenues that served as the basis for calculating bonuses were generated immediately, while the risk outcomes might not have been realized for months or years after the transactions were completed. When these, or similarly misaligned incentive-based compensation arrangements, are common in an institution, the foundation of sound risk management can be undermined by the actions of employees seeking to maximize their own compensation. The effect of flawed incentive-based compensation practices is demonstrated by the arrangements implemented by Washington Mutual (WaMu). According to the Senate Permanent Subcommittee on Investigations Staff’s report on the failure of WaMu ‘‘[l]oan officers and processors were paid primarily on volume, not primarily on the quality of their loans, and were paid more for issuing higher risk loans. Loan officers and mortgage brokers were also paid more when they got borrowers to pay higher interest rates, even if the borrower qualified for a lower rate—a practice that enriched WaMu in the short term, but made defaults more likely down the road.’’ 15 at a large financial institution engaged in activities that caused losses of an estimated EUR4.9 billion in 2007, which was approximately 23 percent of the firm’s 2007 tier 1 capital. https:// www.societegenerale.com/sites/default/files/ 03%20March%202008%202008%20 Registration%20Document.pdf, Pages, 52, 159–160; https://www.societegenerale.com/sites/default/files/ 12%20May%202008%20The%20report%20by %20the%20General%20Inspection%20of%20 Societe%20Generale.pdf, Pages 1–71. In 2011, one trader at another large financial institution caused losses of an estimated $2.25 billion, which represented approximately 5.4 percent of the firm’s tier 1 capital. https://www.fca.org.uk/news/pressreleases/fca-bans-kweku-mawuli-adoboli-from-thefinancial-services-industry, Page 1; https:// www.ubs.com/global/en/about_ubs/investor_ relations/other_filings/sec.html. 2012 SEC Form 20– F, Page 34. In 2007, one trader caused losses of an estimated $264 million at a large financial institution, which represented approximately 1.7 percent of its tier 1 capital. https:// www.federalreserve.gov/newsevents/press/ enforcement/20081118a.htm, Page 1; https:// www.bmo.com/ci/ar2008/downloads/bmo_ ar2008.pdf, Page 61. 15 Staff of S. Permanent Subcomm. on Investigations, Wall Street and the Financial Crisis: Anatomy of a Financial Collapse at 143 (Comm. Print 2011). PO 00000 Frm 00006 Fmt 4701 Sfmt 4702 Flawed incentive-based compensation arrangements were evident in not just U.S. financial institutions, but also major financial institutions worldwide.16 In a 2009 survey of banking organizations engaged in wholesale banking activities, the Institute of International Finance found that 98 percent of respondents recognized the contribution of incentive-based compensation practices to the financial crisis.17 Shareholders and other stakeholders in a covered institution 18 have an interest in aligning the interests of executives, managers, and other employees with the institution’s longterm health. However, aligning the interests of shareholders (or members, in the case of credit unions, mutual savings associations, mutual savings banks, some mutual holding companies, and Federal Home Loan Banks) and other stakeholders with employees may not always be sufficient to protect the safety and soundness of an institution, deter excessive compensation, or deter behavior or inappropriate risk-taking that could lead to material financial loss at the institution. Executive officers and employees of a covered institution may be willing to tolerate a degree of risk that is inconsistent with the interests of stakeholders, as well as broader public policy goals. Generally, the incentive-based compensation arrangements of a covered institution should reflect the interests of the shareholders and other stakeholders, to the extent that the incentive-based compensation makes those covered persons demand more or less reward for their risk-taking at the covered institution, and to the extent that incentive-based compensation 16 See Financial Stability Forum, ‘‘FSF Principles for Sound Compensation Practices’’ (April 2009) (the ‘‘FSB Principles’’), available at https:// www.financialstabilityboard.org/publications/r_ 0904b.pdf; Senior Supervisors Group, ‘‘Riskmanagement Lessons from the Global Banking Crisis of 2008’’ (October 2009), available at https:// www.newyorkfed.org/newsevents/news/banking/ 2009/ma091021.html. The Financial Stability Forum was renamed the Financial Stability Board (‘‘FSB’’) in April 2009. 17 See Institute of International Finance, Inc., ‘‘Compensation in Financial Services: Industry Progress and the Agenda for Change’’ (March 2009), available at https://www.oliverwyman.com/ow/pdf_ files/OW_En_FS_Publ_2009_ CompensationInFS.pdf. See also UBS, ‘‘Shareholder Report on UBS’s Write-Downs,’’ (April 18, 2008), at 41–42 (identifying incentive effects of UBS compensation practices as contributing factors in losses suffered by UBS due to exposure to the subprime mortgage market), available at https:// www.ubs.com/1/ShowMedia/investors/ agm?contentId=140333&name=080418Shareholder Report.pdf. 18 As discussed below, the proposed rule uses the term ‘‘covered institution’’ rather than the statutory term ‘‘covered financial institution.’’ E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 changes those covered persons’ risktaking. However, risks undertaken by a covered institution—particularly a larger institution—can spill over into the broader economy, affecting other institutions and stakeholders. Therefore, there may be reasons why the preferences of all of the stakeholders are not fully reflected in incentive-based compensation arrangements. Hence, there is a public interest in curtailing the inappropriate risk-taking incentives provided by incentive-based compensation arrangements. Without restrictions on incentive-based compensation arrangements, covered institutions may engage in more risktaking than is optimal from a societal perspective, suggesting that regulatory measures may be required to cut back on the risk-taking incentivized by such arrangements. Particularly at larger institutions, shareholders and other stakeholders may have difficulty effectively monitoring and controlling the impact of incentive-based compensation arrangements throughout the institution that may affect the institution’s risk profile, the full range of stakeholders, and the larger economy. As a result, supervision and regulation of incentive-based compensation can play an important role in helping safeguard covered institutions against incentive-based compensation practices that threaten safety and soundness, are excessive, or could lead to material financial loss. In particular, such supervision and regulation can help address the negative externalities affecting the broader economy or other institutions that may arise from inappropriate risk-taking by large financial institutions. B. Supervisory Experience To address such practices, the Federal Banking Agencies proposed, and then later adopted, the 2010 Federal Banking Agency Guidance governing incentivebased compensation programs, which applies to all banking organizations regardless of asset size. This Guidance uses a principles-based approach to ensure that incentive-based compensation arrangements appropriately tie rewards to longer-term performance and do not undermine the safety and soundness of banking organizations or create undue risks to the financial system. In addition, to foster implementation of improved incentive-based compensation practices, the Board, in cooperation with the OCC and FDIC, initiated in late 2009 a multidisciplinary, horizontal review (‘‘Horizontal Review’’) of incentivebased compensation practices at 25 large, complex banking organizations, VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 which is still ongoing.19 One goal of the Horizontal Review is to help improve the Federal Banking Agencies’ understanding of the range and evolution of incentive-based compensation practices across institutions and categories of employees within institutions. The second goal is to provide guidance to each institution in implementing the 2010 Federal Banking Agency Guidance. The supervisory experience of the Federal Banking Agencies in this area is also relevant to the incentive-based compensation practices at brokerdealers and investment advisers. As part of the Horizontal Review, the Board conducted reviews of line of business operations in the areas of trading, mortgage, credit card, and commercial lending operations as well as senior executive incentive-based compensation awards and payouts. The institutions subject to the Horizontal Review have made progress in developing practices that would incorporate the principles of the 2010 Federal Banking Agency Guidance into their risk management systems, including through better recognition of risk in incentive-based compensation decision-making and improved practices to better balance risk and reward. Many of those changes became evident in the actual compensation arrangements of the institutions as the review progressed. In 2011, the Board made public its initial findings from the Horizontal Review, recognizing the steps the institutions had made towards improving their incentive-based compensation practices, but also noting that each institution needed to do more.20 In early 2012, the Board initiated a second, cross-firm review of 12 additional large banking organizations (‘‘2012 LBO Review’’). The Board also monitors incentivebased compensation as part of ongoing supervision. Supervisory oversight 19 The financial institutions in the Horizontal Review are Ally Financial Inc.; American Express Company; Bank of America Corporation; The Bank of New York Mellon Corporation; Capital One Financial Corporation; Citigroup Inc.; Discover Financial Services; The Goldman Sachs Group, Inc.; JPMorgan Chase & Co.; Morgan Stanley; Northern Trust Corporation; The PNC Financial Services Group, Inc.; State Street Corporation; SunTrust Banks, Inc.; U.S. Bancorp; and Wells Fargo & Company; and the U.S. operations of Barclays plc, BNP Paribas, Credit Suisse Group AG, Deutsche Bank AG, HSBC Holdings plc, Royal Bank of Canada, The Royal Bank of Scotland Group plc, Societe Generale, and UBS AG. 20 Board, ‘‘Incentive Compensation Practices: A Report on the Horizontal Review of Practices at Large Banking Organizations’’ (October 2011) (‘‘2011 FRB White Paper), available at https:// www.federalreserve.gov/publications/other-reports/ files/incentive-compensation-practices-report201110.pdf. PO 00000 Frm 00007 Fmt 4701 Sfmt 4702 37675 focuses most intensively on large banking organizations because they are significant users of incentive-based compensation and because flawed approaches at these organizations are more likely to have adverse effects on the broader financial system. As part of that supervision, the Board also conducts targeted incentive-based compensation exams and considers incentive-based compensation in the course of wider line of business and risk-related reviews. For the past several years, the Board also has been actively engaged in international compensation, governance, and conduct working groups that have produced a variety of publications aimed at further improving incentive-based compensation practices.21 The FDIC reviews incentive-based compensation practices as part of its safety and soundness examinations of state nonmember banks, most of which are smaller community institutions that would not be covered by the proposed rule. FDIC incentive-based compensation reviews are conducted in the context of the 2010 Federal Banking Agency Guidance and Section 39 of the FDIA. Of the 518 bank failures resolved by the FDIC between 2007 and 2015, 65 involved banks with total assets of $1 billion or more that would have been covered by the proposed rule. Of the 65 institutions that failed with total assets of $1 billion or more, 18 institutions or approximately 28 percent, were identified as having some level of issues or concerns related to compensation arrangements, many of which involved incentive-based compensation. Overall, most of the compensation issues related to either excessive compensation or tying financial incentives to metrics such as corporate performance or loan production without adequate consideration of related risks. Also, several cases involved poor governance practices, most commonly, dominant 21 See, e.g., FSB Principles; FSB, ‘‘FSB Principles for Sound Compensation Practices: Implementation Standards, Basel, Switzerland’’ (September 2009), available at https://www.fsb.org/wp-content/ uploads/r_090925c.pdf?page_moved=1 (together with the FSB Principles, the ‘‘FSB Principles and Implementation Standards’’); Basel Committee on Banking Supervision, ‘‘Report on Range of Methodologies for Risk and Performance Alignment of Remuneration’’ (May 2011); Basel Committee on Banking Supervision, ‘‘Principles for the Effective Supervision of Financial Conglomerates’’ (September 2012); FSB, ‘‘Implementing the FSB Principles for Sound Compensation Practices and their Implementation Standards—First, Second, Third, and Fourth Progress Reports’’ (June 2012, August 2013, November 2014, November 2015), available at https://www.fsb.org/publications/ ?policy_area%5B%5D=24. E:\FR\FM\10JNP2.SGM 10JNP2 37676 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 management influencing improper incentives.22 The OCC reviews and assesses compensation practices at individual banks as part of its normal supervisory activities. For example, the OCC identifies matters requiring attention (MRAs) relating to compensation practices, including matters relating to governance and risk management and controls for compensation. The OCC’s Guidelines Establishing Heightened Standards for Certain Large Insured National Banks, Insured Federal Savings Associations, and Insured Federal Branches 23 (the ‘‘OCC’s Heightened Standards’’) require covered banks to establish and adhere to compensation programs that prohibit incentive-based payment arrangements that encourage inappropriate risks by providing excessive compensation or that could lead to material financial loss. The OCC includes an assessment of the banks’ compensation practices when determining compliance with the OCC’s Heightened Standards. In addition to safety and soundness oversight, FHFA has express statutory authorities and mandates related to compensation paid by its regulated entities. FHFA reviews compensation arrangements before they are implemented at Fannie Mae, Freddie Mac, the Federal Home Loan Banks, and the Office of Finance of the Federal Home Loan Bank System. By statute, FHFA must prohibit its regulated entities from providing compensation to any executive officer of a regulated entity that is not reasonable and comparable with compensation for employment in other similar businesses (including publicly held financial institutions or major financial services companies) involving similar duties and responsibilities.24 FHFA also has additional authority over the Enterprises during conservatorship, and has established compensation programs for Enterprise executives.25 22 The Inspector General of the appropriate federal banking agency must conduct a Material Loss Review (‘‘MLR’’) when losses to the Deposit Insurance Fund from failure of an insured depository institution exceed certain thresholds. See FDIC MLRs, available at https:// www.fdicig.gov/mlr.shtml; Board MLRs available at https://oig.federalreserve.gov/reports/auditreports.htm; and OCC MLRs, available at https:// www.treasury.gov/about/organizational-structure/ ig/Pages/audit_reports_index.aspx. See also the Subcommittee Report. 23 12 CFR part 30, appendix D. 24 12 U.S.C. 4518(a). 25 As conservator, FHFA succeeded to all rights, titles, powers and privileges of the Enterprises, and of any shareholder, officer or director of each company with respect to the company and its assets. The Enterprises have been under conservatorship since September 2008. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 In early 2014, FHFA issued two final rules related to compensation pursuant to its authority over compensation under the Safety and Soundness Act.26 The Executive Compensation Rule sets forth requirements and processes with respect to compensation provided to executive officers by the Enterprises, the Federal Home Loan Banks, and the Federal Home Loan Bank System’s Office of Finance.27 Under the rule, those entities may not enter into an incentive plan with an executive officer or pay any incentive compensation to an executive officer without providing advance notice to FHFA.28 FHFA’s Golden Parachute Payments Rule governs golden parachute payments in the case of a regulated entity’s insolvency, conservatorship, or troubled condition.29 In part because of the work described above, incentive-based compensation practices and the design of incentivebased compensation arrangements at banking organizations supervised by the Federal Banking Agencies have improved significantly in the years since the recent financial crisis. However, the Federal Banking Agencies have continued to evaluate incentivebased compensation practices as a part of their ongoing supervision responsibilities, with a particular focus on the design of incentive-based compensation arrangements for senior executive officers; deferral practices (including compensation at risk through forfeiture and clawback mechanisms); governance and the use of discretion; ex ante risk adjustment; and control function participation in incentivebased compensation design and risk evaluation. The Federal Banking Agencies’ supervision has been focused on ensuring robust risk management and governance practices rather than on prescribing levels of pay. Generally, the supervisory work of the Federal Banking Agencies and FHFA has promoted more risk-sensitive incentive-based compensation practices and effective risk governance. Incentivebased compensation decision-making increasingly leverages underlying risk management frameworks to help ensure better risk identification, monitoring, and escalation of risk issues. Prior to the 26 12 CFR parts 1230 and 1231, under the authority of the Safety and Soundness Act (12 U.S.C. 4518), as amended by the Housing and Economic Recovery Act of 2008. Congress enacted HERA, including new or amended provisions addressing compensation at FHFA’s regulated entities, at least in part in response to the financial crisis that began in 2007. 27 12 CFR part 1230. 28 12 CFR 1230.3(d). 29 12 CFR part 1231. PO 00000 Frm 00008 Fmt 4701 Sfmt 4702 recent financial crisis, many institutions had no effective risk adjustments to incentive-based compensation at all. Today, the Board has observed that incentive-based compensation arrangements at the largest banking institutions reflect risk adjustments, the largest banking institutions take into consideration adverse outcomes, more pay is deferred, and more of the deferred amount is subject to reduction based on failure to meet assigned performance targets or as a result of adverse outcomes that trigger forfeiture and clawback reviews.30 Similarly, prior to the recent financial crisis, institutions rarely involved risk management and control personnel in incentive-based compensation decisionmaking. Today, control functions frequently play an increased role in the design and operation of incentive-based compensation, and institutions have begun to build out frameworks to help validate the effectiveness of risk adjustment mechanisms. Risk-related performance objectives and ‘‘risk reviews’’ are increasingly common. Prior to the recent financial crisis, boards of directors had begun to consider the relationship between incentive-based compensation and risk, but were focused on incentive-based compensation for senior executives. Today, refined policies and procedures promote some consistency and effectiveness across incentive-based compensation arrangements. The role of boards of directors has expanded and the quality of risk information provided to those boards has improved. Finance and audit committees work together with compensation committees with the goal of having incentive-based compensation result in prudent risktaking. Notwithstanding the recent progress, incentive-based compensation practices are still in need of improvement, including better targeting of performance measures and risk metrics to specific activities, more consistent application of risk adjustments, and better documentation of the decisionmaking process. Congress has required the Agencies to jointly prescribe regulations or guidelines that cover not only depository institutions and depository institution holding companies, but also other financial institutions. While the Federal Banking Agencies’ supervisory approach based on the 2010 Federal Banking Agency 30 See generally 2011 FRB White Paper. The 2011 FRB White Paper provides specific examples of how compensation practices at the institutions involved in the Board’s Horizontal Review of Incentive Compensation have changed since the recent financial crisis. E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules Guidance and the work of FHFA have resulted in improved incentive-based compensation practices, there are even greater benefits possible under rulebased supervision. Using their collective supervisory experiences, the Agencies are proposing a uniform set of enforceable standards applicable to a larger group of institutions supervised by all of the Agencies. The proposed rule would promote better incentivebased compensation practices, while still allowing for some flexibility in the design and operation of incentive-based compensation arrangements among the varied institutions the Agencies supervise, including through the tiered application of the proposed rule’s requirements. mstockstill on DSK3G9T082PROD with PROPOSALS2 C. Overview of the 2011 Proposed Rule and Public Comment The Agencies proposed a rule in 2011, rather than guidelines, to establish requirements applicable to the incentive-based compensation arrangements of all covered institutions. The 2011 Proposed Rule would have supplemented existing rules, guidance, and ongoing supervisory efforts of the Agencies. The 2011 Proposed Rule would have prohibited incentive-based compensation arrangements that could encourage inappropriate risks. It would have required compensation practices at regulated financial institutions to be consistent with three key principles— that incentive-based compensation arrangements should appropriately balance risk and financial rewards, be compatible with effective risk management and controls, and be supported by strong corporate governance. The Agencies proposed that financial institutions with $1 billion or more in assets be required to have policies and procedures to ensure compliance with the requirements of the rule, and submit an annual report to their Federal regulator describing the structure of their incentive-based compensation arrangements. The 2011 Proposed Rule included two additional requirements for ‘‘larger financial institutions.’’ 31 The first would have required these larger financial institutions to defer 50 percent of the incentive-based compensation for 31 In the 2011 Proposed Rule, the term ‘‘larger covered financial institution’’ for the Federal Banking Agencies and the SEC meant those covered institutions with total consolidated assets of $50 billion or more. For the NCUA, all credit unions with total consolidated assets of $10 billion or more would have been larger covered institutions. For FHFA, Fannie Mae, Freddie Mac, and all Federal Home Loan Banks with total consolidated assets of $1 billion or more would have been larger covered institutions. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 executive officers for a period of at least three years. The second would have required the board of directors (or a committee thereof) to identify and approve the incentive-based compensation for those covered persons who individually 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, such as traders with large position limits and other individuals who have the authority to place at risk a substantial part of the capital of the covered institution. The Agencies received more than 10,000 comments on the 2011 Proposed Rule, including from private individuals, community groups, several members of Congress, pension funds, labor federations, academic faculty, covered institutions, financial industry associations, and industry consultants. The vast majority of the comments were substantively identical form letters of two types. The first type of form letter urged the Agencies to minimize the incentives for short-term risk-taking by executives by requiring at least a fiveyear deferral period for executive bonuses at big banks, banning executives’ hedging of their pay packages, and requiring specific details from banks on precisely how they ensure that executives will share in the long-term risks created by their decisions. These commenters also asserted that the final rule should apply to the full range of important financial institutions and cover all the key executives at those institutions. The second type of form letter stated that the commenter or the commenter’s family had been affected by the financial crisis that began in 2007, a major cause of which the commenter believed to be faulty pay practices at financial institutions. These commenters suggested various methods of improving these practices, including basing incentive-based compensation on measures of a financial institution’s safety and stability, such as the institution’s bond price or the spread on credit default swaps. Comments from community groups, members of Congress, labor federations, and pension funds generally urged the Agencies to strengthen the proposed rule and many cited evidence suggesting that flawed incentive-based compensation practices in the financial industry were a major contributing factor to the recent financial crisis. Their suggestions included: Revising the 2011 Proposed Rule’s definition of ‘‘incentive-based compensation’’; defining ‘‘excessive compensation’’; increasing the length of time for or PO 00000 Frm 00009 Fmt 4701 Sfmt 4702 37677 amount of compensation subject to the mandatory deferral provision; requiring financial institutions to include quantitative data in their annual incentive-based compensation reports; providing for the annual public reporting by the Agencies of information quantifying the overall sensitivity of incentive-based compensation to longterm risks at major financial institutions; prohibiting stock ownership by board members; and prohibiting hedging strategies used by highly-paid executives on their own incentive-based compensation. The academic faculty commenters submitted analyses of certain compensation issues and recommendations. These recommendations included: Adopting a corporate governance measure tied to stock ownership by board members; regulating how deferred compensation is reduced at future payment dates; requiring covered institutions’ executives to have ‘‘skin in the game’’ for the entire deferral period; and requiring disclosure of personal hedging transactions rather than prohibiting them. A number of covered institutions and financial industry associations favored the issuance of guidelines instead of rules to implement section 956. Others expressed varying degrees of support for the 2011 Proposed Rule but also requested numerous clarifications and modifications. Many of these commenters raised questions concerning the 2011 Proposed Rule’s scope, suggesting that certain types of institutions be excluded from the coverage of the final rule. Some of these commenters questioned the need for the excessive compensation prohibition or requested that the final rule provide specific standards for determining when compensation is excessive. Many of these commenters also opposed the 2011 Proposed Rule’s mandatory deferral provision, and some asserted that the provision was unsupported by empirical evidence and potentially harmful to a covered institution’s ability to attract and retain key employees. In addition, many of these commenters asserted that the material risk-taker provision in the 2011 Proposed Rule was unclear or imposed on the boards of directors of covered institutions duties more appropriately undertaken by the institutions’ management. Finally, these commenters expressed concerns about the burden and timing of the 2011 Proposed Rule. D. International Developments The Agencies considered international developments in E:\FR\FM\10JNP2.SGM 10JNP2 37678 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 developing the 2011 Proposed Rule, mindful that some covered institutions operate in both domestic and international competitive environments.32 Since the release of the 2011 Proposed Rule, a number of foreign jurisdictions have introduced new compensation regulations that require certain financial institutions to meet certain standards in relation to compensation policies and practices. In June 2013, the European Union adopted the Capital Requirements Directive (‘‘CRD’’) IV, which sets out requirements for compensation structures, policies, and practices that apply to all banks and investment firms subject to the CRD.33 The rules require that up to 100 percent of the variable remuneration shall be subject to malus 34 or clawback arrangements, among other requirements.35 The PRA’s and the FCA’s Remuneration Code requires covered companies to defer 40 to 60 percent of a covered person’s variable remuneration—and recently updated their implementing regulations to extend deferral periods to seven years for senior executives and to five years for certain other covered persons.36 The PRA also implemented, in July 2014, a policy requiring firms to set specific criteria for the application of malus and clawback. The PRA’s clawback policy requires that variable remuneration be subject to clawback for a period of at least seven years from the date on which it is awarded.37 32 See 76 FR at 21178. See, e.g., FSB Principles and Implementation Standards. 33 Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 (effective January 1, 2014). The remuneration rules in CRD IV were carried over from CRD III with a few additional requirements. CRD III directed the Committee of European Bank Supervisors (‘‘CEBS’’), now the European Banking Authority (‘‘EBA’’), to develop guidance on how it expected the compensation principles under CRD III to be implemented. See CEBS Guidelines on Remuneration Policies and Practices (December 10, 2010) (‘‘CEBS Guidelines’’), available at https://eurlex.europa.eu/legal-content/EN/TXT/PDF/?uri= CELEX:32010L0076&from=EN. 34 Malus is defined by the European Union as ‘‘an arrangement that permits the institution to prevent vesting of all or part of the amount of a deferred remuneration award in relation to risk outcomes or performance.’’ See, PRA expectations regarding the application of malus to variable remuneration— SS2/13 UPDATE, available at: https://www.bankof england.co.uk/pra/Documents/publications/ss/ 2015/ss213update.pdf. 35 CRD IV provides that at least 50 percent of total variable remuneration should consist of equitylinked interests and at least 40 percent of any variable remuneration must be deferred over a period of three to five years. In the case of variable remuneration of a particularly high amount, the minimum amount required to be deferred is increased to 60 percent. 36 See UK Remuneration Rules. 37 See PRA, ‘‘PRA PS7/14: Clawback’’ (July 2014), available at https://www.bankofengland.co.uk/pra/ Pages/publications/ps/2014/ps714.aspx. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 Also in 2013, the EBA finalized the process and criteria for the identification of categories of staff who have a material impact on the institution’s risk profile (‘‘Identified Staff’’).38 These Identified Staff are subject to provisions related, in particular, to the payment of variable compensation. The standards cover remuneration packages for Identified Staff categories and aim to ensure that appropriate incentives for prudent, long-term oriented risk-taking are provided. The criteria used to determine who is identified are both qualitative (i.e., related to the role and decisionmaking authority of staff members) and quantitative (i.e., related to the level of total gross remuneration in absolute or in relative terms). More recently, in December 2015, the EBA released its final Guidelines on Sound Remuneration Policies.39 The final Guidelines on Sound Remuneration Policies set out the governance process for implementing sound compensation policies across the European Union under CRD IV, as well as the specific criteria for categorizing all compensation components as either fixed or variable pay. The final Guidelines on Sound Remuneration Policies also provide guidance on the application of deferral arrangements and pay-out instruments to ensure that variable pay is aligned with an institution’s long-term risks and that any ex-post risk adjustments can be applied as appropriate. These Guidelines will apply as of January 1, 2017, and will replace the Guidelines on Remuneration Policies and Practices that were published by the CEBS in December 2010. Other regulators, including those in Canada, Australia, and Switzerland, have taken either a guidance-based approach to the supervision and regulation of incentive-based compensation or an approach that combines guidance and regulation that 38 EBA Regulatory Technical Standards on criteria to identify categories of staff whose professional activities have a material impact on an institution’s risk profile under Article 94(2) of Directive 2013/36/EU. Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 (December 16, 2013), available at https:// www.eba.europa.eu/documents/10180/526386/ EBA-RTS-2013-11+%28On+identified+ staff%29.pdf/c313a671-269b-45be-a748-29e1c 772ee0e. 39 EBA, ‘‘Guidelines for Sound Remuneration Policies under Articles 74(3) and 75(2) of Directive 2013/36/EU and Disclosures under Article 450 of Regulation (EU) No 575/2013’’ (December 21, 2015) (‘‘EBA Remuneration Guidelines’’), available at https://www.eba.europa.eu/documents/10180/ 1314839/EBA-GL-2015-22+Guidelines+ on+Sound+Remuneration+Policies.pdf/1b0f3f99f913-461a-b3e9-fa0064b1946b. PO 00000 Frm 00010 Fmt 4701 Sfmt 4702 is generally consistent with the FSB Principles and Implementation Standards. In Australia,40 all deposittaking institutions and insurers are expected to comply in full with all the requirements in the APRA’s Governance standard (which includes remuneration provisions). APRA also supervises according to its Remuneration Prudential Practice Guide (guidance). In Canada,41 all federally regulated financial institutions (domestic and foreign) are expected to comply with the FSB Principles and Implementation Standards, and the six Domestic Systemically Important Banks and three largest life insurance companies are expected to comply with the FSB’s Principles and Implementation Standards. OSFI has also issued a Corporate Governance Guideline that contain compensation provisions.42 Switzerland’s Swiss Financial Markets Supervisory Authority has also published a principles-based rule on remuneration consistent with the FSB Principles and Implementation Standards that applies to major banks and insurance companies.43 As compensation practices continue to evolve, the Agencies recognize that international coordination in this area is important to ensure that internationally active financial organizations are subject to consistent requirements. For this reason, the Agencies will continue to work with their domestic and international counterparts to foster sound compensation practices across the financial services industry. Importantly, the proposed rule is consistent with the FSB Principles and Implementation Standards. E. Overview of the Proposed Rule The Agencies are re-proposing a rule, rather than proposing guidelines, to establish general requirements applicable to the incentive-based compensation arrangements of all covered institutions. Like the 2011 Proposed Rule, the proposed rule would prohibit incentive-based compensation arrangements at covered institutions that could encourage inappropriate risks by providing excessive compensation or that could lead to a material financial 40 See APRA, ‘‘Prudential Standard CPS 510 Governance’’ (January 2015), available at https:// www.apra.gov.au/CrossIndustry/Documents/FinalPrudential-Standard-CPS-510-Governance%28January-2014%29.pdf; APRA, Prudential Practice Guide PPG 511—Remuneration (November 30, 2009), available at https://www.apra.gov.au/adi/ PrudentialFramework/Pages/adi-prudentialframework.aspx. 41 See OSFI Corporate Governance Guidelines and OSFI Supervisory Framework. 42 See OSFI Corporate Governance Guidelines. 43 See FINMA Remuneration Circular. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules loss. However, the proposed rule reflects the Agencies’ collective supervisory experiences since they proposed the 2011 Proposed Rule. These supervisory experiences, which are described above, have allowed the Agencies to propose a rule that incorporates practices that financial institutions and foreign regulators have adopted to address the deficiencies in incentive-based compensation practices that helped contribute to the financial crisis that began in 2007. For that reason, the proposed rule differs in some respects from the 2011 Proposed Rule. This section provides a general overview of the proposed rule and highlights areas in which the proposed rule differs from the 2011 Proposed Rule. A more detailed, section-bysection description of the proposed rule and the reasons for the proposed rule’s requirements is provided later in this SUPPLEMENTARY INFORMATION section. Scope and Initial Applicability. Similar to the 2011 Proposed Rule, the proposed rule would apply to any covered institution with average total consolidated assets greater than or equal to $1 billion that offers incentive-based compensation to covered persons. The compliance date of the proposed rule would be no later than the beginning of the first calendar quarter that begins at least 540 days after a final rule is published in the Federal Register. The proposed rule would not apply to any incentive-based compensation plan with a performance period that begins before the compliance date. Definitions. The proposed rule includes a number of new definitions that were not included in the 2011 Proposed Rule. These definitions are described later in the section-by-section analysis in this Supplementary Information section. Notably, the Agencies have added a definition of significant risk-taker, which is intended to include individuals who are not senior executive officers but who are in the position to put a Level 1 or Level 2 covered institution at risk of material financial loss. This definition is explained in more detail below. Applicability. The proposed rule distinguishes covered institutions by asset size, applying less prescriptive incentive-based compensation program requirements to the smallest covered institutions within the statutory scope and progressively more rigorous requirements to the larger covered institutions. Although the 2011 Proposed Rule contained specific requirements for covered financial institutions with at least $50 billion in total consolidated assets, the proposed VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 rule creates an additional category of institutions with at least $250 billion in average total consolidated assets. These larger institutions are subject to the most rigorous requirements under the proposed rule. The proposed rule identifies three categories of covered institutions based on average total consolidated assets: 44 • Level 1 (greater than or equal to $250 billion); • Level 2 (greater than or equal to $50 billion and less than $250 billion); and • Level 3 (greater than or equal to $1 billion and less than $50 billion).45 Upon an increase in average total consolidated assets, a covered institution would be required to comply with any newly applicable requirements under the proposed rule no later than the first day of the first calendar quarter that begins at least 540 days after the date on which the covered institution becomes a Level 1, Level 2, or Level 3 covered institution. The proposed rule would grandfather any incentive-based compensation plan with a performance period that begins before such date. Upon a decrease in total consolidated assets, a covered institution would remain subject to the provisions of the proposed rule that applied to it before the decrease until total consolidated assets fell below $250 billion, $50 billion, or $1 billion, as applicable, for four consecutive regulatory reports (e.g., Call Reports). A covered institution under the Board’s, the OCC’s, or the FDIC’s proposed rule that is a subsidiary of another covered institution under the Board’s, the OCC’s, or the FDIC’s proposed rule, respectively, may meet any requirement of the Board’s, OCC’s, or the FDIC’s proposed rule if the parent covered institution complies with that requirement in such a way that causes the relevant portion of the incentivebased compensation program of the 44 For covered institutions that are subsidiaries of other covered institutions, levels would generally be determined by reference to the average total consolidated assets of the top-tier parent covered institution. A detailed explanation of consolidation under the proposed rule is included under the heading ‘‘Definitions pertaining to covered institutions’’ below in this Supplementary Information section. 45 As explained later in this Supplementary Information section, the proposed rule includes a reservation of authority that would allow the appropriate Federal regulator of a Level 3 covered institution with average total consolidated assets greater than or equal to $10 billion and less than $50 billion to require the Level 3 covered institution to comply with some or all of the provisions of sections ll.5 and ll.7 through ll.11 of the proposed rule if the agency determines that the complexity of operations or compensation practices of the Level 3 covered institution are consistent with those of a Level 1 or Level 2 covered institution. PO 00000 Frm 00011 Fmt 4701 Sfmt 4702 37679 subsidiary covered institution to comply with that requirement. Requirements and Prohibitions Applicable to All Covered Institutions. Similar to the 2011 Proposed Rule, the proposed rule would prohibit all covered institutions from establishing or maintaining incentive-based compensation arrangements that encourage inappropriate risk by providing covered persons with excessive compensation, fees, or benefits or that could lead to material financial loss to the covered institution. Also consistent with the 2011 Proposed Rule, the proposed rule provides that compensation, fees, and benefits will be considered excessive when amounts paid are unreasonable or disproportionate to the value of the services performed by a covered person, taking into consideration all relevant factors, including: • The combined value of all compensation, fees, or benefits provided to a covered person; • The compensation history of the covered person and other individuals with comparable expertise at the covered institution; • The financial condition of the covered institution; • Compensation practices at comparable institutions, based upon such factors as asset size, geographic location, and the complexity of the covered institution’s operations and assets; • For post-employment benefits, the projected total cost and benefit to the covered institution; and • Any connection between the covered person and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the covered institution. The proposed rule is also similar to the 2011 Proposed Rule in that it provides that an incentive-based compensation arrangement will be considered to encourage inappropriate risks that could lead to material financial loss to the covered institution, unless the arrangement: • Appropriately balances risk and reward; • Is compatible with effective risk management and controls; and • Is supported by effective governance. However, unlike the 2011 Proposed Rule, the proposed rule specifically provides that an incentive-based compensation arrangement would not be considered to appropriately balance risk and reward unless it: • Includes financial and nonfinancial measures of performance; E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37680 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules • Is designed to allow non-financial measures of performance to override financial measures of performance, when appropriate; and • Is subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance. The proposed rule also contains requirements for the board of directors of a covered institution that are similar to requirements included in the 2011 Proposed Rule. Under the proposed rule, the board of directors of each covered institution (or a committee thereof) would be required to: • Conduct oversight of the covered institution’s incentive-based compensation program; • Approve incentive-based compensation arrangements for senior executive officers, including amounts of awards and, at the time of vesting, payouts under such arrangements; and • Approve material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers. The 2011 Proposed Rule contained an annual reporting requirement, which has been replaced by a recordkeeping requirement in the proposed rule. Covered institutions would be required to create annually and maintain for at least seven years records that document the structure of incentive-based compensation arrangements and that demonstrate compliance with the proposed rule. The records would be required to be disclosed to the covered institution’s appropriate Federal regulator upon request. Disclosure and Recordkeeping Requirements for Level 1 and Level 2 Covered Institutions. The proposed rule includes more detailed disclosure and recordkeeping requirements for larger covered institutions than the 2011 Proposed Rule. The proposed rule would require all Level 1 and Level 2 covered institutions to create annually and maintain for at least seven years records that document: (1) The covered institution’s senior executive officers and significant risk-takers, listed by legal entity, job function, organizational hierarchy, and line of business; (2) the incentive-based compensation arrangements for senior executive officers and significant risk-takers, including information on the percentage of incentive-based compensation deferred and form of award; (3) any forfeiture and downward adjustment or clawback reviews and decisions for senior executive officers and significant risk-takers; and (4) any material changes to the covered institution’s incentive- VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 based compensation arrangements and policies. Level 1 and Level 2 covered institutions would be required to create and maintain records in a manner that would allow for an independent audit of incentive-based compensation arrangements, policies, and procedures, and to provide the records described above in such form and frequency as the appropriate Federal regulator requests. Deferral, Forfeiture and Downward Adjustment, and Clawback Requirements for Level 1 and Level 2 Covered Institutions. The proposed rule would require incentive-based compensation arrangements that appropriately balance risk and reward. For Level 1 and Level 2 covered institutions, the proposed rule would require that incentive-based compensation arrangements for certain covered persons include deferral of payments, risk of downward adjustment and forfeiture, and clawback to appropriately balance risk and reward. The 2011 Proposed Rule required deferral for three years of 50 percent of annual incentive-based compensation for executive officers of covered financial institutions with $50 billion or more in total consolidated assets. The proposed rule would apply deferral requirements to significant risk-takers as well as senior executive officers, and, as described below, would require 40, 50, or 60 percent deferral depending on the size of the covered institution and whether the covered person receiving the incentive-based compensation is a senior executive officer or a significant risk-taker. Unlike the 2011 Proposed Rule, the proposed rule would explicitly require a shorter deferral period for incentive-based compensation awarded under a long-term incentive plan. The proposed rule also provides more detailed requirements and prohibitions than the 2011 Proposed Rule with respect to the measurement, composition, and acceleration of deferred incentive-based compensation; the manner in which deferred incentivebased compensation can vest; increases to the amount of deferred incentivebased compensation; and the amount of deferred incentive-based compensation that can be in the form of options. Deferral. Under the proposed rule, the mandatory deferral requirements for Level 1 and Level 2 covered institutions for incentive-based compensation awarded each performance period would be as follows: • A Level 1 covered institution would be required to defer at least 60 percent of a senior executive officer’s ‘‘qualifying incentive-based compensation’’ (as defined in the proposed rule) and 50 percent of a PO 00000 Frm 00012 Fmt 4701 Sfmt 4702 significant risk-taker’s qualifying incentive-based compensation for at least four years. A Level 1 covered institution also would be required to defer for at least two years after the end of the related performance period at least 60 percent of a senior executive officer’s incentive-based compensation awarded under a ‘‘long-term incentive plan’’ (as defined in the proposed rule) and 50 percent of a significant risktaker’s incentive-based compensation awarded under a long-term incentive plan. Deferred compensation may vest no faster than on a pro rata annual basis, and, for covered institutions that issue equity or are subsidiaries of covered institutions that issue equity, the deferred amount would be required to consist of substantial amounts of both deferred cash and equity-like instruments throughout the deferral period. Additionally, if a senior executive officer or significant risk-taker receives incentive-based compensation in the form of options for a performance period, the amount of such options used to meet the minimum required deferred compensation may not exceed 15 percent of the amount of total incentivebased compensation awarded for that performance period. • A Level 2 covered institution would be required to defer at least 50 percent of a senior executive officer’s qualifying incentive-based compensation and 40 percent of a significant risk-taker’s qualifying incentive-based compensation for at least three years. A Level 2 covered institution also would be required to defer for at least one year after the end of the related performance period at least 50 percent of a senior executive officer’s incentive-based compensation awarded under a longterm incentive plan and 40 percent of a significant risk-taker’s incentive-based compensation awarded under a longterm incentive plan. Deferred compensation may vest no faster than on a pro rata annual basis, and, for covered institutions that issue equity or are subsidiaries of covered institutions that issue equity, the deferred amount would be required to consist of substantial amounts of both deferred cash and equity-like instruments throughout the deferral period. Additionally, if a senior executive officer or significant risk-taker receives incentive-based compensation in the form of options for a performance period, the amount of such options used to meet the minimum required deferred compensation may not exceed 15 percent of the amount of total incentivebased compensation awarded for that performance period. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules The proposed rule would also prohibit Level 1 and Level 2 covered institutions from accelerating the payment of a covered person’s deferred incentive-based compensation, except in the case of death or disability of the covered person. Forfeiture and Downward Adjustment. Compared to the 2011 Proposed Rule, the proposed rule provides more detailed requirements for Level 1 and Level 2 covered institutions to reduce (1) incentive-based compensation that has not yet been awarded to a senior executive officer or significant risk-taker, and (2) deferred incentive-based compensation of a senior executive officer or significant risk-taker. Under the proposed rule, ‘‘forfeiture’’ means a reduction of the amount of deferred incentive-based compensation awarded to a person that has not vested. ‘‘Downward adjustment’’ means a reduction of the amount of a covered person’s incentive-based compensation not yet awarded for any performance period that has already begun. The proposed rule would require a Level 1 or Level 2 covered institution to make subject to forfeiture all unvested deferred incentive-based compensation of any senior executive officer or significant risk-taker, including unvested deferred amounts awarded under long-term incentive plans. This forfeiture requirement would apply to all unvested, deferred incentive-based compensation for those individuals, regardless of whether the deferral was required by the proposed rule. Similarly, a Level 1 or Level 2 covered institution would also be required to make subject to downward adjustment all incentive-based compensation amounts not yet awarded to any senior executive officer or significant risk-taker for the current performance period, including amounts payable under long-term incentive plans. A Level 1 or Level 2 covered institution would be required to consider forfeiture or downward adjustment of incentive-based compensation if any of the following adverse outcomes occur: • Poor financial performance attributable to a significant deviation from the covered institution’s risk parameters set forth in the covered institution’s policies and procedures; • Inappropriate risk-taking, regardless of the impact on financial performance; • Material risk management or control failures; • Non-compliance with statutory, regulatory, or supervisory standards resulting in enforcement or legal action brought by a federal or state regulator or agency, or a requirement that the VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 covered institution report a restatement of a financial statement to correct a material error; and • Other aspects of conduct or poor performance as defined by the covered institution. Clawback. In addition to deferral, downward adjustment, and forfeiture, the proposed rule would require a Level 1 or Level 2 covered institution to include clawback provisions in the incentive-based compensation arrangements for senior executive officers and significant risk-takers. The term ‘‘clawback’’ refers to a mechanism by which a covered institution can recover vested incentive-based compensation from a senior executive officer or significant risk-taker if certain events occur. The proposed rule would require clawback provisions that, at a minimum, allow the covered institution to recover incentive-based compensation from a current or former senior executive officer or significant risk-taker for seven years following the date on which such compensation vests, if the covered institution determines that the senior executive officer or significant risk-taker engaged in misconduct that resulted in significant financial or reputational harm to the covered institution, fraud, or intentional misrepresentation of information used to determine the senior executive officer or significant risk-taker’s incentivebased compensation. The 2011 Proposed Rule did not include a clawback requirement. Additional Prohibitions. The proposed rule contains a number of additional prohibitions for Level 1 and Level 2 covered institutions that were not included in the 2011 Proposed Rule. These prohibitions would apply to: • Hedging; • Maximum incentive-based compensation opportunity (also referred to as leverage); • Relative performance measures; and • Volume-driven incentive-based compensation. Risk Management and Controls. The proposed rule’s risk management and controls requirements for large covered institutions are generally more extensive than the requirements contained in the 2011 Proposed Rule. The proposed rule would require all Level 1 and Level 2 covered institutions to have a risk management framework for their incentive-based compensation programs that is independent of any lines of business; includes an independent compliance program that provides for internal controls, testing, monitoring, and training with written policies and procedures; and is commensurate with the size and complexity of the covered PO 00000 Frm 00013 Fmt 4701 Sfmt 4702 37681 institution’s operations. In addition, the proposed rule would require Level 1 and Level 2 covered institutions to: • Provide individuals in control functions with appropriate authority to influence the risk-taking of the business areas they monitor and ensure covered persons engaged in control functions are compensated independently of the performance of the business areas they monitor; and • Provide for independent monitoring of: (1) Incentive-based compensation plans to identify whether the plans appropriately balance risk and reward; (2) events related to forfeiture and downward adjustment and decisions of forfeiture and downward adjustment reviews to determine consistency with the proposed rule; and (3) compliance of the incentive-based compensation program with the covered institution’s policies and procedures. Governance. Unlike the 2011 Proposed Rule, the proposed rule would require each Level 1 or Level 2 covered institution to establish a compensation committee composed solely of directors who are not senior executive officers to assist the board of directors in carrying out its responsibilities under the proposed rule. The compensation committee would be required to obtain input from the covered institution’s risk and audit committees, or groups performing similar functions, and risk management function on the effectiveness of risk measures and adjustments used to balance incentivebased compensation arrangements. Additionally, management would be required to submit to the compensation committee on an annual or more frequent basis a written assessment of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution. The compensation committee would also be required to obtain an independent written assessment from the internal audit or risk management function of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution. Policies and Procedures. The proposed rule would require all Level 1 and Level 2 covered institutions to have policies and procedures that, among other requirements: • Are consistent with the requirements and prohibitions of the proposed rule; E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37682 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules • Specify the substantive and procedural criteria for forfeiture and clawback; • Document final forfeiture, downward adjustment, and clawback decisions; • Specify the substantive and procedural criteria for the acceleration of payments of deferred incentive-based compensation to a covered person; • Identify and describe the role of any employees, committees, or groups authorized to make incentive-based compensation decisions, including when discretion is authorized; • Describe how discretion is exercised to achieve balance; • Require that the covered institution maintain documentation of its processes for the establishment, implementation, modification, and monitoring of incentive-based compensation arrangements; • Describe how incentive-based compensation arrangements will be monitored; • Specify the substantive and procedural requirements of the independent compliance program; and • Ensure appropriate roles for risk management, risk oversight, and other control personnel in the covered institution’s processes for designing incentive-based compensation arrangements and determining awards, deferral amounts, deferral periods, forfeiture, downward adjustment, clawback, and vesting and assessing the effectiveness of incentive-based compensation arrangements in restraining inappropriate risk-taking. These policies and procedures requirements for Level 1 and Level 2 covered institutions are generally more detailed than the requirements in the 2011 Proposed Rule. Indirect Actions. The proposed rule would prohibit covered institutions from doing indirectly, or through or by any other person, anything that would be unlawful for the covered institution to do directly under the proposed rule. This prohibition is similar to the evasion provision contained in the 2011 Proposed Rule. Enforcement. For five of the Agencies, the proposed rule would be enforced under section 505 of the Gramm-LeachBliley Act, as specified in section 956. For FHFA, the proposed rule would be enforced under subtitle C of the Safety and Soundness Act. Conservatorship or Receivership for Certain Covered Institutions. FHFA’s and NCUA’s proposed rules contain provisions that would apply to covered institutions that are managed by a government agency or a governmentappointed agent, or that are in VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 conservatorship or receivership or are limited-life regulated entities under the Safety and Soundness Act or the Federal Credit Union Act.46 A detailed description of the proposed rule and requests for comments are set forth below. II. Section-by-Section Description of the Proposed Rule § ll.1 Authority, Scope and Initial Applicability Section ll.1 provides that the proposed rule is issued pursuant to section 956. The Agencies also have listed applicable additional rulemaking authority in their respective authority citations. The OCC is issuing the proposed rule under its general rulemaking authority, 12 U.S.C. 93a and the Home Owners’ Loan Act, 12 U.S.C. 1461 et seq., its safety and soundness authority under 12 U.S.C. 1818, and its authority to regulate compensation under 12 U.S.C. 1831p–1. The Board is issuing the proposed rule under its safety and soundness authority under section 5136 of the Revised Statutes (12 U.S.C. 24), the Federal Reserve Act (12 U.S.C. 321– 338a), the FDIA (12 U.S.C. 1818), the Bank Holding Company Act (12 U.S.C. 1844(b)), the Home Owners’ Loan Act (12 U.S.C. 1462a and 1467a), and the International Banking Act (12 U.S.C. 3108). The FDIC is issuing the proposed rule under its general rulemaking authority, 12 U.S.C. 1819 Tenth, as well as its general safety and soundness authority under 12 U.S.C. 1818 and authority to regulate compensation under 12 U.S.C. 1831p–1. FHFA is issuing the proposed rule pursuant to its authority under the Safety and Soundness Act (particularly 12 U.S.C. 4511(b), 4513, 4514, 4518, 4526, and ch. 46 subch. III.). NCUA is issuing the proposed rule under its general rulemaking and safety and soundness authorities in the Federal Credit Union Act, 12 U.S.C. 1751 et seq. The SEC is issuing the proposed rule pursuant to its rulemaking authority under the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940 (15 U.S.C. 78q, 78w, 80b–4, and 80b–11). The approach taken in the proposed rule is within the authority granted by section 956. The proposed rule would prohibit types and features of incentive46 The FDIC’s proposed rule would not apply to institutions for which the FDIC is appointed receiver under the FDIA or Title II of the DoddFrank Act, as appropriate, as those statutes govern such cases. PO 00000 Frm 00014 Fmt 4701 Sfmt 4702 based compensation arrangements that encourage inappropriate risks. As explained more fully below, incentivebased compensation arrangements that result in payments that are unreasonable or disproportionate to the value of services performed could encourage inappropriate risks by providing excessive compensation, fees, and benefits. Further, incentive-based compensation arrangements that do not appropriately balance risk and reward, that are not compatible with effective risk management and controls, or that are not supported by effective governance are the types of incentivebased compensation arrangements that could encourage inappropriate risks that could lead to material financial loss to covered institutions. Because these types of incentive-based compensation arrangements encourage inappropriate risks, they would be prohibited under the proposed rule. The Federal Banking Agencies have found that any incentive-based compensation arrangement at a covered institution will encourage inappropriate risks if it does not sufficiently expose the risk-takers to the consequences of their risk decisions over time, and that in order to do this, it is necessary that meaningful portions of incentive-based compensation be deferred and placed at risk of reduction or recovery. The proposed rule reflects the minimums that are required to be effective for that purpose, as well as minimum standards of robust governance, and the disclosures that the statute requires. The Agencies’ position in this respect is informed by the country’s experience in the recent financial crisis, as well as by their experience supervising their respective institutions and their observation of the experience and judgments of regulators in other countries. Consistent with section 956, section ll.1 provides that the proposed rule would apply to a covered institution with average total consolidated assets greater than or equal to $1 billion that offers incentive-based compensation arrangements to covered persons. The Agencies propose the compliance date of the proposed rule to be the beginning of the first calendar quarter that begins at least 540 days after the final rule is published in the Federal Register. Any incentive-based compensation plan with a performance period that begins before such date would not be required to comply with the requirements of the proposed rule. Whether a covered institution is a Level 1, Level 2, or Level 3 covered E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules institution 47 on the compliance date would be determined based on average total consolidated assets as of the beginning of the first calendar quarter that begins after a final rule is published in the Federal Register. For example, if the final rule is published in the Federal Register on November 1, 2016, then the compliance date would be July 1, 2018. In that case, any incentive-based compensation plan with a performance period that began before July 1, 2018 would not be required to comply with the rule. Whether a covered institution is a Level 1, Level 2, or Level 3 covered institution on July 1, 2018 would be determined based on average total consolidated assets as of the beginning of the first quarter of 2017. The Agencies recognize that most incentive-based compensation plans are implemented at the beginning of the fiscal or calendar year. Depending on the date of publication of a final rule, the proposed compliance date would provide at least 18 months, and in most cases more than two years, for covered institutions to develop and approve new incentive-based compensation plans and 18 months for covered institutions to develop and implement the supporting policies, procedures, risk management framework, and governance that would be required under the proposed rule. 1.1. The Agencies invite comment on whether this timing would be sufficient to allow covered institutions to implement any changes necessary for compliance with the proposed rule, particularly the development and implementation of policies and procedures. Is the length of time too long or too short and why? What specific changes would be required to bring existing policies and procedures into compliance with the rule? What constraints exist on the ability of covered institutions to meet the proposed deadline? 1.2. The Agencies invite comment on whether the compliance date should instead be the beginning of the first performance period that starts at least 365 days after the final rule is published in the Federal Register in order to have the proposed rule’s policies, procedures, risk management, and governance requirements begin when the requirements applicable to incentivecompensation plans and arrangements begin. Why or why not? Section ll.1 also specifies that the proposed rule is not intended to limit 47 As discussed below, the proposed rule includes baseline requirements for all covered institutions and additional requirements for Level 1 and Level 2 covered institutions, which are larger covered institutions. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 the authority of any Agency under other provisions of applicable law and regulations. For example, the proposed rule would not affect the Federal Banking Agencies’ authority under section 39 of the FDIA and the Federal Banking Agency Safety and Soundness Guidelines. The Board’s Enhanced Prudential Standards under 12 CFR part 252 (Regulation YY) would not be affected. The OCC’s Heightened Standards also would continue to be in effect. The NCUA’s authority under 12 U.S.C. 1761a, 12 CFR 701.2, part 701 App. A, Art. VII. section 8, 701.21(c)(8)(i), 701.23(g) (1), 701.33, 702.203, 702.204, 703.17, 704.19, 704.20, part 708a, 712.8, 721.7, and part 750, and the NCUA Examiners Guide, Chapter 7,48 would not be affected. Neither would the proposed rule affect the applicability of FHFA’s executive compensation rule, under section 1318 of the Safety and Soundness Act (12 U.S.C. 4518), 12 CFR part 1230. The Agencies acknowledge that some individuals who would be considered covered persons, senior executive officers, or significant risk-takers under the proposed rule are subject to other Federal compensation-related requirements. Further, some covered institutions may be subject to SEC rules regarding the disclosure of executive compensation,49 and mortgage loan originators are subject to the Consumer Financial Protection Bureau’s restrictions on compensation. This rule is not intended to affect the application of these other Federal compensationrelated requirements. § ll.2 Definitions Section ll.2 defines the various terms used in the proposed rule. Where the proposed rule uses a term defined in section 956, the proposed rule generally adopts the definition included in section 956.50 Definitions Pertaining to Covered Institutions Section 956(e)(2) of the Dodd-Frank Act defines the term ‘‘covered financial institution’’ to mean a depository institution; a depository institution holding company; a registered brokerdealer; a credit union; an investment adviser; the Federal National Mortgage 48 The NCUA Examiners Guide, Chapter 7, available at https://www.ncua.gov/Legal/GuidesEtc/ ExaminerGuide/Chapter07.pdf. 49 See Item 402 of Regulation S–K. 17 CFR 229.402. 50 The definitions in the proposed rule would be for purposes of administering section 956 and would not affect the interpretation or construction of the same or similar terms for purposes of any other statute or regulation administered by the Agencies. PO 00000 Frm 00015 Fmt 4701 Sfmt 4702 37683 Association (‘‘Fannie Mae’’) and the Federal Home Loan Mortgage Corporation (‘‘Freddie Mac’’) (together, the ‘‘Enterprises’’); and any other financial institution that the Agencies determine, jointly, by rule, should be treated as a covered financial institution for purposes of section 956. Section 956(f) provides that the requirements of section 956 do not apply to covered financial institutions with assets of less than $1 billion. The Agencies propose to jointly, by rule, designate additional financial institutions as covered institutions. The Agencies propose to include the Federal Home Loan Banks as covered institutions because they pose risks similar to those of some institutions covered under the proposed rule and should be subject to the same regulatory regime. The Agencies also propose to include as covered institutions the statelicensed uninsured branches and agencies of a foreign bank, organizations operating under section 25 or 25A of the Federal Reserve Act (i.e., Edge and Agreement Corporations), as well as the other 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). Applying the same requirements to these institutions would be consistent with other regulatory requirements that are applicable to foreign banking organizations operating in the United States and would not distort competition for human resources between U.S. banking organizations and foreign banking organizations operating in the United States. These offices and operations currently are referenced in the Federal Banking Agency Guidance and are subject to section 8 of the FDIA (12 U.S.C. 1818), which prohibits institutions from engaging in unsafe or unsound practices to the same extent as insured depository institutions and bank holding companies.51 In addition, the Agencies propose to jointly, by rule, designate statechartered non-depository trust companies that are members of the Federal Reserve System as covered institutions. The definition of ‘‘covered financial institution’’ under section 956 of the Dodd-Frank Act includes a depository institution as such term is defined in section 3 of the FDIA (12 U.S.C. 1813); that term includes all national banks and any state banks, including trust companies, that are engaged in the business of receiving deposits other than trust funds. As a consequence of these definitions, all 51 See E:\FR\FM\10JNP2.SGM 12 U.S.C. 1813(c)(3) and 1818(b)(4). 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37684 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules national banks, including national banks that are non-depository trust companies, are ‘‘depository institutions’’ within the meaning of section 956, but non-FDIC insured state non-depository trust companies that are members of the Federal Reserve System are not. In order to achieve equal treatment across similar entities with different charters, the Agencies propose to include state-chartered nondepository member trust companies as covered institutions. These institutions would be ‘‘regulated institutions’’ under the definition of ‘‘state member bank’’ in the Board’s rule. Each Agency’s proposed rule contains a definition of the term ‘‘covered institution’’ that describes the covered financial institutions the Agency regulates. The Agencies have tailored the requirements of the proposed rule to the size and complexity of covered institutions, and are proposing to designate covered institutions as Level 1, Level 2, or Level 3 covered institutions to effectuate this tailoring. The Agencies have observed through their supervisory experience that large financial institutions typically have complex business activities in multiple lines of business, distinct subsidiaries, and regulatory jurisdictions, and frequently operate and manage their businesses in ways that cross those lines of business, subsidiaries, and jurisdictions. Level 3 covered institutions would generally be subject to only the basic set of prohibitions and disclosure requirements. The proposed rule would apply additional prohibitions and requirements to incentive-based compensation arrangements at Level 1 and Level 2 covered institutions, as discussed below. Whether a covered institution that is a subsidiary of a depository institution holding company is a Level 1, Level 2, or Level 3 covered institution would be based on the average total consolidated assets of the top-tier depository institution holding company. Whether that subsidiary has at least $1 billion will be based on the subsidiary’s average total consolidated assets. The Agency definitions of covered institution, Level 1, Level 2, and Level 3 covered institution, and related terms are summarized below. Covered Institution and Regulated Institution. Each Agency has set forth text for its Agency-specific definition of the term ‘‘covered institution’’ that specifies the entities to which that VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 Agency’s rule applies.52 Under the proposed rule, a ‘‘covered institution’’ would include all of the following: • In the case of the OCC: Æ A national bank, Federal savings association, or Federal branch or agency of a foreign bank 53 with average total consolidated assets greater than or equal to $1 billion; and Æ A subsidiary of a national bank, Federal savings association, or Federal branch or agency of a foreign bank, if the subsidiary (A) is not a broker, dealer, person providing insurance, investment company, or investment adviser; and (B) has average total consolidated assets greater than or equal to $1 billion. • In the case of the Board, the proposed definition of the term ‘‘covered institution’’ is a ‘‘regulated institution’’ with average total consolidated assets greater than or equal to $1 billion, and the Board’s definition of the term ‘‘regulated institution’’ includes: Æ A state member bank, as defined in 12 CFR 208.2(g); Æ A bank holding company, as defined in 12 CFR 225.2(c), that is not a foreign banking organization, as defined in 12 CFR 211.21(o), and a subsidiary of such a bank holding company that is not a depository institution, broker-dealer or investment adviser; Æ A savings and loan holding company, as defined in 12 CFR 238.2(m), and a subsidiary of a savings and loan holding company that is not a depository institution, broker-dealer or investment adviser; Æ An organization operating under section 25 or 25A of the Federal Reserve Act (Edge and Agreement Corporation); Æ A state-licensed uninsured branch or agency of a foreign bank, as defined in section 3 of the FDIA (12 U.S.C. 1813); and Æ The U.S. operations of a foreign banking organization, as defined in 12 CFR 211.21(o), and a U.S. subsidiary of such foreign banking organization that is not a depository institution, brokerdealer, or investment adviser. • In the case of the FDIC, ‘‘covered institution’’ means a: Æ State nonmember bank, state savings association, and a state insured branch of a foreign bank, as such terms are defined in section 3 of the FDIA, 12 U.S.C. 1813, with average total 52 The Agency-specific definitions are intended to be applied only for purposes of administering a final rule under section 956. 53 The term ‘‘Federal branch or agency of a foreign bank’’ refers to both insured and uninsured Federal branches and agencies of foreign banks. PO 00000 Frm 00016 Fmt 4701 Sfmt 4702 consolidated assets greater than or equal to $1 billion; and Æ A subsidiary of a state nonmember bank, state savings association, or a state insured branch of a foreign bank, as such terms are defined in section 3 of the FDIA, 12 U.S.C. 1813, that: (i) Is not a broker, dealer, person providing insurance, investment company, or investment adviser; and (ii) Has average total consolidated assets greater than or equal to $1 billion. • In the case of the NCUA, a credit union, as described in section 19(b)(1)(A)(iv) of the Federal Reserve Act, meaning an insured credit union as defined under 12 U.S.C. 1752(7) or credit union eligible to make application to become an insured credit union under 12 U.S.C. 1781. Instead of the term ‘‘covered financial institution,’’ the NCUA uses the term ‘‘credit union’’ throughout its proposed rule, as credit unions are the only type of covered institution NCUA regulates. The scope section of the rule defines the credit unions that will be subject to this rule— that is, credit unions with $1 billion or more in total consolidated assets. • In the case of the SEC, a broker or dealer registered under section 15 of the Securities Exchange Act of 1934, 15 U.S.C. 78o; and an investment adviser, as such term is defined in section 202(a)(11) of the Investment Advisers Act of 1940, 15 U.S.C. 80b–2(a)(11).54 The proposed rule would not apply to persons excluded from the definition of investment adviser contained in section 202(a)(11) of the Investment Advisers Act nor would it apply to such other persons not within the intent of section 202(a)(11) of the Investment Advisers Act, as the SEC may designate by rules and regulations or order. Section 956 does not contain exceptions or exemptions for investment advisers based on registration.55 54 By its terms, the definition of ‘‘covered financial institution’’ in section 956 includes any institution that meets the definition of ‘‘investment adviser’’ under the Investment Advisers Act of 1940 (‘‘Investment Advisers Act’’), regardless of whether the institution is registered as an investment adviser under that Act. Banks and bank holding companies are generally excluded from the definition of ‘‘investment adviser’’ under section 202(a)(11) of the Investment Advisers Act, although they would still be ‘‘covered institutions’’ under the relevant Agency’s proposed rule. 55 Commenters to the 2011 Proposed Rule requested clarification with respect to those entities that are excluded from the definition of ‘‘investment adviser’’ under the Investment Advisers Act and those that are exempt from registration as an investment adviser under the Investment Advisers Act. Section 956 expressly includes any institution that meets the definition of investment adviser regardless of whether the institution is registered under the Investment Advisers Act. See supra note 54. Thus, the proposed rule would apply to institutions that meet E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 • In the case of FHFA, the proposed definition of the term ‘‘covered institution’’ is a ‘‘regulated institution’’ with average total consolidated assets greater than or equal to $1 billion, and FHFA’s definition of the term ‘‘regulated institution’’ means an Enterprise, as defined in 12 U.S.C. 4502(10), and a Federal Home Loan Bank. Level 1, Level 2, and Level 3 covered institutions. The Agencies have tailored the requirements of the proposed rule to the size and complexity of covered institutions. All covered institutions would be subject to a basic set of prohibitions and disclosure requirements, as described in section ll.4 of the proposed rule. The Agencies are proposing to group covered institutions into three levels. The first level, Level 1 covered institutions, would generally be covered institutions with average total consolidated assets of greater than $250 billion and subsidiaries of such institutions that are covered institutions. The next level, Level 2 covered institutions, would generally be covered institutions with average total consolidated assets between $50 billion and $250 billion and subsidiaries of such institutions that are covered institutions. The smallest covered institutions, those with average total consolidated assets between $1 and $50 billion, would be Level 3 covered institutions and generally would be subject to only the basic set of prohibitions and requirements.56 The proposed rule would apply additional prohibitions and requirements to incentive-based compensation arrangements at Level 1 and Level 2 covered institutions, as described in section ll.5 and sections ll.7 through ll.11 of the proposed rule and further discussed below. The specific requirements of the proposed rule that would apply to Level 1 and Level 2 covered institutions are the same, with the exception of the deferral amounts and deferral periods described the definition of investment adviser under section 202(a)(11) of the Investment Advisers Act and would not exempt any such institutions that may be prohibited or exempted from registering with the SEC under the Investment Advisers Act. 56 As discussed later in this Supplemental Information section, under section ll.6 of the proposed rule, an Agency would be able to require a covered institution with average total consolidated assets greater than or equal to $10 billion and less than $50 billion to comply with some or all of the provisions of section ll.5 and sections ll.7 throughll.11, if the Agency determines that the activities, complexity of operations, risk profile, or compensation practices of the covered institution are consistent with those of a Level 1 or Level 2 covered institution. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 in section ll.7(a)(1) and section ll.7(a)(2). Consolidation Generally, the Agencies also propose that covered institutions that are subsidiaries of other covered institutions would be subject to the same requirements, and defined to be the same level, as the parent covered institution,57 even if the subsidiary covered institution is smaller than the parent covered institution.58 This approach of assessing risks at the level of the holding company for a consolidated organization recognizes that financial stress or the improper management of risk in one part of an organization has the potential to spread rapidly to other parts of the organization. Large depository institution holding companies increasingly operate and manage their businesses in such a way that risks affect different subsidiaries within the consolidated organization and are managed on a consolidated basis. For example, decisions about business lines including management and resource allocation may be made by executives and employees in different subsidiaries. Integrating products and operations may offer significant efficiencies but can also result in financial stress or the improper management of risk in one part of a consolidated organization and has the potential to spread risk rapidly to other parts of the consolidated organization. Even when risk is assessed at the level of the holding company, risk will also be assessed at individual institutions within that consolidated organization. For example, a bank subsidiary of a large, complex bank holding company 57 Commenters on the 2011 Proposed Rule questioned how the requirements would apply in the context of consolidated organizations where a parent holding company structure may include one or more subsidiary banks, broker-dealers, or investment advisers each with total consolidated assets either above or below, or somewhere in between, the relevant thresholds. They also expressed concern that the 2011 Proposed Rule could lead to ‘‘regulatory overlap’’ where the parent holding company and individual subsidiaries are regulated by different agencies. 58 For the U.S. operations of a foreign banking organization, level would be determined by the total consolidated U.S. assets of the foreign banking organization, including the assets of any U.S. branches or agencies of the foreign banking organization, any U.S. subsidiaries of the foreign banking organization, and any U.S. operations held pursuant to section 2(h)(2) of the Bank Holding Company Act. In contrast, the level of an OCCregulated Federal branch or agency of a foreign bank would be determined with reference to the assets of the Federal branch or agency. This treatment is consistent with the determination of the level of a national bank or Federal savings association that is not a subsidiary of a holding company and the OCC’s approach to regulation of Federal branches and agencies. PO 00000 Frm 00017 Fmt 4701 Sfmt 4702 37685 might have a different risk profile than the bank holding company. In that situation, a risk assessment would have different results when conducted at the level of the bank and at the level of the bank holding company. Moreover, in the experience of the Federal Banking Agencies, incentivebased compensation programs generally are designed at the holding company level and are applied throughout the consolidated organization. Many holding companies establish incentivebased compensation programs in this manner because it can help maintain effective risk management and controls for the entire consolidated organization. More broadly, the expectations and incentives established by the highest levels of corporate leadership set the tone for the entire organization and are important factors of whether an organization is capable of maintaining fully effective risk management and internal control processes. The Board has observed that some large, complex depository institution holding companies have evolved toward comprehensive, consolidated risk management to measure and assess the range of their exposures and the way these exposures interrelate, including in the context of incentive-based compensation programs. In supervising the activities of depository institution holding companies, the Board has adopted and continues to follow the principle that depository institution holding companies should serve as a source of financial and managerial strength for their subsidiary depository institutions.59 The proposed rule is designed to reinforce the ability of institutions to establish and maintain effective risk management and controls for the entire consolidated organization with respect to the organization’s incentive-based compensation program. Moreover, the structure of the proposed rule is also consistent with the reality that within many large depository institution holding companies, covered persons may be employed by one legal entity but may do work for one or more of that entity’s affiliates. For example, an employee of a national bank might also perform certain responsibilities on behalf of an affiliated broker-dealer. Applying the same requirements to all subsidiary covered institutions may reduce the possibility of evasion of the more specific standards applicable to certain individuals at Level 1 or Level 2 covered institutions. Finally, this approach may enable holding company structures to more effectively manage 59 See E:\FR\FM\10JNP2.SGM 12 U.S.C. 1831o–1; 12 CFR 225.4(a)(1). 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37686 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules human resources, because applying the same requirements to all subsidiary covered institutions would treat similarly the incentive-based compensation arrangements for similar positions at different subsidiaries within a holding company structure.60 The proposed rule would also be consistent with the requirements of overseas regulators who have examined the role that incentive-based compensation plays in institutions. After examining the risks posed by certain incentive-based compensation programs, many foreign regulators are now requiring that the rules governing incentive-based compensation be applied at the group, parent, and subsidiary operating levels (including those in offshore financial centers).61 The Agencies are cognizant that the approach being proposed may have some disadvantages for smaller subsidiaries within a larger depository institution holding company structure by applying the more specific provisions of the proposed rule to these smaller institutions that would not otherwise apply to them but for being a subsidiary of a depository institution holding company. As further discussed below, in an effort to reduce burden, the Board’s proposed rule would permit institutions that are subsidiaries of depository institution holding companies and that are subject to the Board’s proposed rule to meet the requirements of the proposed rule if the parent covered institution complies with the requirements in such a way that causes the relevant portion of the incentive-based compensation program of the subsidiary covered institution to comply with the requirements.62 Similarly, the OCC’s proposed rule would allow a covered institution subject to the OCC’s proposed rule that is a subsidiary of another covered institution subject to the OCC’s proposed rule to meet a requirement of the OCC’s proposed rule if the parent covered institution complies with that requirement in a way that causes the relevant portion of the incentive-based compensation program of the subsidiary covered institution to comply with that requirement. The FDIC’s proposed rule would similarly allow a covered institution subject to the FDIC’s proposed rule that 60 For example, requirements that apply to certain job functions in one part of a consolidated organization but not to the same job function in another operating unit of the same holding company structure could create uneven treatment across the legal entities. 61 See, e.g., Article 92 of the CRD IV (2013/36/ EU). 62 See section ll.3(c) of the proposed rule. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 is a subsidiary of another covered institution subject to the FDIC’s proposed rule to meet a requirement of the FDIC’s proposed rule if the parent covered institution complies with that requirement in a way that causes the relevant portion of the incentive-based compensation program of the subsidiary covered institution to comply with that requirement. The SEC is not proposing to require a covered institution under its proposed rule that is a subsidiary of another covered institution under that proposed rule to be subject to the same requirements, and defined to be the same levels, as the parent covered institution. In general, the operations, services, and products of broker-dealers and investments advisers are not typically effected through subsidiaries 63 and it is expected that their incentivebased compensation arrangements are typically derived from the activities of the broker-dealers and investment advisers themselves. Because of this, any inappropriate risks for which the incentive-based compensation programs at these firms may encourage should be localized, and the management of these risks similarly should reside at the broker-dealer or investment adviser. Where that is not the case, individuals that are employed by subsidiaries of a broker-dealer or investment adviser may still be considered to be a ‘‘significant risk-taker’’ for the covered institution and, therefore, subject to the proposed rule.64 In addition, broker-dealers and investment advisers that are subsidiaries of depository institution holding companies would be consolidated on the basis of such depository institution holding companies generally, where there is often a greater integration of products and operations, public interest, 63 In addition, the SEC’s regulatory regime with respect to broker-dealers and investment advisers generally applies on an entity-by-entity basis. For example, subject to certain exclusions, any person that for compensation is engaged in the business of providing advice, making recommendations, issuing reports, or furnishing analyses on securities, either directly or through publications is subject to the Investment Advisers Act. See 15 U.S.C. 80b– 2(a)(11). 64 The proposed rule also prohibits a covered institution from doing indirectly, or through or by any other person, anything that would be unlawful for such covered institution to do directly. See section 303.12. For example, the SEC has stated that it will, based on facts and circumstances, treat as a single investment adviser two or more affiliated investment advisers that are separate legal entities but are operationally integrated. See Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Investment Advisers Act Release No. 3222 (June 22, 2011) 76 FR 39,646 (July 6, 2011); In the Matter of TL Ventures, Inc., Investment Advisers Act Release No. 3859 (June 20, 2014) (settled action); section 15 U.S.C. 80b–8. PO 00000 Frm 00018 Fmt 4701 Sfmt 4702 and assessment and management of risk (including those related to incentivebased compensation) across the depository institution holding companies and their subsidiaries.65 Level 1, Level 2, and Level 3 Covered Institutions For purposes of the proposed rule, the Agencies have specified the three levels of covered institutions as: • In the case of the OCC: Æ A ‘‘Level 1 covered institution’’ means: (i) A covered institution that is a subsidiary of a depository institution holding company with average total consolidated assets greater than or equal to $250 billion; (ii) a covered institution with average total consolidated assets greater than or equal to $250 billion that is not a subsidiary of a covered institution or of a depository institution holding company; and (iii) a covered institution that is a subsidiary of a covered institution with average total consolidated assets greater than or equal to $250 billion. Æ A ‘‘Level 2 covered institution’’ means: (i) A covered institution that is a subsidiary of a depository institution holding company with average total consolidated assets greater than or equal to $50 billion but less than $250 billion; (ii) a covered institution with average total consolidated assets greater than or equal to $50 billion but less than $250 billion that is not a subsidiary of a covered institution or of a depository institution holding company; and (iii) a covered institution that is a subsidiary of a covered institution with average total consolidated assets greater than or equal to $50 billion but less than $250 billion. Æ A ‘‘Level 3 covered institution’’ means: (i) A covered institution with average total consolidated assets greater 65 As discussed above in this Supplementary Information, the Agencies propose that covered institutions that are subsidiaries of covered institutions that are depository institution holding companies would be subject to the same requirements, and defined to be the same level, as the parent covered institutions. Because the failure of a depository institution may cause losses to the deposit insurance fund, there is a heightened interest in the safety and soundness of depository institutions and their holding companies. Moreover, as noted above, depository institution holding companies should serve as a source of financial and managerial strength for their subsidiary depository institutions. Additionally, in the experience of the Federal Banking Agencies, incentive-based compensation programs generally are designed at the holding company level and are applied throughout the consolidated organization. The Board has observed that complex depository institution holding companies have evolved toward comprehensive, consolidated risk management to measure and assess the range of their exposures and the way these exposures interrelate, including in the context of incentive-based compensation programs. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules than or equal to $1 billion but less than $50 billion; and (ii) a covered institution that is a subsidiary of a covered institution with average total consolidated assets greater than or equal to $1 billion but less than $50 billion. • In the case of the Board: Æ A ‘‘Level 1 covered institution’’ means a covered institution with average total consolidated assets greater than or equal to $250 billion and any subsidiary of a Level 1 covered institution that is a covered institution. Æ A ‘‘Level 2 covered institution’’ means a covered institution with average total consolidated assets greater than or equal to $50 billion that is not a Level 1 covered institution and any subsidiary of a Level 2 covered institution that is a covered institution. Æ A ‘‘Level 3 covered institution’’ means a covered institution with average total consolidated assets greater than or equal to $1 billion that is not a Level 1 or Level 2 covered institution. • In the case of the FDIC: Æ A ‘‘Level 1 covered institution’’ means: (i) A covered institution that is a subsidiary of a depository institution holding company with average total consolidated assets greater than or equal to $250 billion; (ii) a covered institution with average total consolidated assets greater than or equal to $250 billion that is not a subsidiary of a depository institution holding company; and (iii) a covered institution that is a subsidiary of a covered institution with average total consolidated assets greater than or equal to $250 billion. Æ A ‘‘Level 2 covered institution’’ means: (i) A covered institution that is a subsidiary of a depository institution holding company with average total consolidated assets greater than or equal to $50 billion but less than $250 billion; (ii) a covered institution with average total consolidated assets greater than or equal to $50 billion but less than $250 billion that is not a subsidiary of a depository institution holding company; and (iii) a covered institution that is a subsidiary of a covered institution with average total consolidated assets greater than or equal to $50 billion but less than $250 billion. Æ A ‘‘Level 3 covered institution’’ means: (i) A covered institution that is a subsidiary of a depository institution holding company with average total consolidated assets greater than or equal to $1 billion but less than $50 billion; (ii) a covered institution with average total consolidated assets greater than or equal to $1 billion but less than $50 billion that is not a subsidiary of a depository institution holding company; and (iii) a covered institution that is a subsidiary of a covered institution with VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 average total consolidated assets greater than or equal to $1 billion but less than $50 billion. • In the case of the NCUA: Æ A ‘‘Level 1 credit union’’ means a credit union with average total consolidated assets of $250 billion or more. Æ A ‘‘Level 2 credit union’’ means a credit union with average total consolidated assets greater than or equal to $50 billion that is not a Level 1 credit union. Æ A ‘‘Level 3 credit union’’ means a credit union with average total consolidated assets greater than or equal to $1 billion that is not a Level 1 or Level 2 credit union. • In the case of the SEC: Æ A ‘‘Level 1 covered institution’’ means: (i) A covered institution with average total consolidated assets greater than or equal to $250 billion; or (ii) a covered institution that is a subsidiary of a depository institution holding company that is a Level 1 covered institution pursuant to 12 CFR 236.2. Æ A ‘‘Level 2 covered institution’’ means: (i) A covered institution with average total consolidated assets greater than or equal to $50 billion that is not a Level 1 covered institution; or (ii) a covered institution that is a subsidiary of a depository institution holding company that is a Level 2 covered institution pursuant to 12 CFR 236.2. Æ A ‘‘Level 3 covered institution’’ means a covered institution with average total consolidated assets greater than or equal to $1 billion that is not a Level 1 covered institution or Level 2 covered institution. • In the case of FHFA: Æ A ‘‘Level 1 covered institution’’ means a covered institution with average total consolidated assets greater than or equal to $250 billion that is not a Federal Home Loan Bank. Æ A ‘‘Level 2 covered institution’’ means a covered institution with average total consolidated assets greater than or equal to $50 billion that is not a Level 1 covered institution and any Federal Home Loan Bank that is a covered institution. Æ A ‘‘Level 3 covered institution’’ means a covered institution with average total consolidated assets greater than or equal to $1 billion that is not a Level 1 covered institution or Level 2 covered institution. The Agencies considered the varying levels of complexity and risks across covered institutions that would be subject to this proposed rule, as well as the general correlation of asset size with those potential risks, in proposing to distinguish covered institutions by their PO 00000 Frm 00019 Fmt 4701 Sfmt 4702 37687 asset size.66 In general, larger financial institutions have more complex structures and operations. These more complex structures make controlling risk-taking more difficult. Moreover, these larger, more complex institutions also tend to be significant users of incentive-based compensation. Significant use of incentive-based compensation combined with more complex business operations can make it more difficult to immediately recognize and assess risks for the institution as a whole. Therefore, the requirements of the proposed rule are tailored to reflect the size and complexity of each of the three levels of covered institutions identified in the proposed rule. The proposed rule assigns covered institutions to one of three levels, based on each institution’s average total consolidated assets. Additionally, the Agencies considered the exemption in section 956 for institutions with less than $1 billion in assets along with other asset-level thresholds in the Dodd-Frank Act 67 as an indication that Congress views asset size as an appropriate basis for the requirements and prohibitions established under this proposed rule. Consistent with this approach, the Agencies also looked to asset size to determine the types of prohibitions that would be necessary to discourage inappropriate risks at covered institutions that could lead to material financial loss. The Agencies are proposing that more rigorous requirements apply to institutions with $50 billion or more in assets. These institutions with assets of $50 billion or more tend to be significantly more complex and, the risk-taking of these institutions, and their potential failure, implicates greater risks for the financial system and the overall economy. Tailoring application of the requirements of the proposed rule is consistent with other provisions of the Dodd-Frank Act, which distinguish requirements for institutions with $50 66 But see earlier discussion regarding consolidation. 67 See, e.g., section 116 of the Dodd-Frank Act (12 U.S.C. 5326) (allowing the Financial Stability Oversight Council to require a bank holding company with total consolidated assets of $50 billion or more to submit reports); section 163 of the Dodd-Frank Act (12 U.S.C. 5363) (requiring prior notice to the Board for certain acquisitions by bank holding companies with total consolidated assets of $50 billion or more); section 165 of the Dodd-Frank Act (12 U.S.C. 5365) (requiring enhanced prudential standards for bank holding companies with total consolidated assets of $50 billion or more); section 318(c) of the Dodd-Frank Act (12 U.S.C. 16) (authorizing the Board to collect assessments, fees, and other charges from bank holding companies and savings and loan holding companies with total consolidated assets of $50 billion or more). E:\FR\FM\10JNP2.SGM 10JNP2 37688 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules billion or more in total consolidated assets. For example, the enhanced supervision and prudential standards for nonbank financial companies and bank holding companies under section 165 68 apply to bank holding companies with total consolidated assets of $50 billion or greater. It is also consistent with the definitions of advanced approaches institutions under the Federal Banking Agencies’ domestic capital rules,69 which are linked to the total consolidated assets of an institution. Other statutory and regulatory provisions recognize this difference.70 Most of the requirements of the proposed rule would apply to Level 1 and Level 2 covered institutions in a similar manner. Deferral requirements, however, would be different for Level 1 and Level 2 covered institutions, as discussed further below: Incentivebased compensation for senior executive officers and significant risk-takers at covered institutions with average total consolidated assets equal to or greater than $250 billion would be subject to a higher percentage of deferral, and longer deferral periods. In the experience of the Agencies, covered institutions with assets of $250 billion or more tend to be significantly more complex and thus exposed to a higher level of risk than those with assets of less than $250 billion. The risk-taking of these institutions, and their potential failure, implicates the greatest risks for the broader economy and financial system. Other statutory and regulatory provisions recognize this difference. For example, the definitions of advanced approaches institutions under the Federal Banking Agencies’ domestic capital rules establish a $250 billion threshold for coverage. This approach is similar to that used in the international 68 12 U.S.C. 5365. 12 CFR 3.100(b)(1) (advanced approaches national banks and Federal savings associations); 12 CFR 324.100(b)(1) (advanced approaches state nonmember banks, state savings associations, and insured branches of foreign banks); 12 CFR 217.100(b)(1) (advanced approaches bank holding companies, savings and loan holding companies, and state member banks). 70 See, e.g., Board, ‘‘Regulatory Capital Rules: Implementation of Risk-Based Capital Surcharges for Global Systemically Important Bank Holding Companies,’’ 80 FR 49081 (August 14, 2015); Board, ‘‘Single-Counterparty Credit Limits for Large Banking Organizations; Proposed Rule,’’ 81 FR 14327 (March 4, 2016); Board, ‘‘Debit Card Interchange Fees and Routing; Final Rule,’’ 76 FR 43393 (July 20, 2011); Board, ‘‘Supervision and Regulation Assessments for Bank Holding Companies and Savings and Loan Holding Companies With Total Consolidated Assets of $50 Billion or More and Nonbank Financial Companies Supervised by the Federal Reserve,’’ 78 FR 52391 (August 23, 2013); OCC, Board, FDIC, ‘‘Supplementary Leverage Ratio; Final Rule,’’ 79 FR 57725 (September 26, 2014). mstockstill on DSK3G9T082PROD with PROPOSALS2 69 See VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 standards published by the Basel Committee on Banking Supervision, and rules implementing such capital standards, under which banks with consolidated assets of $250 billion or more are subject to enhanced capital and leverage standards. As noted above, the Agencies propose to designate the Federal Home Loan Banks as covered institutions. Under FHFA’s proposed rule, each Federal Home Loan Bank would be a Level 2 covered institution by definition, as opposed to by total consolidated assets. As long as a Federal Home Loan Bank is a covered institution under this part, with average total consolidated assets greater than or equal to $1 billion, it is a Level 2 covered institution. FHFA proposes this approach because generally for the Federal Home Loan Banks, asset size is not a meaningful indicator of risk. The Federal Home Loan Banks all operate in a similar enough manner that treating them differently based on asset size is not justifiable. Because of the scalability of the Federal Home Loan Bank business model, it is possible for a Federal Home Loan Bank to pass back and forth over the asset-size threshold without any meaningful change in risk profile. FHFA proposes to designate the Federal Home Loan Banks as Level 2 covered institutions instead of Level 3 covered institutions because at the time of the proposed rule, at least one Federal Home Loan Bank would be a Level 2 covered institution if determined by asset size, and the regulatory requirements under the proposed rule that seem most appropriate for the Federal Home Loan Banks are those of Level 2 covered institutions. Similar to the approach used by the Federal Banking Agencies in their general supervision of banking organizations, if the proposed rule were adopted, the Agencies would generally expect to coordinate oversight and, to the extent applicable, supervision for consolidated organizations in order to assess compliance throughout the consolidated organization with any final rule. The Agencies are cognizant that effective and consistent supervision generally requires coordination among the Agencies that regulate the various entities within a consolidated organization. The supervisory authority of each appropriate Federal regulator to examine and review its covered institutions for compliance with the proposed rule would not be affected under this approach. Affiliate. For the OCC, the Board, the FDIC, and the SEC, the proposed rule would define ‘‘affiliate’’ to mean any company that controls, is controlled by, PO 00000 Frm 00020 Fmt 4701 Sfmt 4702 or is under common control with another company. FHFA’s proposed rule would not include a definition of ‘‘affiliate.’’ The Federal Home Loan Banks have no affiliates, and affiliates of the Enterprises are included as part of the definition of Enterprise in the Safety and Soundness Act, which is referenced in the definition of regulated entity. The NCUA’s proposed rule also would not include a definition of ‘‘affiliate.’’ While in some cases, credit union service organizations (‘‘CUSOs’’) might be considered affiliates of a credit union, NCUA has determined that this rule would not apply to CUSOs. Average total consolidated assets. Consistent with section 956, the proposed rule would not apply to institutions with less than $1 billion in assets. Additionally, as discussed above, under the proposed rule, more specific requirements would apply to institutions with higher levels of assets. The Agencies propose to use average total consolidated assets to measure assets for the purposes of determining applicability of the requirements of this rule. Whether a covered institution that is a subsidiary of a depository institution holding company is a Level 1, Level 2, or Level 3 covered institution would be based on the average total consolidated assets of the top-tier depository institution holding company. Whether that subsidiary has at least $1 billion will be based on the subsidiary’s average total consolidated assets. For an institution that is not an investment adviser, average total consolidated assets would be determined with reference to the average of the total consolidated assets reported on regulatory reports for the four most recent consecutive quarters. This method is consistent with those used to calculate total consolidated assets for purposes of other rules that have $50 billion thresholds,71 and it may reduce administrative burden on institutions—particularly Level 3 covered institutions that become Level 2 covered institutions—if average total consolidated assets are calculated in the same way for the proposed rule. For an institution that does not have a regulatory report for each of the four most recent consecutive quarters to reference, average total consolidated assets would mean the average of total consolidated assets, as reported on the relevant regulatory reports, for the most recent quarter or consecutive quarters available, as applicable. Average total 71 See, e.g., OCC’s Heightened Standards (12 CFR part 30, Appendix D); 12 CFR 46.3; 12 CFR 225.8; 12 CFR 243.2; 12 CFR 252.30; 2 CFR 252.132; 12 CFR 325.202; 12 CFR 381.2. E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 consolidated assets would be measured on the as-of date of the most recent regulatory report used in the calculation of the average. For a covered institution that is an investment adviser, average total consolidated assets would be determined by the investment adviser’s total assets (exclusive of non-proprietary assets) shown on the balance sheet for the adviser’s most recent fiscal year end.72 The Board’s proposed rule would require that savings and loan holding companies that do not file a regulatory report within the meaning of section ll.2(ee)(3) of the Board’s proposed rule report their average total consolidated assets to the Board on a quarterly basis. In addition, foreign banking organizations with U.S. operations would be required to report their total consolidated U.S. assets to the Board on a quarterly basis. These regulated institutions would be required to report their average total consolidated assets to the Board either because they do not file reports of their total consolidated assets with the Board (in the case of savings and loan holding companies that do not file a regulatory report with the Board within the meaning of section ll.2(ee)(3) of the Board’s proposed rule), or because the reports filed do not encompass the full range of assets (in the case of foreign banking organizations with U.S. operations). Asset information concerning the U.S. operations of foreign banking organizations is filed on form FRY–7Q, but the information does not include U.S. assets held pursuant to section 2(h)(2) of the Bank Holding Company Act. Foreign banking organizations with U.S. operations would report their average total consolidated U.S. assets including assets held pursuant to section 2(h)(2) of the Bank Holding Company Act for 72 This proposed method of calculation for investment advisers corresponds to the reporting requirement in Item 1.O. of Part 1A of Form ADV, which currently requires an investment adviser to check a box to indicate if it has assets of $1 billion or more. See Form ADV, Part IA, Item 1.O.; SEC, ‘‘Rules Implementing Amendments to the Investment Advisers Act of 1940, Investment Advisers Release No. IA–3221,’’ 76 FR 42950 (July 19, 2011). Many commenters to the first notice of proposed rulemaking indicated that they understood that the SEC did not intend ‘‘total consolidated assets’’ to include non-proprietary assets, such as client assets under management; others requested clarification that this understanding is correct. The SEC is clarifying in the proposed rule that investment advisers should include only proprietary assets in the calculation— that is, non-proprietary assets, such as client assets under management would not be included, regardless of whether they appear on an investment adviser’s balance sheet. The SEC notes that this method is drawn directly from section 956. See section 956(f) (referencing ‘‘assets’’ only). VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 purposes of complying with the requirements of section ll.2(ee)(3) of the Board’s proposed rule. The Board would propose that reporting forms be created or modified as necessary for these institutions to meet these reporting requirements. The proposed rule does not specify a method for determining the total consolidated assets of some types of subsidiaries that would be considered covered institutions under the proposed rule, because those subsidiaries do not currently submit regular reports of their asset size to the Agencies. For the subsidiary of a national bank, Federal savings association, or Federal branch or agency of a foreign bank, the OCC would rely on a report of the subsidiary’s total consolidated assets prepared by the subsidiary, national bank, Federal savings association, or Federal branch or agency in a form that is acceptable to the OCC. Similarly, for a regulated institution subsidiary of a bank holding company, savings and loan holding company, or foreign banking organization the Board would rely on a report of the subsidiary’s total consolidated assets prepared by the bank holding company or savings and loan holding company in a form that is acceptable to the Board. Control. The definition of control in the proposed rule is similar to the definition of the same term in the Bank Holding Company Act.73 Any company would have control over a bank or any company if: (1) The company directly or indirectly or acting through one or more other persons owns, controls, or has power to vote 25 percent or more of any class of voting securities of the bank or company; (2) the company controls in any manner the election of a majority of the directors or trustees of the bank or company; or (3) the appropriate Federal regulator determines, after notice and opportunity for hearing, that the company directly or indirectly exercises a controlling influence over the management or policies of the bank or company. Depository institution holding company. The OCC’s, the FDIC’s, and the SEC’s proposed rules define ‘‘depository institution holding company’’ to mean a top-tier depository institution holding company, where ‘‘depository institution holding company’’ would have the same meaning as in section 3 of the FDIA.74 In a multi-tiered depository institution holding company, references in the OCC’s, FDIC’s and SEC’s proposed rules to the ‘‘depository institution holding 73 12 U.S.C. 1841(a)(2). 12 U.S.C. 1813(w). 74 See PO 00000 Frm 00021 Fmt 4701 Sfmt 4702 37689 company’’ would mean the top-tier depository institution holding company of the multi-tiered holding company only. For example, for the purpose of determining whether a state nonmember bank that is a subsidiary of a depository institution holding company and is within a multi-tiered depository institution holding company structure is a Level 1, Level 2, or Level 3 covered institution under the FDIC’s proposed rule, the state nonmember would look to the top-tier depository institution holding company’s average total consolidated assets. Thus, in a situation in which a state nonmember bank with average total consolidated assets of $35 billion is a subsidiary of a depository institution holding company with average total consolidated assets of $45 billion that is itself a subsidiary of a depository institution holding company with $75 billion in average total consolidated assets, the state nonmember bank would be treated as a Level 2 covered institution because the top-tier depository institution holding company has average total consolidated assets of $75 billion (which is greater than or equal to $50 billion but less than $250 billion). Similarly, state member banks and national banks within multitiered depository institution holding company structures would look to the top-tier depository institution holding company’s average total consolidated assets when determining if they are a Level 1, Level 2 or Level 3 covered institution under the Board’s and the OCC’s proposed rules. Subsidiary. For the OCC, the Board, the FDIC, and the SEC, the proposed rule would define ‘‘subsidiary’’ to mean any company which is owned or controlled directly or indirectly by another company. The Board proposes to exclude from its definition of ‘‘subsidiary’’ any merchant banking investment that is owned or controlled pursuant to 12 U.S.C. 1843(k)(4)(H) and subpart J of the Board’s Regulation Y (12 CFR part 225) and any company with respect to which the covered institution acquired ownership or control in the ordinary course of collecting a debt previously contracted in good faith. Depository institution holding companies may hold such investments only for limited periods of time by law. Application of the proposed rule to these institutions directly would not further the purpose of the proposed rule under section 956. The holding company and any nonbanking subsidiary holding these investments would be subject to the proposed rule. For these reasons, the Board is proposing to exclude from the definition E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37690 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules of subsidiary companies owned by a holding company as merchant banking investments or through debt previously contracted in good faith. These companies would, therefore, not be required to conform their incentivebased compensation programs to the requirements of the proposed rule. FHFA’s proposed rule would not include a definition of ‘‘subsidiary.’’ The Federal Home Loan Banks have no subsidiaries, and any subsidiaries of the Enterprises as defined by other Agencies under the proposed rule would be included as affiliates as part of the definition of Enterprise in the Safety and Soundness Act, which is referenced in the definition of regulated entity. The NCUA’s proposed rule also would not include a definition of ‘‘subsidiary.’’ While in some cases, CUSOs might be considered subsidiaries of a credit union, NCUA has determined that this rule would not apply to CUSOs. 2.1. The Agencies invite comment on whether other financial institutions should be included in the definition of ‘‘covered institution’’ and why. 2.2. The Agencies invite comment on whether any additional financial institutions should be included in the proposed rule’s definition of subsidiary and why. 2.3. The Agencies invite comment on whether any additional financial institutions (such as registered investment companies) should be excluded from the proposed rule’s definition of subsidiary and why. 2.4. The Agencies invite comment on the definition of average total consolidated assets. 2.5. The Agencies invite comment on the proposed rule’s approach to consolidation. Are there any additional advantages to the approach? For example, the Agencies invite comment on the advantages of the proposed rule’s approach for reinforcing the ability of an institution to establish and maintain effective risk management and controls for the entire consolidated organization and enabling holding company structures to more effectively manage human resources. Are there advantages to the approach of the proposed rule in helping to reduce the possibility of evasion of the more specific standards applicable to certain individuals at Level 1 or Level 2 covered institutions? Are there any disadvantages to the proposed rule’s approach to consolidation? For example, the Agencies invite comment on any disadvantages smaller subsidiaries of a larger covered institution may have by applying the more specific provisions of the proposed rule to these smaller institutions that would not otherwise VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 apply to them but for being a subsidiary of a larger institution. Is there another approach that the proposed rule should take? The Agencies invite comment on any advantages and disadvantages of the SEC’s proposal to not consolidate subsidiaries of broker-dealers and investment advisers that are not themselves subsidiaries of depository institution holding companies. Are the operations, services, and products of broker-dealers and investment advisers not typically effected through subsidiaries? Should the SEC adopt an express requirement to treat two or more affiliated investment advisers or brokerdealers that are separate legal entities (e.g., investment advisers that are operationally integrated) as a single investment adviser or broker-dealer for purposes of the proposed rule’s thresholds? 2.6. The Agencies invite comment on whether the three-level structure would be a workable approach for categorizing covered institutions by asset size and why. 2.7. The Agencies invite comment on whether the asset thresholds used in these definitions would divide covered institutions into appropriate groups based on how they view the competitive marketplace. If asset thresholds are not the appropriate methodology for determining which requirements apply, which other alternative methodologies would be appropriate and why? 2.8. Are there instances where it may be appropriate to modify the requirements of the proposed rule where there are multiple covered institutions subsidiaries within a single parent organization based upon the relative size, complexity, risk profile, or business model, and use of incentivebased compensation of the covered institution subsidiaries within the consolidated organization? In what situations would that be appropriate and why? 2.9. Is the Agencies’ assumption that incentive-based compensation programs are generally designed and administered at the holding company level for the organization as a whole correct? Why or why not? To what extent do brokerdealers or investment advisers within a holding company structure apply the same compensation standards as other subsidiaries in the parent company? 2.10. Bearing in mind that section 956 by its terms seeks to address incentivebased compensation arrangements that could lead to material financial loss to a covered institution, commenters are asked to provide comments on the proposed method of determining asset size for investment advisers. Are there instances where it may be appropriate to PO 00000 Frm 00022 Fmt 4701 Sfmt 4702 determine asset size differently, by for example, including client assets under management for investment advisers? In what situations would that be appropriate and why? 2.11. Should the determination of average total consolidated assets for investment advisers exclude nonproprietary assets that are included on a balance sheet under accounting rules, such as certain types of client assets under management required to be included on an investment adviser’s balance sheet? Why or why not? 2.12. Should the determination of average total consolidated assets be further tailored for certain types of investment advisers, such as charitable advisers, non-U.S.-domiciled advisers, or insurance companies and, if so, why and in what manner? 2.13. The Agencies invite comment on the methods for determining whether foreign banking organizations and Federal branches and agencies are Level 1, Level 2, or Level 3 covered institutions. Should the same method be used for both foreign banking organizations and Federal branches and agencies? Why or why not? Definitions Pertaining to Covered Persons Covered person. The proposed rule defines ‘‘covered person’’ as any executive officer, employee, director, or principal shareholder who receives incentive-based compensation at a covered institution.75 The term ‘‘executive officer’’ would include individuals who are senior executive officers, as defined in the proposed rule, as well as other individuals designated as executive officers by the covered institution. As described further below, section ll.4 of the proposed rule would apply requirements and prohibitions on all incentive-based compensation arrangements for covered persons at covered institutions. Included in the class of covered persons are senior executive officers and significant risk-takers, discussed further below. Senior executive officers and significant risk-takers are covered persons that may have the ability to expose a covered institution to significant risk through their positions or actions. Accordingly, the proposed rule would prohibit the incentive-based 75 Section 956 requires the Agencies to jointly prescribe regulations or guidelines that prohibit certain incentive-based compensation arrangements or features of such arrangements that encourage inappropriate risk by providing an executive officer, employee, director, or principal shareholder with excessive compensation, fees, or benefits or that could lead to material financial loss to the covered financial institution. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules compensation arrangements for senior executive officers and significant risktakers from including certain features that encourage inappropriate risk, consistent with the approach under sections ll.5, ll.9, ll.10, and ll.11 of the proposed rule of requiring risk-mitigating features for the incentive-based compensation programs at larger and more complex covered institutions. For Federal credit unions, only one director, if any, would be considered a covered person because, under section 112 of the Federal Credit Union Act 76 and NCUA’s regulations at 12 CFR 701.33, only one director may be compensated as an officer of the board of directors. The insurance and indemnification benefits that are excluded from the definition of ‘‘compensation’’ for purposes of 12 CFR 701.33 would not cause a noncompensated director of a credit union to be included under the definition of ‘‘covered person’’ because these benefits would not be ‘‘incentive-based compensation’’ under the proposed rule. Director. The proposed rule defines ‘‘director’’ as a member of the board of directors of a covered institution. Any member of a covered institution’s governing body would be included within this definition. Principal shareholder. Section 956 applies to principal shareholders as well as executive officers, employees, and directors. The proposed rule defines ‘‘principal shareholder’’ as a natural person who, directly or indirectly, or acting through or in concert with one or more persons, owns, controls, or has the power to vote 10 percent or more of any class of voting securities of a covered institution. The 10 percent threshold for identifying principal shareholders is used in a number of bank regulatory contexts.77 The NCUA’s proposed rule does not include this definition because credit unions are not-for-profit financial cooperatives with member owners. The Agencies recognize that some other types of covered institutions, for example, mutual savings associations, mutual savings banks, and some mutual holding companies, do not have principal shareholders. 2.14. The Agencies invite comment on whether the definition of ‘‘principal shareholder’’ reflects a common understanding of who would be a principal shareholder of a covered institution. Senior executive officer. The proposed rule defines ‘‘senior executive officer’’ 76 12 U.S.C. 1761a. e.g., 12 CFR 215.2(m), 12 CFR 225.2(n)(2), and 12 CFR 225.41(c)(2). 77 See, VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 as a covered person who holds the title or, without regard to title, salary, or compensation, performs the function of one or more of the following positions at a covered institution for any period of time in the relevant performance period: President, chief executive officer (CEO), executive chairman, chief operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer, chief compliance officer, chief audit executive, chief credit officer, chief accounting officer, or head of a major business line or control function. As described below, a Level 1 or Level 2 covered institution would be required to defer a portion of the incentive-based compensation of a senior executive officer and subject the incentive-based compensation to forfeiture, downward adjustment, and clawback. The proposed rule would also limit the extent to which options could be used to meet the proposed rule’s minimum deferral requirements for senior executive officers. The proposed rule would require a covered institution’s board of directors, or a committee thereof, to approve incentive-based compensation arrangements for senior executive officers and any material exceptions or adjustments to incentivebased compensation policies or arrangements for senior executive officers. Additionally, Level 1 and Level 2 covered institutions would be required to create and maintain records listing senior executive officers and to document forfeiture, downward adjustment, and clawback decisions for senior executive officers. The proposed rule would limit the extent to which a Level 1 or Level 2 covered institution may award incentive-based compensation to a senior executive officer in excess of the target amount for the incentive-based compensation. Senior executive officers also would not be eligible to serve on the compensation committee of a Level 1 or Level 2 covered institution under the proposed rule. The 2011 Proposed Rule contained a definition of ‘‘executive officer’’ that included the positions of president, CEO, executive chairman, chief operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer, and head of a major business line. It did not include the positions of chief compliance officer, chief audit executive, chief credit officer, chief accounting officer, or head of a control function. One commenter asserted that the term ‘‘executive officer’’ should not be defined with reference to specific PO 00000 Frm 00023 Fmt 4701 Sfmt 4702 37691 position, but, rather, should be identified by the board of directors of a covered institution. Other commenters asked the Agencies for additional specificity about the types of executive officers that would be covered at large and small covered institutions, particularly with respect to the heads of major business lines. Some commenters encouraged the Agencies to align the definition of ‘‘executive officer’’ with the Securities Exchange Act of 1934 by focusing on individuals with significant policymaking functions. In the alternative, some of these commenters suggested that the definition be revised to conform to the 2010 Federal Banking Agency Guidance. The definition of ‘‘senior executive officer’’ in the proposed rule retains the list of positions included in the 2011 Proposed Rule and is consistent with other rules and agency guidance. The list includes the minimum positions that are considered ‘‘senior executives’’ under the Federal Banking Agency Safety and Soundness Guidelines.78 The Agencies also took into account the positions that would be considered ‘‘officers’’ under section 16 of the Securities Exchange Act of 1934.79 In addition to the positions listed in the 2011 Proposed Rule, the proposed definition of ‘‘senior executive officer’’ includes the positions of chief compliance officer, chief audit executive, chief credit officer, chief accounting officer, and other heads of a control function. Individuals in these positions do not generally initiate activities that generate risk of material financial loss, but they play an important role in identifying, addressing, and mitigating that risk. Individuals in these positions have the ability to influence the risk measures and other information and judgments that a covered institution uses for risk management, internal control, or financial purposes.80 Improperly structured incentive-based compensation arrangements could create incentives for individuals in these positions to use their authority in ways that increase, rather than mitigate, risk of material financial loss. Some larger institutions have designated 78 These minimum positions include ‘‘executive officers,’’ within the meaning of Regulation O (12 CFR 215.2(e)(1)) and ‘‘named officers’’ within the meaning of the SEC’s rules on disclosure of executive compensation (17 CFR 229.402). In addition to these minimum positions, the Federal Banking Agency Safety and Soundness Guidelines also apply to individuals ‘‘who are responsible for oversight of the organization’s firm-wide activities or material business lines.’’ 75 FR at 36407. 79 See 17 CFR 240.16a–1. 80 See 2010 Federal Banking Agency Guidance, 75 FR at 36411. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37692 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules individuals in these positions as ‘‘covered persons’’ for purposes of the 2010 Federal Banking Agency Guidance. The definition of ‘‘senior executive officer’’ also includes a covered person who performs the function of a senior executive officer for a covered institution, even if the covered person’s formal title does not reflect that role or the covered person is employed by a different entity. For example, under the proposed rule, a covered person who is an employee of a bank holding company and also performs the functions of a chief financial officer for the subsidiary bank would, in addition to being a covered person of the bank holding company, also be a senior executive officer of the bank holding company’s subsidiary bank. This approach would address attempts to evade being included within the definition of ‘‘senior executive officer’’ by changing an individual’s title but not that individual’s responsibilities. In some instances, the determination of senior executive officers and compliance with relevant requirements of the proposed rule may be influenced by the covered institution’s organizational structure.81 If a covered institution does not have any covered person who holds the title or performs the function of one or more of the positions listed in the definition of ‘‘senior executive officer,’’ the proposed rule would not require the covered institution to designate a covered person to fill such position for purposes of the proposed rule. Similarly, if a senior executive officer at one covered institution also holds the title or performs the function of one of more of the positions listed for a subsidiary that is also a covered institution, then that individual would be a senior executive officer for both the parent and the subsidiary covered institutions. The list of positions in the proposed definition sets forth the types of positions whose incumbents would be considered senior executive officers. The Agencies are proposing this list to aid covered institutions in identifying their senior executive officers while allowing the covered institutions some degree of flexibility in determining which business lines are major business lines. 2.15. The Agencies invite comment on whether the types of positions identified in the proposed definition of senior executive officer are appropriate, whether additional positions should be included, whether any positions should be removed, and why. 81 See section ll.3(c) of the proposed rule. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 2.16. The Agencies invite comment on whether the term ‘‘major business line’’ provides enough information to allow a covered institution to identify individuals who are heads of major business lines. Should the proposed rule refer instead to a ‘‘core business line,’’ as defined in FDIC and FRB rules relating to resolution planning (12 CFR 381.2(d)), to a ‘‘principal business unit, division or function,’’ as described in SEC definitions of the term ‘‘executive officer’’ (17 CFR 240.3b–7), or to business lines that contribute greater than a specified amount to the covered institution’s total annual revenues or profit? Why? 2.17. Should the Agencies include the chief technology officer (‘‘CTO’’), chief information security officer, or similar titles as positions explicitly listed in the definition of ‘‘senior executive officer’’? Why or why not? Individuals in these positions play a significant role in information technology management.82 The CTO is generally responsible for the development and implementation of the information technology strategy to support the institution’s business strategy in line with its appetite for risk. In addition, these positions are generally responsible for implementing information technology architecture, security, and business resilience. Significant risk-taker. The proposed rule’s definition of ‘‘significant risktaker’’ is intended to include individuals who are not senior executive officers but are in the position to put a Level 1 or Level 2 covered institution at risk of material financial loss so that the proposed rule’s requirements and prohibitions on incentive-based compensation arrangements apply to such individuals. In order to ensure that incentive-based compensation arrangements for significant risk-takers appropriately balance risk and reward, most of the proposed rule’s requirements for Level 1 and Level 2 covered institutions relating to senior executive officers would also apply to significant risk-takers to some degree. These requirements include the disclosure and recordkeeping requirements of section ll.5; the deferral, forfeiture, downward adjustment, and clawback requirements of section ll.7 (including the related limitation on options); and the maximum incentive-based compensation opportunity limit of section ll.8. 82 See generally Federal Financial Institutions Examination Council (‘‘FFIEC’’) Information Technology Examination Handbook, available at https://ithandbook.ffiec.gov/it-booklets.aspx. PO 00000 Frm 00024 Fmt 4701 Sfmt 4702 The proposed definition of ‘‘significant risk-taker’’ incorporates two tests for determining whether a covered person is a significant risk-taker. A covered person would be a significant risk-taker if either test was met. The first test is based on the amounts of annual base salary and incentive-based compensation of a covered person relative to other covered persons working for the covered institution and its affiliate covered institutions (the ‘‘relative compensation test’’). This test is intended to determine whether the individual is among the top 5 percent (for Level 1 covered institutions) or top 2 percent (for Level 2 covered institutions) of highest compensated covered persons in the entire consolidated organization, including affiliated covered institutions. The second test is based on whether the covered person has authority to commit or expose 0.5 percent or more of the capital of the covered institution or an affiliate that is itself a covered institution (the ‘‘exposure test’’).83 The definition of significant risk-taker applies to only Level 1 and Level 2 covered institutions. The definition of significant risk-taker does not apply to senior executive officers. Senior 83 In the proposed rule, the Agencies have tailored the measure of capital to the type of covered institution. For most covered institutions, the exposure test would be based on common equity tier 1 capital. For depository institution holding companies, foreign banking organizations, and affiliates of those institutions that do not report common equity tier 1 capital, the Board would work with covered institutions to determine the appropriate measure of capital. For registered securities brokers or dealers, the exposure test would be based on tentative net capital. See 17 CFR 240.15c3–1(c)(15). For Federal Home Loan Banks, the exposure test would be based on regulatory capital. For the Enterprises, the exposure test would be based on minimum capital. For credit unions, the exposure test would be based on net worth or total capital. For simplicity in describing the exposure test in this SUPPLEMENTARY INFORMATION section, common equity tier 1 capital, tentative net capital, regulatory capital, minimum capital, net worth, and total capital are referred to generally as ‘‘capital.’’ The Agencies expect that a covered institution that is an investment adviser will use common equity tier 1 capital or tentative net capital to the extent it would be a covered institution in another capacity (e.g., if the investment adviser also is a depository institution holding company, a bank, a broker-dealer, or a subsidiary of a depository institution holding company). For an investment adviser that would not be a covered institution in any other capacity, the proposed rule’s exposure test would not be measured against the investment adviser’s capital. For a covered person of such an investment adviser that can commit or expose capital of an affiliated covered institution, the exposure test would be based on common equity tier 1 capital or tentative net capital of that affiliated covered institution. For other covered persons of any investment adviser that would not be a covered institution in any other capacity, no exposure test is proposed to apply. Comment is requested below regarding what measure would be appropriate for an exposure test. E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 executive officers of Level 1 and Level 2 covered institutions would be separately subject to the proposed rule, as discussed earlier in this Supplemental Information section. The significant risk-taker definition under either test would be applicable only to covered persons who received annual base salary and incentive-based compensation of which at least onethird is incentive-based compensation (one-third threshold), based on the covered person’s annual base salary paid and incentive-based compensation awarded during the last calendar year that ended at least 180 days before the beginning of the performance period for which significant risk-takers are being identified.84 For example, an individual who received $180,000 in annual base salary during calendar year 2019 and was awarded incentive-based compensation of $120,000 for performance periods that ended during calendar year 2019 could be a significant risk-taker because one-third of the individual’s compensation was incentive-based. Specifically, the individual would be a significant risktaker for a performance period beginning on or after June 28, 2020 if the individual also met the relative compensation test or the exposure test.85 Under the proposed rule, in order for covered persons to be designated as significant risk-takers, the covered persons would have to be awarded a level of incentive-based compensation that would be sufficient to influence their risk-taking behavior. In order to ensure that significant risk-takers are only those covered persons who have incentive-based compensation arrangements that could provide incentives to engage in inappropriate risk-taking, only covered persons who meet the one-third threshold could be significant risk-takers. The proposed one-third threshold is consistent with the more conservative end of the range identified in industry practice. Institutions in the Board’s 2012 LBO Review that would be Level 2 covered institutions under the proposed rule reported that they generally rewarded their self-identified individual risk-takers with incentive-based compensation in the range of 8 percent 84 Incentive-based compensation awarded in a particular calendar year would include any incentive-based compensation awarded with respect to a performance period that ended during that calendar year. 85 In this example, incentive-based compensation awarded ($120,000) would be 40 percent of the total $300,000 received in annual base salary ($180,000) and incentive-based compensation awarded ($120,000). VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 to 90 percent of total compensation, with an average range of 32 percent to 71 percent. The proposed threshold of one-third or more falls within the lower end of that average range. The one-third threshold would also be consistent with other standards regarding compensation. Under the Emergency Economic Stabilization Act of 2008 (as amended by section 7001 of the American Recovery and Reinvestment Act of 2009), recipients of financial assistance under Treasury’s Troubled Asset Relief Program (‘‘TARP’’) were prohibited from paying or accruing any bonus, retention award, or incentive compensation except for the payment of long-term restricted stock if that stock had a value that was not greater than one third of the total amount of annual compensation of the employee receiving the stock.86 In addition, some international regulators also use a threshold of one-third incentive-based compensation for determining the scope of application for certain compensation standards.87 The Agencies included the 180-day period in the one-third threshold of annual base salary and incentive-based compensation because, based upon the supervisory experience of the Federal Banking Agencies and FHFA, this period would allow covered institutions an adequate period of time to calculate the total compensation of their covered persons and, for purposes of the relative compensation test, the individuals receiving incentive-based compensation from their affiliate covered institutions over a full calendar year. The Agencies expect, based on the experience of exceptional assistance recipients under TARP,88 that 180 days would be a reasonable period of time for Level 1 and Level 2 covered institutions to finalize compensation paid to and awarded to covered persons and to perform the necessary calculations to determine which covered persons are significant risk-takers. This time period would allow covered institutions to U.S.C. 5221(b)(3)(D). ‘‘Supervisory Statement LSS8/13, Remuneration Standards: The Application of Proportionality’’ (April 2013), at 11, available at https://www.bankofengland.co.uk/publications/ Documents/other/pra/policy/2013/ remunerationstandardslss8-13.pdf. 88 The institutions that accepted ‘‘exceptional assistance’’ under TARP were required to submit to the Office of the Special Master for approval the compensation levels and structures for the five named executive officers and the next 20 most highly compensated executive officers (‘‘Top 25’’) and the compensation structures for the next 75 most highly compensated employees. The requirement for submission of the Top 25 necessitated the collection of the compensation data for executives worldwide and took considerable time and effort on the part of the institutions. 37693 make awards following the end of the performance period, calculate the annual base salary and incentive-based compensation for all employees in the consolidated organization, including affiliated covered institutions, and then implement new compensation arrangements for the significant risktakers identified, if necessary. The Agencies recognize that the relative compensation test and the exposure test, combined with the onethird threshold, may not identify all covered persons at Level 1 and Level 2 covered institutions who have the ability to expose a covered institution or its affiliated covered institutions to material financial loss. Accordingly, paragraph (2) of the proposed rule’s definition of significant risk-taker would allow covered institutions or the Agencies the flexibility to designate additional persons as significant risktakers. An Agency would be able to designate a covered person as a significant risk-taker if the covered person has the ability to expose the covered institution to risks that could lead to material financial loss in relation to the covered institution’s size, capital, or overall risk tolerance. Each Agency would use its own procedures for making such a designation. Such procedures generally would include reasonable advance written notice of the proposed action, including a description of the basis for the proposed action, and opportunity for the covered person and covered institution to respond. Relative Compensation Test The relative compensation test in paragraphs (1)(i) and (ii) of the proposed definition of ‘‘significant risk-taker’’ would require a covered institution to determine which covered persons received the most annual base salary and incentive-based compensation among all individuals receiving incentive-based compensation from the covered institution and any affiliates of the covered institution that are also subject to the proposed rule.89 The 86 12 87 PRA, PO 00000 Frm 00025 Fmt 4701 Sfmt 4702 89 The OCC, Board, FDIC, and SEC’s proposed rules include a defined term, ‘‘section 956 affiliate,’’ that is intended to function as shorthand for the types of entities that are considered ‘‘covered institutions’’ under the six Agencies’ proposed rules. The term ‘‘section 956 affiliate’’ is used only in the definition of ‘‘significant risk-taker,’’ and it is not intended to affect the scope of any Agency’s rule or the entities considered ‘‘covered institutions’’ under any Agency’s rule. Given the proposed location of each Agency’s proposed rule in the Code of Federal Regulations, the crossreferences used in each of the OCC, Board, FDIC, and SEC’s proposed rule differ slightly. NCUA’s proposed rule does not include a definition of ‘‘section 956 affiliate,’’ because credit unions are not affiliated with the entities that are considered E:\FR\FM\10JNP2.SGM Continued 10JNP2 37694 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 definition contains two percentage thresholds for measuring whether an individual is a significant risk-taker. For a Level 1 covered institution, a covered person would be a significant risk-taker if the person receives annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the performance period that places the person among the highest 5 percent of all covered persons in salary and incentive-based compensation (excluding senior executive officers) of the Level 1 covered institution and, in the cases of the OCC, the Board, the FDIC, and the SEC, any section 956 affiliates of the Level 1 covered institution. For Level 2 covered institutions, the threshold would be 2 percent rather than 5 percent. For example, if a hypothetical bank holding company were a Level 1 covered institution and had $255 billion in average total consolidated assets might have a subsidiary national bank with $253 billion in average total consolidated assets, a mortgage subsidiary with $1.9 billion in average total consolidated assets, and a wealth management subsidiary with $100 million in average total consolidated assets.90 The relative compensation test would analyze the annual base salary and incentive-based compensation of all covered persons (other than senior executive officers) who receive incentive-based compensation at the bank holding company, the subsidiary national bank, and the mortgage subsidiary, which are all covered institutions with assets greater than or equal to $1 billion. Individuals at the wealth management subsidiary would not be included because that subsidiary has less than $1 billion in average total consolidated assets. Thus, if the bank holding company, state member bank, and mortgage subsidiary collectively had 150,000 covered persons (excluding senior executive officers), then the covered institution should identify the 7,500 or 5 percent of covered persons (other than senior executive officers) who receive the most annual base salary ‘‘covered institutions’’ under the other Agencies’ rules. Similarly, FHFA’s proposed rule does not include a definition of ‘‘section 956 affiliate’’ because its regulated institutions are not affiliated with other Agencies’ covered institutions. 90 Under the proposed rule, all of these subsidiaries in this example other than the wealth management subsidiary would be subject to the same requirements as the bank holding company, including the specific requirements applying to identification of significant risk-takers. The wealth management subsidiary would not be subject to the requirements of the proposed rule because it has less than $1 billion in average total consolidated assets. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 and incentive-based compensation out of those 150,000 covered persons, and identify as significant risk-takers any of those 7,500 persons who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period of which at least one-third is incentivebased compensation.91 Some of those 7,500 covered persons might receive incentive-based compensation from the bank holding company; others might receive incentive-based compensation from the national bank or the mortgage subsidiary. Each covered person that satisfies all requirements would be considered a significant risk-taker of the covered institution from which they receive incentive-based compensation. This example is provided solely for the purpose of illustrating the calculation of the number of significant risk-takers under the relative compensation test as proposed. It does not reflect any specific institution, nor does it reflect the experience or judgment of the Agencies of the number of covered persons or significant risk-takers at any institution that would be a Level 1 covered institution under the proposed rule. Annual base salary and incentivebased compensation would be measured based on the last calendar year that ended at least 180 days before the beginning of the performance period for the reasons discussed above. The Agencies propose that Level 1 and Level 2 covered institutions generally should consider a covered person’s annual base salary actually paid during the calendar year. If, for example, a covered person was a manager during the first half of the year, with an annual salary of $100,000, and was then promoted to a senior manager with an annual salary of $150,000 on July 1 of that year, the annual base salary would be the $50,000 that person received as manager for the first half of the year plus the $75,000 received as a senior manager for the second half of the year, for a total of $125,000. For the purposes of determining significant risk-takers, covered institutions should consider the incentive-based compensation that was awarded for any performance period that ended during a particular calendar year, regardless of when the performance period began. For example, if a covered person is awarded incentive-based compensation relating to (i) a plan with a three-year 91 The Agencies anticipate that covered institutions that are within a depository institution holding company structure would work together to ensure that significant risk-takers are correctly identified under the relative compensation test. PO 00000 Frm 00026 Fmt 4701 Sfmt 4702 performance period that began on January 1, 2017, (ii) a plan with a twoyear performance period that began on January 1, 2018, and (iii) a plan with a one-year performance period that began on January 1, 2019, then all three of these awards would be included in the calculation of incentive-based compensation for calendar year 2019 because all three performance periods would end on December 31, 2019. The amount of previously deferred incentive-based compensation that vests in a particular year would not affect the measure of a covered person’s incentivebased compensation for purposes of the relative compensation test.92 To reduce the administrative burden of calculating annual base salary and incentive-based compensation, the calculation would not include fringe benefits such as the value of medical insurance or the use of a company car. For purposes of such calculation, any non-cash compensation, such as stock or options, should be valued as of the date of the award. In the Agencies’ supervisory experience, the amount of a covered person’s annual base salary and incentive-based compensation can reasonably be expected to relate to the amount of responsibility that the covered person has within an organization, and covered persons with a higher level of responsibility generally either (1) have a greater ability to expose a covered institution to financial loss or (2) supervise covered persons who have a greater ability to expose a covered institution to financial loss. For this reason, the Agencies are proposing to use the relative compensation test as one basis for identifying significant risktakers. Although a large number of covered persons may be able to expose a covered institution to a financial loss, the Agencies have limited the relative compensation test to the most highly compensated individuals in order to focus on those covered persons whose behavior can directly or indirectly expose a Level 1 or Level 2 covered institution to a financial loss that is material. Based on an analysis of public disclosures of large, international banking organizations 93 and on the 92 Level 1 and Level 2 covered institutions would also use this method of calculating a covered person’s incentive-based compensation for a particular calendar year for purposes of determining (1) whether such person received annual base salary and incentive-based compensation of which at least one third was incentive-based compensation and (2) the amount of a covered person’s annual base salary and incentive-based compensation under the dollar threshold test. 93 Agencies examined information available through various public reports, including the FSB’s E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 Agencies’ own supervision of incentivebased compensation, the top 5 percent most highly compensated covered persons among the covered institutions in the consolidated structure of Level 1 covered institutions are the most likely to have the potential to encourage inappropriate risk-taking by the covered institution because their compensation is excessive (the first test in section 956) or be the personnel who are able to expose the organization to risk of material financial loss (the second test in section 956). The Board and the OCC, as a part of their supervisory efforts, reviewed a limited sample of banking organizations with total consolidated assets of $50 billion or more to better understand what types of positions within these organizations would be captured by various thresholds for highly compensated employees. In the review, the Board and the OCC also considered annual Compensation Progress Report. For instance, many international jurisdictions require firms to identify a population of employees who can expose a firm to material amounts of risk (sometimes called material risk takers or key risk takers), who are subject to specific requirements including deferral. In 2014 the FSB published information indicating that the average percentage of total global employees identified as risk-takers under these various jurisdictions’ requirements at a sample of large firms ranged from 0.01 percent of employees of the global consolidated organization to more than 5 percent. The number varied between, but also within, individual jurisdictions and institutions as a result of factors such as specific institutions surveyed, the size of institution, and the nature of business conducted. See FSB, Implementing the FSB Principles for Sound Compensation Practices and their Implementation Standards Third Progress Report (November 2014), at 19, available at https:// www.fsb.org/2014/11/fsb-publishes-third-progressreport-on-compensation-practices. In addition, the Agencies relied to a certain extent on information disclosed on a legal entity basis as a result of Basel Pillar 3 remuneration disclosure requirements, for instance those required under implementing regulations such as Article 450 of the Capital Requirements Regulation (EU No 575/2013) in the European Union. See, e.g., Morgan Stanley, Article 450 of CRR Disclosure: Remuneration Policy (December 31, 2014), available at https:// www.morganstanley.com/about-us-ir/pillar3/2014_ CRR_450_Disclosure.pdf. Remuneration disclosure requirements apply to ‘‘significant’’ firms. CRD IV defines institutions that are significant ‘‘in terms of size, internal organisation and nature, scope and complexity of their activities.’’ Under the EBA Guidance on Sound Remuneration Policies, significant institutions means institutions referred to in Article 131 of Directive 2013/36/EU (global systemically important institutions or ‘G–SIIs,’ and other systemically important institutions or ‘O– SIIs’), and, as appropriate, other institutions determined by the competent authority or national law, based on an assessment of the institutions’ size, internal organization and the nature, the scope and the complexity of their activities. Some, but not all, national regulators have provided further guidance on interpretation of that term, including the United Kingdom’s FCA which provides a form of methodology to determine if a firm is ‘‘significant’’—based on quantitative tests of balance sheet assets, liabilities, annual fee commission income, client money and client assets. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 how far below the CEO within the organizational hierarchy the selected thresholds would reach. Generally, at banking organizations that would be Level 1 covered institutions under the proposed rule, a 5 percent threshold would include positions such as managing directors, directors, senior vice presidents, relationship and sales managers, mortgage brokers, financial advisors, and product managers. Such positions generally have the ability to expose the organization to the risk of material financial loss. Based on this review, the Agencies believe it is reasonable to propose a 5 percent threshold under the relative compensation test for Level 1 covered institutions. At banking organizations that would be Level 2 covered institutions under the proposed rule, a 5 percent threshold yielded results that went much deeper into the organization and identified roles with individuals who might not individually take significant risks for the organization. Additional review of a limited sample of these banking organizations that would be Level 2 covered institutions under the proposed rule showed that, on average, the institutions in the limited sample identified approximately 2 percent of their total global employees as individual employees whose activities may expose the organization to material amounts of risk, as consistent with the 2010 Federal Banking Agency Guidance. A lower percentage threshold for Level 2 covered institutions relative to Level 1 covered institutions also is consistent with the observation that larger covered institutions generally have more complex structures and use incentivebased compensation more significantly than relatively smaller covered institutions. Based on this analysis, the Agencies chose to propose a 2 percent threshold for Level 2 covered institutions. A lower percentage threshold for Level 2 covered institutions relative to Level 1 covered institutions would reduce the burden on relatively smaller covered institutions. Under the proposed rule, if an Agency determines, in accordance with procedures established by the Agency, that a Level 1 covered institution’s activities, complexity of operations, risk profile, and compensation practices are similar to those of a Level 2 covered institution, then the Agency may apply a 2 percent threshold under the relative compensation test rather than the 5 percent threshold that would otherwise apply. This provision is intended to allow an Agency the flexibility to adjust the number of covered persons who are significant risk-takers with respect to a PO 00000 Frm 00027 Fmt 4701 Sfmt 4702 37695 Level 1 covered institution if the Agency determines that, notwithstanding the Level 1 covered institution’s average total consolidated assets, its actual activities and risks are similar to those of a Level 2 covered institution, and therefore it would be appropriate for the Level 1 covered institution to have fewer significant risk-takers. Exposure Test Under the exposure test, a covered person would be a significant risk-taker with regard to a Level 1 or Level 2 covered institution if the individual may commit or expose 94 0.5 percent or more of capital of the covered institution or, and, in the cases of the OCC, the Board, the FDIC, and the SEC, any section 956 affiliates of the covered institution, whether or not the individual is employed by that specific legal entity. The exposure test relates to a covered person’s authority to commit or expose significant amounts of an institution’s capital, regardless of whether or not such exposures or commitments are realized. The exposure test would relate to a covered person’s authority to cause the covered institution to be subject to credit risk or market risk. The exposure test would not relate to the ability of a covered person to expose a covered institution to other types of risk that may be more difficult to measure or quantify, such as compliance risk. The measure of capital would relate to a covered person’s authority over the course of the most recent calendar year, in the aggregate, and would be based on the maximum amount that the person has authority to commit or expose during the year. For example, a Level 1 or Level 2 covered institution might allocate $10 million to a particular covered person as an authorized level of lending for a calendar year. For purposes of the exposure test in the proposed rule, the covered person’s authority to commit or expose would be $10 million. This would be true even if the individual only made $8 million in loans during the year or if the covered institution reduced the authorized amount to $7.5 million at some point during the year. It would also be true even if the covered person did not have the authority through any single transaction to lend $10 million, so long as over the course of the year the covered person could lend up to $10 million in the aggregate. If, however, in 94 An individual may commit or expose capital of a covered institution or affiliate if the individual has the ability to put the capital at risk of loss due to market risk or credit risk. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37696 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules the course of the year the covered person received authorization for an additional $5 million in lending, $15 million would become the authorization amount for purposes of the exposure test. If a covered person had no specific maximum amount of lending for the year, but instead his or her lending was subject to approval on a rolling basis, then the covered person would be assumed to have an authorized annual lending amount in excess of the 0.5 percent threshold. As an additional example, a Level 1 or Level 2 covered institution could authorize a particular covered person to trade up to $5 million per day in a calendar year. For purposes of the exposure test, the covered person’s authorized annual lending amount would be $5 million times the number of trading days in the year (for example, $5 million times 260 days or $1.3 billion). This would be true even if the covered person only traded $1 million per day during the year or if the covered institution reduced the authorized trading amount to $2.5 million per day at some point during the year. If, however, in the course of the year the covered person received authorization for an additional $2 million in trading per day, the covered person’s authority to commit or expose capital for purposes of the exposure test would be $1.82 billion ($7 million times 260 days). The Agencies are aware that institutions may not calculate their exposures in this manner and are requesting comment upon it, as set forth below. The exposure test would also include individuals who are voting members of a committee that has the decisionmaking authority to commit or expose 0.5 percent or more of the capital of a covered institution or of a section 956 affiliate of a covered institution. For example, if a committee that is comprised of five covered persons has the authority to make investment decisions with respect to 0.5 percent or more of a state member bank’s capital, then each voting member of such committee would have the authority to commit or expose 0.5 percent or more of the state member bank’s capital for purposes of the exposure test. However, individuals who participate in the meetings of such a committee but who do not have the authority to exercise voting, veto, or similar rights that lead to the committee’s decision would not be included. The exposure test would also cause a covered person to be considered a significant risk-taker if he or she can commit or expose 0.5 percent or more of the capital of any section 956 affiliate VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 of the covered institution by which the covered person is employed. For example, if a covered person of a nonbank subsidiary of a bank holding company has the authority to commit 0.5 percent or more of the bank holding company’s capital or the capital of the bank holding company’s subsidiary national bank (and received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period of which at least one-third is incentivebased compensation), then the covered person would be considered a significant risk-taker of the bank holding company or national bank, whichever is applicable. This would be true even if the covered person is not employed by the bank holding company or the bank holding company’s subsidiary national bank, and even if the covered person does not have the authority to commit or expose the capital of the nonbank subsidiary that employs the covered person. The exposure test would require a Level 1 or Level 2 covered institution to consider the authority of an individual to take an action that could result in significant credit or market risk exposures to the covered institution. The Agencies are proposing the exposure test because individuals who have the authority to expose covered institutions to significant amounts of risk can cause material financial losses to covered institutions. For example, in proposing the exposure test, the Agencies were cognizant of the significant losses caused by actions of individuals, or a trading group, at some of the largest financial institutions during and after the financial crisis that began in 2007.95 The exposure test would identify significant risk-takers based on the extent of an individual’s authority to expose an institution to market risk or credit risk, measured by reference to 0.5 percent of the covered institution’s regulatory capital. Measuring this authority by reference to an existing capital standard would provide a uniform and clearly defined metric to apply among covered persons at Level 1 and Level 2 covered institutions. The Agencies have selected credit and market risks as the most relevant types of exposures because the majority of assets on a covered institution’s balance sheet generally give rise to market or credit risk exposure. In proposing a threshold of 0.5 percent of relevant capital, the Agencies considered both the absolute and 95 See PO 00000 supra note 14. Frm 00028 Fmt 4701 relative amount of losses that the threshold would represent for covered institutions, and the fact that incentivebased compensation programs generally apply to numerous employees at a covered institution. In the Agencies’ view, the proposed threshold represents a material financial loss within the meaning of section 956 for any institution and multiple losses at the same firm incentivized by a single incentive-based compensation program could impair the firm. The Agencies considered the cumulative effect of incentive-based compensation arrangements across a covered institution. The Agencies recognize that many covered persons who have the authority to expose a covered institution to risk are subject to similar incentive-based compensation arrangements. The effect of an incentive-based compensation arrangement on a covered institution would be the cumulative effect of the behavior of all covered persons subject to the incentive-based compensation arrangement. If multiple covered persons are incented to take inappropriate risks, their combined risktaking behavior could lead to a financial loss at the covered institution that is significantly greater than the financial loss that could be caused by any one individual.96 Although many institutions already have governance and risk management systems to help ensure the commitment of significant amounts of capital is subject to appropriate controls, as noted above, incentive-based compensation arrangements that provide inappropriate risk-taking incentives can weaken those governance and risk management systems. These considerations about the cumulative effect of incentive-based compensation arrangements weigh in favor of a conservative threshold under the exposure test so that large groups of covered persons with the authority to commit a covered institution’s capital are not subject to flawed incentivebased compensation arrangements which would incentivize them to subject the covered institution to inappropriate risks. The Agencies also considered that in another regulatory context, a relatively small decrease in a large institution’s capital requires additional safeguards for safety and soundness. Under the capital plan rule in the Board’s Regulation Y, well-capitalized bank holding companies with average total consolidated assets of $50 billion or more are subject to prior approval requirements on incremental capital 96 See, Sfmt 4702 E:\FR\FM\10JNP2.SGM e.g., the Subcommittee Report. 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules distributions if those distributions, as measured over a one-year period, would exceed pre-approved amounts by more than 1 percent of the bank holding company’s tier 1 capital.97 Relative to the capital plan rule, a lower threshold of capital is appropriate in the context of incentive-based compensation in light of the potential cumulative effect of multiple covered persons with incentives to take inappropriate risks and the possibility that correlated inappropriate risk-taking incentives could, in the aggregate, significantly erode capital buffers at Level 1 and Level 2 covered institutions. Taking into consideration the cumulative impact of incentive-based compensation arrangements described above, the Agencies have proposed a threshold level for the exposure test of 0.5 percent of capital. The exposure test would be measured on an annual basis to align with the common practice at many institutions of awarding incentive-based compensation on an annual basis, taking into account a covered person’s performance and risktaking over 12 months. The Agencies also considered international compensation regulations that also use a 0.5 percent threshold, but on a per transaction basis.98 The Agencies are proposing to apply the threshold on an aggregate annual basis because a per transaction basis could permit an individual to evade designation as a significant risk-taker and the related incentive-based compensation restrictions by keeping his or her individual transactions below the threshold, but completing multiple transactions during the course of the year that, in the aggregate, far exceed the threshold. mstockstill on DSK3G9T082PROD with PROPOSALS2 Exposure Test at Certain Affiliates Paragraph (3) of the definition of significant risk-taker is intended to address potential evasion of the exposure test by a Level 1 or Level 2 covered institution that authorizes an employee of one of its affiliates that is not a covered institution because it has less than $1 billion in average total 97 See 12 CFR 225.8(g). Bank holding companies that are well-capitalized and that meet other requirements under the rule must provide the Board with prior notice for incremental capital distributions, as measured over a one-year period, that represent more than 1 percent of their tier 1 capital. Id. 98 See, e.g., EBA, ‘‘Regulatory Technical Standards on Criteria to Identify Categories of Staff Whose Professional Activities Have a Material Impact on an Institution’s Risk Profile under Article 94(2) of Directive 2013/36/EU’’ (December 16, 2013), available athttps://www.eba.europa.eu/ documents/10180/526386/EBA-RTS-2013-11+ %28On+identified+staff%29.pdf/c313a671-269b45be-a748-29e1c772ee0e. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 consolidated assets or is not considered a covered institution under one of the six Agencies’ proposed rules, to commit or expose 0.5 percent or more of capital of the Level 1 or Level 2 covered institution. The Agencies are concerned that in such a situation, the employee would be functioning as a significant risk-taker at the affiliated Level 1 or Level 2 covered institution but would not be subject to the requirements of the proposed rule that would be applicable to a significant risk-taker at the affiliated Level 1 or Level 2 covered institution. To address this circumstance, the proposed rule would treat such employee as a significant risk-taker with respect to the affiliated Level 1 or Level 2 covered institution for which the employee may commit or expose capital. That Level 1 or Level 2 covered institution would be required to ensure that the employee’s incentive-based compensation arrangement complies with the proposed rule. Dollar Threshold Test As an alternative to the relative compensation test, the Agencies also considered using a specific absolute compensation threshold, measured in dollars, to determine whether an individual is a significant risk-taker. Under this test, a covered person who receives annual base salary and incentive-based compensation 99 in excess of a specific dollar threshold would be a significant risk-taker, regardless of how that covered person’s annual base salary and incentive-based compensation compared to others in the consolidated organization (the ‘‘dollar threshold test’’). A dollar threshold test would include adjustments such as for inflation. If the dollar threshold test replaced the relative compensation test, the definition of ‘‘significant risk-taker’’ would still include only covered persons who received annual base salary and incentive-based compensation of which at least onethird was incentive-based compensation, based on the covered person’s annual base salary paid and incentive-based compensation awarded during the last calendar year that ended at least 180 days before the beginning of the performance period. One advantage of a dollar threshold test compared to the relative compensation test is that it could be less burdensome to implement and monitor. With a dollar threshold test covered institutions can determine whether an 99 For purposes of the dollar threshold test, the measure of annual base salary and incentive-based compensation would be calculated in the same way as the measure for the one-third threshold discussed above. PO 00000 Frm 00029 Fmt 4701 Sfmt 4702 37697 individual covered person meets the dollar threshold test of the significant risk-taker definition by reviewing the compensation of only that single individual. The dollar threshold test would also allow an institution to implement incentive-based compensation structures, policies, and procedures with some foreknowledge of which employees would be covered by them. However, even with adjustment for inflation, a dollar threshold put in place by regulation would assume that a certain dollar threshold is an appropriate level for all Level 1 and Level 2 covered institutions and covered persons. On the other hand, a dollar threshold could set expectations so that individual employees would know based on their own compensation if they are significant risk-takers. Based on FHFA’s supervisory experience analyzing compensation both at FHFA’s regulated entities and at other financial institutions, a dollar threshold would be an appropriate approach to identify individuals with the ability to put the covered institution at risk of material loss. FHFA must prohibit its regulated entities from providing compensation to any executive officer of the regulated entity that is not reasonable and comparable with compensation for employment in other similar businesses (including publicly held financial institutions or major financial services companies) involving similar duties and responsibilities.100 In order to meet this statutory mandate, FHFA analyzes, assesses, and compares the compensation paid to employees of its regulated entities and compensation paid to employees of other financial institutions of various asset sizes. In performing this analysis, FHFA has observed that the amount of a covered person’s annual base salary and incentive-based compensation reasonably relates to the level of responsibility that the covered person has within an organization. A dollar threshold test, if set at the appropriate level, would identify covered persons who either (1) have a greater ability to expose a covered institution to financial loss or (2) supervise covered persons who have a greater ability to expose a covered institution to financial loss. One disadvantage of the dollar threshold test is that it may not appropriately capture all individuals who subject the firm to significant risks. A dollar threshold put in place by regulation that is static across all Level 1 and Level 2 covered institutions also is not sensitive to the compensation 100 12 E:\FR\FM\10JNP2.SGM U.S.C. 4518(a). 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37698 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules practices of an individual organization. The relative compensation test, while not as easy to implement, could be more sensitive to the compensation structure of an organization because it is based on the relative compensation of individuals that the organization concludes should be the mostly highly compensated. 2.18. For purposes of a designation under paragraph (2) of the definition of significant risk-taker, should the Agencies provide a specific standard for what would constitute ‘‘material financial loss’’ and/or ‘‘overall risk tolerance’’? If so, how should these terms be defined and why? 2.19. The Agencies specifically invite comment on the one-third threshold in the proposed rule. Is one-third of the total of annual base salary and incentive-based compensation an appropriate threshold level of incentivebased compensation that would be sufficient to influence risk-taking behavior? Is using compensation from the last calendar year that ended at least 180 days before the beginning of the performance period for calculating the one-third threshold appropriate? 2.20. The Agencies specifically invite comment on the percentages of employees proposed to be covered under the relative compensation test. Are 5 percent and 2 percent reasonable levels? Why or why not? Would 5 percent and 2 percent include all of the significant risk-takers or include too many covered persons who are not significant risk-takers? 2.21. The Agencies specifically invite comment on the time frame needed to identify significant risk-takers under the relative compensation test. Is using compensation from the last calendar year that ended at least 180 days before the beginning of the performance period appropriate? The Agencies invite comment on whether there is another measure of total compensation that would be possible to measure closer in time to the performance period for which a covered person would be identified as a significant risk-taker. 2.22. The Agencies invite comment on all aspects of the exposure test, including potential costs and benefits, the appropriate exposure threshold and capital equivalent, efficacy at identifying those non-senior executive officers who have the authority to place the capital of a covered institution at risk, and whether an exposure test is a useful complement to the relative compensation test. If so, what specific types of activities or transactions, and at what level of exposure, should the exposure test cover? The Agencies also invite comment on whether the exposure test is workable and why. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 What, if any, additional details would need to be specified in order to make the exposure test workable, such as further explanation of the meanings of ‘‘commit’’ or ‘‘expose’’? In addition to committees, should the exposure test apply to groups of persons, such as traders on a desk? If so, how should it be applied? 2.23. With respect to the exposure test, the Agencies specifically invite comment on the proposed capital commitment levels. Is 0.5 percent of capital of a covered institution a reasonable proxy for material financial loss, or are there alternative levels or dollar thresholds that would better achieve the statutory objectives? If alternative methods would better achieve the statutory objectives, what are the advantages and disadvantages of those alternatives compared to the proposed level? For depository institution holding company organizations with multiple covered institutions, should the capital commitment level be consistent across all such institutions or should it vary depending on specified factors and why? For example, should the levels for covered institutions that are subsidiaries of a parent who is also a covered institution vary depending on: (1) The size of those subsidiaries relative to the parent; and/or (2) whether the entity would be subject to comparable restrictions if it were not affiliated with the parent? What are the advantages and disadvantages of any such variation, and what would be the appropriate levels? The Agencies recognize that certain covered institutions under the Board’s, the OCC’s, the FDIC’s, and the SEC’s proposed rules, such as Federal and state branches and agencies of foreign banks and investment advisers that are not also depository institution holding companies, banks, or broker-dealers or subsidiaries of those institutions, are not otherwise required to calculate common equity tier 1 capital or tentative net capital, as applicable. How should the capital commitment level be determined under the Board’s, the OCC’s, the FDIC’s, and the SEC’s proposed rules for those covered institutions? Is there a capital or other measure that the Agencies should consider for those covered institutions that would achieve similar objectives to common equity tier 1 capital or tentative net capital? If so, what are the advantages and disadvantages of such a capital or other measure? 2.24. The Agencies invite comment on whether it is appropriate to limit the exposure test to market risk and credit risk and why. What other types of risk should be included, if any and how PO 00000 Frm 00030 Fmt 4701 Sfmt 4702 would such exposures be measured? Should the Agencies prescribe a method for measurement of market risk and credit risk? Should exposures be measured as notional amounts or is there a more appropriate measure? If so, what would it be? Should the exposure test take into account hedging? How should the exposure test be applied to an individual in a situation where a firm calculates an exposure limit for a trading desk comprised of a group of people? Should a de minimis threshold be introduced for any transaction counted toward the 0.5 percent annual exposure test? 2.25. Should the exposure test consider the authority of a covered person to initiate or structure proposed product offerings, even if the covered person does not have final decisionmaking authority over such product offerings? Why or why not? If so, are there specific types of products with respect to which this approach would be appropriate and why? 2.26. Should the exposure test measure a covered person’s authority to commit or expose (a) through one transaction or (b) as currently proposed, through multiple transactions in the aggregate over a period of time? What would be the benefits and disadvantages of applying the test on a per-transaction versus aggregate basis over a period of time? If measured on an aggregate basis, what period of time is appropriate and why? For example, should paragraph (1)(iii) of the definition of significant risk-taker read: ‘‘A covered person of a covered institution who had the authority to commit or expose in any single transaction during the previous calendar year 0.5 percent or more of the capital 101 of the covered institution or of any section 956 affiliate of the covered institution, whether or not the individual is a covered person of that specific legal entity’’? Why or why not? 2.27. If the exposure test were based on a single transaction, would 0.5 percent of capital be the appropriate threshold for significant risk-taker status? Why or why not? If not, what would be the appropriate percentage of capital to include in the exposure test and why? 2.28. Should the Agencies introduce an absolute exposure threshold in addition to a percentage of capital test if a per-transaction test was introduced instead of the annual exposure test? Why or why not? For example, would a threshold formulated as ‘‘the lesser of 0.5 percent of capital or $100 million’’ 101 Under this alternative language, each Agency’s rule text would include the relevant capital metrics for its covered institutions. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules help to level the playing field across Level 1 covered institutions and the smallest Level 2 covered institutions and better ensure that the right set of activities is being considered by all institutions? The Agencies’ supervisory experience indicates that many large institutions, for example, require additional scrutiny of significant transactions, which helps to ensure that the potential risks posed by large transactions are adequately considered before such transactions are approved. Would $100 million be the appropriate level at which additional approval procedures are required before a transaction is approved, or would a lower threshold be appropriate if an absolute dollar threshold were combined with the capital equivalent threshold? 2.29. Should the exposure test measure exposures or commitments actually made, or should the authority to make an exposure or commitment be sufficient to meet the test and why? For example, should paragraph (1)(iii) of the definition of significant risk-taker read: ‘‘A covered person of a covered institution who committed or exposed in the aggregate during the previous calendar year 0.5 percent or more of the common equity tier 1 capital, or in the case of a registered securities broker or dealer, 0.5 percent or more of the tentative net capital, of the covered institution or of any section 956 affiliate of the covered institution, whether or not the individual is a covered person of that specific legal entity’’? 2.30. Would a dollar threshold test, as described above, achieve the statutory objectives better than the relative compensation test? Why or why not? If using a dollar threshold test, and assuming a mechanism for inflation adjustment, would $1 million be the right threshold or should it be higher or lower? For example, would a threshold of $2 million dollars be more appropriate? Why or why not? How should the threshold be adjusted for inflation? Are there other adjustments that should be made to ensure the threshold remains appropriate? What are the advantages and disadvantages of a dollar threshold test compared to the proposed relative compensation test? 2.31. The Agencies specifically invite comment on replacement of the relative compensation test in paragraphs (1)(i) and (ii) of the definition of significant risk-taker with a dollar threshold test, as follows: ‘‘a covered person of a Level 1 or Level 2 covered institution who receives annual base salary and incentive-based compensation of $1 million or more in the last calendar year that ended at least 180 days before the VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 beginning of the performance period.’’ Under this alternative, the remaining language in the definition of ‘‘significant risk-taker’’ would be unchanged. 2.32. The Agencies invite comment on all aspects of a dollar threshold test, including potential costs and benefits, the appropriate amount, efficacy at identifying those non-senior executive officers who have the ability to place the institution at risk, time frame needed to identify significant risk-takers, and comparison to a relative compensation test such as the one proposed. Is the last calendar year that ended at least 180 days before the beginning of the performance period an appropriate time frame or for the dollar threshold test or would using compensation from the performance period that ended in the most recent calendar year be appropriate? The Agencies specifically invite comment on whether to use an exposure test if a dollar threshold test replaces the relative compensation test and why. 2.33. The Agencies invite comment on all aspects of the definition of ‘‘significant risk-taker.’’ The Agencies specifically invite comment on whether the definition should rely solely on the relative compensation test, solely on the exposure test, or on both tests, as proposed. What are the advantages and disadvantages of each of these options? 2.34. In addition to the tests outlined above, are there alternative tests of, or proxies for, significant risk-taking that would better achieve the statutory objectives? What are the advantages and disadvantages of alternative approaches? What are the implementation burdens of any of the approaches, and how could they be addressed? 2.35. How many covered persons would likely be identified as significant risk-takers under the proposed rule? How many covered persons would likely be identified under only the relative compensation test with the onethird threshold? How many covered persons would likely be identified under only the exposure test as measured on an annual basis with the one-third threshold? How many covered persons would be identified under only an exposure test formulated on a per transaction basis with the one-third threshold? How many covered persons would be identified under only the dollar threshold test, assuming the dollar threshold is $1 million, with the one-third threshold? How many covered persons would be identified under each test individually without a one-third threshold? PO 00000 Frm 00031 Fmt 4701 Sfmt 4702 37699 Other Definitions To award. The proposed rule defines ‘‘to award’’ as to make a final determination, conveyed to a covered person, of the amount of incentivebased compensation payable to the covered person for performance over a performance period. The Agencies acknowledge that some covered institutions use the term ‘‘award’’ to refer to the decisions that covered institutions make about incentive-based compensation structures and performance measure targets before or soon after the relevant performance period begins. However, in the interest of clarity and consistency, the proposed rule uses the phrase ‘‘to award’’ only with reference to final determinations about incentive-based compensation amounts that an institution makes and communicates to the covered person who could receive the award under an incentive-based compensation arrangement for a given performance period. In most cases, incentive-based compensation will be awarded near the end of the performance period. Neither the length of the performance period nor the decision to defer some or all incentive-based compensation would affect the determination of when incentive-based compensation is awarded for purposes of the proposed rule. For example, at the beginning of a one-year performance period, a covered institution might inform a covered person of the amount of incentive-based compensation that the covered person could earn at the end of the performance period if certain measures and other criteria are met. The covered institution might also inform the covered person that a portion of the covered person’s incentive-based compensation will be deferred for a four-year period. The covered person’s incentive-based compensation for that performance period—including both the portion that is deferred and the portion that vests immediately—would be ‘‘awarded’’ when the covered institution determines what amount of incentive-based compensation the covered person has earned based on his or her performance during the performance period. For equity-like instruments, such as stock appreciation rights and options, the date when incentive-based compensation is awarded may be different than from the date when the instruments vest, are paid out, or can be exercised. For example, a covered institution could determine at the end of a performance period that a covered person has earned options on the basis of performance during that performance E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37700 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules period, and the covered institution could provide that the covered person cannot exercise the options for another five years. The options would be considered to have been ‘‘awarded’’ at the end of the performance period, even if they cannot be exercised for five years. Under the proposed rule, covered institutions would have the flexibility to decide how the determination of the amount of incentive-based compensation would be conveyed to a covered person. For example, some covered institutions may choose to inform covered persons of their award amounts in writing or by electronic message. Others may choose to allow managers to orally inform covered persons of their award amounts. 2.36. The Agencies invite comment on whether the proposed rule’s definition of ‘‘to award’’ should include language on when incentive-based compensation is awarded for purposes of the proposed rule. Specifically, the Agencies invite comment on whether the definition should read: ‘‘To award incentive-based compensation means to make a final determination, conveyed to a covered person, at the end of the performance period, of the amount of incentive-based compensation payable to the covered person for performance over that performance period.’’ Why or why not? Board of directors. The proposed rule defines ‘‘board of directors’’ as the governing body of a covered institution that oversees the activities of the covered institution, often referred to as the board of directors or board of managers. Under the Board’s proposed rule, for a foreign banking organization, ‘‘board of directors’’ would mean the relevant oversight body for the institution’s state insured or uninsured branch, agency, or operations, consistent with the foreign banking organization’s overall corporate and management structure. Under the FDIC’s proposed rule, for a state insured branch of a foreign bank, ‘‘board of directors’’ would refer to the relevant oversight body for the state insured branch consistent with the foreign bank’s overall corporate and management structure. Under the OCC’s proposed rule, for a Federal branch or agency of a foreign bank, ‘‘board of directors’’ would refer to the relevant oversight body for the Federal branch or agency, consistent with its overall corporate and management structure. The OCC would work closely with Federal branches and agencies to determine the appropriate person or committee to undertake the responsibilities assigned to the oversight body. NCUA’s proposed rule defines VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 ‘‘board of directors’’ as the governing body of a credit union. Clawback. The term ‘‘clawback’’ under the proposed rule refers specifically to a mechanism that allows a covered institution to recover from a senior executive officer or significant risk-taker incentive-based compensation that has vested if the covered institution determines that the senior executive officer or significant risk-taker has engaged in fraud or the types of misconduct or intentional misrepresentation described in section ll.7(c) of the proposed rule. Clawback would not apply to incentivebased compensation that has been awarded but is not yet vested. As used in the proposed rule, the term ‘‘clawback’’ is distinct from the terms ‘‘forfeiture’’ and ‘‘downward adjustment,’’ in that clawback provisions allow covered institutions to recover incentive-based compensation that has already vested. In contrast, forfeiture applies only after incentivebased compensation is awarded but before it vests. Downward adjustment occurs only before incentive-based compensation is awarded. Compensation, fees, or benefits. The proposed rule defines ‘‘compensation, fees, or benefits’’ to mean all direct and indirect payments, both cash and noncash, awarded to, granted to, or earned by or for the benefit of, any covered person in exchange for services rendered to the covered institution. The form of payment would not affect whether such payment meets the definition of ‘‘compensation, fees, or benefits.’’ The term would include, among other things, payments or benefits pursuant to an employment contract, compensation, pension, or benefit agreements, fee arrangements, perquisites, options, post-employment benefits, and other compensatory arrangements. The term is defined broadly under the proposed rule in order to include all forms of incentivebased compensation. The term ‘‘compensation, fees, or benefits’’ would exclude reimbursement for reasonable and proper costs incurred by covered persons in carrying out the covered institution’s business. Control function. The proposed rule defines ‘‘control function’’ as a compliance, risk management, internal audit, legal, human resources, accounting, financial reporting, or finance role responsible for identifying, measuring, monitoring, or controlling risk-taking.102 The term would include loan review and Bank Secrecy Act roles. Section ll.9(b) of the proposed rule would require a Level 1 or Level 2 covered institution to provide individuals engaged in control functions with the authority to influence the risktaking of the business areas they monitor and ensure that covered persons engaged in control functions are compensated in accordance with the achievement of performance objectives linked to their control functions and independent of the performance of the business areas they monitor. As described below, section ll.11 of the proposed rule would also require that a Level 1 or Level 2 covered institution’s policies and procedures provide an appropriate role for control function personnel in the covered institution’s incentive-based compensation program. The heads of control functions would also be considered senior executive officers for purposes of the proposed rule, because such employees can individually affect the risk profile of a covered institution. Although covered persons in control functions generally do not perform activities designed to generate revenue or reduce expenses, they may nonetheless have the ability to expose covered institutions to risk of material financial loss. For example, individuals in human resources and risk management roles contribute to the design and review of performance measures used in incentive-based compensation arrangements, which may allow them to influence the activities of risk-takers in a covered institution. For that reason, the proposed rule would treat covered persons who are the heads of control functions as senior executive officers who would be subject to certain additional requirements under the proposed rule as described further below. 2.37. The Agencies invite comment on whether and in what circumstances, the proposed definition of ‘‘control function’’ should include additional individuals and organizational units that (a) do not engage in activities designed to generate revenue or reduce expenses; (b) provide operational support or servicing to any organizational unit or function; or (c) provide technology services. Deferral. The proposed rule defines ‘‘deferral’’ as the delay of vesting of incentive-based compensation beyond the date on which the incentive-based compensation is awarded. As discussed below in this Supplementary Information section, under the proposed 102 The term ‘‘control function’’ would serve a different purpose than, and is not intended to affect the interpretation of, the term ‘‘front line unit,’’ as used in the OCC’s Heightened Standards. PO 00000 Frm 00032 Fmt 4701 Sfmt 4702 E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules rule, a Level 1 or Level 2 covered institution would be required to defer a portion of the incentive-based compensation of senior executive officers and significant risk-takers. The Agencies would not consider compensation that has vested, but that the covered person then chooses to defer, e.g., for tax reasons, to be deferred incentive-based compensation for purposes of the proposed rule because it would not be subject to forfeiture. The Agencies note that the deferral period under the proposed rule would not include any portion of the performance period, even for incentivebased compensation plans that have longer performance periods. Deferral involves a ‘‘look-back’’ period that is intended as a stand-alone interval that follows the performance period and allows time for ramifications (such as losses or other adverse consequences) of, and other information about, risktaking decisions made during the performance period to become apparent. If incentive-based compensation is paid in the form of options, the period of time between when an option vests and when the option can be exercised would not be considered deferral under the proposed rule. As with other types of incentive-based compensation, an option would count toward the deferral requirement only if it has been awarded but has not yet vested, regardless of when the option could be exercised.103 2.38. To the extent covered institutions are already deferring incentive-based compensation, does the proposed definition of deferral reflect current practice? If not, in what way does it differ? Deferral period. The proposed rule defines ‘‘deferral period’’ as the period of time between the date a performance period ends and the last date on which the incentive-based compensation that is awarded for such performance period vests. A deferral period and a performance period that both relate to the same incentive-based compensation award could not occur concurrently. Because sectionsll.7(a)(1)(iii) and (a)(2)(iii) of the proposed rule would allow for pro rata vesting of deferred amounts during a deferral period, some deferred incentive-based compensation awarded for a performance period could vest before the end of the deferral period following that performance period. As a result, the deferral period would be considered to end on the date that the last tranche of incentive-based 103 Section ll.7(a)(4)(ii) of the proposed rule limits the portion of the proposed rule’s minimum deferral requirements that can be met in the form of options. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 compensation awarded for a performance period vests. Downward adjustment. The proposed rule defines ‘‘downward adjustment’’ as a reduction of the amount of a covered person’s incentive-based compensation not yet awarded for any performance period that has already begun, including amounts payable under long-term incentive plans, in accordance with a forfeiture and downward adjustment review under section ll7(b) of the proposed rule. As explained above, downward adjustment is distinct from clawback and forfeiture because downward adjustment affects incentivebased compensation that has not yet been awarded. It is also distinct from performance-based adjustments that covered institutions might make in determining the amount of incentivebased compensation to award to a covered person, absent or separate from a forfeiture or downward adjustment review. Depending on the results of a forfeiture and downward adjustment review under section ll.7(b) of the proposed rule, a covered institution could adjust downward incentive-based compensation that has not yet been awarded to a senior executive officer or significant risk-taker such that the senior executive officer or significant risk-taker is awarded none, or only some, of the incentive-based compensation that could otherwise have been awarded to such senior executive officer or significant risk-taker. Equity-like instrument. The proposed rule defines ‘‘equity-like instrument’’ as (1) equity in the covered institution or of any affiliate of the covered institution; or (2) a form of compensation (i) payable at least in part based on the price of the shares or other equity instruments of the covered institution or of any affiliate of the covered institution; or (ii) that requires, or may require, settlement in the shares of the covered institution or any affiliate of the covered institution. The value of an equity-like instrument would be related to the value of the covered institution’s shares.104 The definition includes three categories. Shares are an example of the first category, ‘‘equity.’’ Examples of the second category, ‘‘a form of compensation payable at least in part based on the price of the shares or other equity instruments of the covered institution or any affiliate of the covered institution,’’ include restricted stock 104 The definition of ‘‘equity-like instrument’’ in the proposed rule is similar to ‘‘share-based payment’’ in Topic 718 of the Financial Accounting Standards Board (FASB) Accounting Standards Codification (formerly FAS 123(R)). Paragraph 718– 10–30–20, FASB Accounting Standards Codification. PO 00000 Frm 00033 Fmt 4701 Sfmt 4702 37701 units (RSUs), stock appreciation rights, and other derivative instruments that settle in cash. Examples of the third category, ‘‘a form of compensation that requires, or may require, settlement in the shares of the covered institution or of any affiliate of the covered institution,’’ include options and derivative securities that settle, either mandatorily or permissively, in shares. An RSU that offers a choice of settlement in either cash or shares is also an example of this third category. The definition of equity-like instrument would include shares in the holding company of a covered institution, or instruments the value of which is dependent on the value of shares in the holding company of a covered institution. For example, the definition would include incentive-based compensation paid in the form of shares in a bank holding company, even if that incentive-based compensation were provided by a national bank subsidiary of that bank holding company. Covered institutions would determine the specific terms and conditions of the equity-like instruments they award to covered persons. NCUA’s proposed rule does not include the definition of ‘‘equity-like instrument’’ because credit unions do not have these types of instruments. 2.39. Are there any financial instruments that are used for incentivebased compensation and have a value that is dependent on the performance of a covered institution’s shares, but are not captured by the definition of ‘‘equity-like instrument’’? If so, what are they, and should such instruments be added to the definition? Why or why not? Forfeiture. The proposed rule defines ‘‘forfeiture’’ as a reduction of the amount of deferred incentive-based compensation awarded to a covered person that has not vested.105 105 Forfeiture is similar to the concept of ‘‘malus’’ common at some covered institutions. Malus is defined in the CEBS Guidelines as ‘‘an arrangement that permits the institution to prevent vesting of all or part of the amount of a deferred remuneration award in relation to risk outcomes or performance.’’ See CEBS Guidelines. The 2011 Proposed Rule did not define the term ‘‘forfeiture,’’ but the concept was implicit in the discussion of adjustments during the deferral period. See 76 FR at 21179, ‘‘Deferred payouts may be altered according to risk outcomes either formulaically or based on managerial judgment, though extensive use of judgment might make it more difficult to execute deferral arrangements in a sufficiently predictable fashion to influence the risk-taking behavior of a covered person. To be most effective in ensuring balance, the deferral period should be sufficiently long to allow for the realization of a substantial portion of the risks from the covered person’s activities, and the measures of loss should be clearly explained to covered persons and closely E:\FR\FM\10JNP2.SGM Continued 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37702 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules Depending on the results of a forfeiture and downward adjustment review under section ll.7(b) of the proposed rule, a covered institution could reduce a significant risk-taker or senior executive officer’s unvested incentivebased compensation such that none, or only some, of the deferred incentivebased compensation vests. As discussed below in this SUPPLEMENTARY INFORMATION section, a Level 1 or Level 2 covered institution would be required to place at risk of forfeiture all unvested deferred incentive-based compensation, including amounts that have been awarded and deferred under long-term incentive plans. Incentive-based compensation. The proposed rule defines ‘‘incentive-based compensation’’ as any variable compensation, fees, or benefits that serve as an incentive or reward for performance. The Agencies propose a broad definition to provide flexibility as forms of compensation evolve. Compensation earned under an incentive plan, annual bonuses, and discretionary awards are all examples of compensation that could be incentivebased compensation. The form of payment, whether cash, an equity-like instrument, or any other thing of value, would not affect whether compensation, fees, or benefits meet the definition of ‘‘incentive-based compensation.’’ In response to a similar definition in the 2011 Proposed Rule, commenters asked for clarification about the components of incentive-based compensation. The proposed definition clarifies that compensation, fees, and benefits that are paid for reasons other than to induce performance would not be included. For example, compensation, fees, or benefits that are awarded solely for, and the payment of which is solely tied to, continued employment (e.g., salary or a retention award that is conditioned solely on continued employment) would not be considered incentive-based compensation. Likewise, payments to new employees at the time of hiring (signing or hiring bonuses) that are not conditioned on performance achievement would not be considered incentive-based compensation because they generally are paid to induce a prospective employee to join the institution, not to influence future performance of such employee. Similarly, a compensation arrangement that provides payments solely for achieving or maintaining a professional certification or higher level of educational achievement would not tied to their activities during the relevant performance period.’’ VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 be considered incentive-based compensation under the proposed rule. In addition, the Agencies do not intend for this definition to include compensation arrangements that are determined based solely on the covered person’s level of fixed compensation and that do not vary based on one or more performance measures (e.g., employer contributions to a 401(k) retirement savings plan computed based on a fixed percentage of an employee’s salary). Neither would the proposed definition include dividends paid and appreciation realized on stock or other equity-like instruments that are owned outright by a covered person. However, stock or other equity-like instruments awarded to a covered person under a contract, arrangement, plan, or benefit would not be considered owned outright while subject to any vesting or deferral arrangement (regardless of whether such deferral is mandatory). 2.40. The Agencies invite comment on the proposed definition of incentivebased compensation. Should the definition be modified to include additional or fewer forms of compensation and in what way? Is the definition sufficiently broad to capture all forms of incentive-based compensation currently used by covered institutions? Why or why not? If not, what forms of incentive-based compensation should be included in the definition? 2.41. The Agencies do not expect that most pensions would meet the proposed rule’s definition of ‘‘incentive-based compensation’’ because pensions generally are not conditioned on performance achievement. However, it may be possible to design a pension that would meet the proposed rule’s definition of ‘‘incentive-based compensation.’’ The Agencies invite comment on whether the proposed rule should contain express provisions addressing the status of pensions in relation to the definition of ‘‘incentivebased compensation.’’ Why or why not? Incentive-based compensation arrangement, incentive-based compensation plan, and incentive-based compensation program. The proposed rule defines three separate, but related, terms describing how covered institutions provide incentive-based compensation.106 Under the proposed rule, ‘‘incentive-based compensation arrangement’’ would mean an agreement between a covered institution and a covered person, under which the covered institution provides incentive106 The use of these terms under the proposed rule is consistent with how the same terms are used in the 2010 Federal Banking Agency Guidance. PO 00000 Frm 00034 Fmt 4701 Sfmt 4702 based compensation to the covered person, including incentive-based compensation delivered through one or more incentive-based compensation plans. An individual employment agreement would be an incentive-based compensation arrangement. ‘‘Incentive-based compensation plan’’ is defined as a document setting forth terms and conditions governing the opportunity for and the delivery of incentive-based compensation payments to one or more covered persons. An incentive-based compensation plan may cover, among other things, specific roles or job functions, categories of individuals, or forms of payment. A covered person may be compensated under more than one incentive-based compensation plan. ‘‘Incentive-based compensation program’’ means a covered institution’s framework for incentive-based compensation that governs incentivebased compensation practices and establishes related controls. A covered institution’s incentive-based compensation program would include all of the covered institution’s incentivebased compensation arrangements and incentive-based compensation plans. Long-term incentive plan. The proposed rule defines ‘‘long-term incentive plan’’ as a plan to provide incentive-based compensation that is based on a performance period of at least three years. Any incentive-based compensation awarded to a covered person for a performance period of less than three years would not be awarded under a long-term incentive plan, but instead would be considered ‘‘qualifying incentive-based compensation’’ as that term is defined under the proposed rule.107 Long-term incentive plans are forward-looking plans designed to reward employees for performance over a multi-year period. These plans generally provide an award of cash or equity at the end of a performance period if the employee meets certain individual or institution-wide performance measures. Because they have longer performance periods, longterm incentive plans allow more time 107 In the 2011 Proposed Rule, the Agencies did not define the term ‘‘long-term incentive plan,’’ but the 2011 Proposed Rule discussed ‘‘longer performance periods’’ as one of four methods used to make compensation more sensitive to risk. 76 FR at 21179 (‘‘Under this method of making incentivebased compensation risk sensitive, the time period covered by the performance measures used in determining a covered person’s award is extended (for example, from one year to two years). Longer performance periods and deferral of payment are related in that both methods allow awards or payments to be made after some or all risk outcomes associated with a covered person’s activities are realized or better known.’’). E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 for information about a covered person’s performance and risk-taking to become apparent, and covered institutions can take that information into account to balance risk and reward. Under current practice, the performance period for a long-term incentive plan is typically three years.108 2.42. The Agencies invite comment on whether the proposed definition of ‘‘long-term incentive plan’’ is appropriate for purposes of the proposed rule. Are there incentivebased compensation arrangements commonly used by financial institutions that would not be included within the definition of ‘‘long-term incentive plan’’ under the proposed rule but that, given the scope and purposes of section 956, should be included in such definition? If so, what are the features of such incentive-based compensation arrangements, why should the definition include such arrangements, and how should the definition be modified to include such arrangements? Option. The proposed rule defines an ‘‘option’’ as an instrument through which a covered institution provides a covered person with the right, but not the obligation, to buy a specified number of shares representing an ownership stake in a company at a predetermined price within a set time period or on a date certain, or any similar instrument, such as a stock appreciation right. Typically, covered persons must wait for a specified time period to conclude before obtaining the 108 See Compensation Advisory Partners, ‘‘Large Complex Banking Organizations: Trends, Practices, and Outlook’’ (June 2012), available at https:// www.capartners.com/uploads/news/id90/ capartners.com-capflash-issue31.pdf; Pearl Meyer & Partners, ‘‘Trends in Incentive Compensation: How the Federal Reserve is Influencing Pay’’ (2013), available at https://pearlmeyer.com/pearl/media/ pearlmeyer/articles/pmp-artfedreserveinfluencingpay-so-bankdirector-5-142013.pdf; Meridian Compensation Partners, LLC, ‘‘Executive Compensation in the Banking Industry: Emerging Trends and Best Practices, 2014–2015’’ (June 22, 2015), available at https:// www.meridiancp.com/wp-content/uploads/ Executive-Compensation-in-the-BankingIndustry.pdf; Compensation Advisory Partners, ‘‘Influence of Federal Reserve on Compensation Design in Financial Services: An Analysis of Compensation Disclosures of 23 Large Banking Organizations’’ (April 24, 2013), available at https:// www.capartners.com/uploads/news/id135/ capartners.com-capflash-issue45.pdf; ‘‘The 2014 Top 250 Report: Long-term Incentive Grant Practices for Executives’’ (‘‘Cook Report’’) (October 2014), available at https://www.fwcook.com/alert_ letters/The_2014_Top_250_Report_Long-Term_ Incentive_Grant_Practices_for_Executives.pdf; ‘‘Study of 2013 Short- and Long-term Incentive Design Criterion Among Top 200 S&P 500 Companies’’ (December 2014), available at https:// www.ajg.com/media/1420659/study-of-2013-shortand-long-term-incentive-design-criterion-amongtop-200.pdf. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 right to exercise an option.109 The definition of option would also include option-like instruments that mirror some or all of the features of an option. For example, the proposed rule would include stock appreciation rights under the definition of option because the value of a stock appreciation right is based on a stock’s price on a future date. As mentioned above, an option would be considered an equity-like instrument, as that term is defined in the proposed rule. NCUA’s proposed rule does not include a definition of ‘‘option’’ because credit unions do not issue options. Performance period. The proposed rule defines ‘‘performance period’’ as the period during which the performance of a covered person is assessed for purposes of determining incentive-based compensation. The Agencies intend for the proposed rule to provide covered institutions with flexibility in determining the length and the start and end dates of their employees’ performance periods. For example, under the proposed rule, a covered institution could choose to have a performance period that coincided with a calendar year or with the covered institution’s fiscal year (if the calendar year and fiscal year were different). A covered institution could also choose to have a performance period of one year for some incentive-based compensation and a performance period of three years for other incentive-based compensation. 2.43. Does the proposed rule’s definition of ‘‘performance period’’ meet the goal of providing covered institutions with flexibility in determining the length and start and end dates of performance periods? Why or why not? Would a prescribed performance period, for example, periods that correspond to calendar years, be preferable? Why or why not? Qualifying incentive-based compensation. The proposed rule defines ‘‘qualifying incentive-based compensation’’ as the amount of incentive-based compensation awarded to a covered person for a particular performance period, excluding amounts awarded to such covered person for that particular performance period under a long-term incentive plan. With the exception of long-term incentive plans, all forms of compensation, fees, and benefits that qualify as ‘‘incentive-based compensation,’’ including annual bonuses, would be included in the amount of qualifying incentive-based compensation. The deferral 109 As explained above in the definition of ‘‘deferral,’’ the time period after the option vests but before it may be exercised is not considered part of the deferral period. PO 00000 Frm 00035 Fmt 4701 Sfmt 4702 37703 requirements of section ll.7(a) of the proposed rule would require a Level 1 or Level 2 covered institution to defer a specified percentage of any qualifying incentive-based compensation awarded to a significant risk-taker or senior executive officer for each performance period. Regulatory report. Each Agency has included a definition of ‘‘regulatory report’’ in its version of the proposed rule that explains which regulatory reports would be required to be used by each of that Agency’s covered institutions for the purposes of measuring average total consolidated assets under the proposed rule. For a national bank, state member bank, state nonmember bank, federal savings association, and state savings association, ‘‘regulatory report’’ would mean the consolidated Reports of Condition and Income (‘‘Call Report’’).110 For a U.S. branch or agency of a foreign bank, ‘‘regulatory report’’ would mean the Reports of Assets and Liabilities of U.S. Branches and Agencies of Foreign Banks—FFIEC 002. For a bank holding company, ‘‘regulatory report’’ would mean Consolidated Financial Statements for Bank Holding Companies (‘‘FR Y–9C’’). For a savings and loan holding company, ‘‘regulatory report’’ would mean FR Y–9C; if a savings and loan holding company is not required to file an FR Y–9C, Quarterly Savings and Loan Holding Company Report (‘‘FR 2320’’), if the savings and loan holding company reports consolidated assets on the FR 2320. For a savings and loan holding company that does not file a regulatory report within the meaning of the preceding sentence, ‘‘regulatory report’’ would mean a report of average total consolidated assets filed with the Board on a quarterly basis. For an Edge or Agreement Corporation, ‘‘regulatory report’’ would mean the Consolidated Report of Condition and Income for Edge and Agreement Corporations (‘‘FR 2886b’’). For the U.S. operations of a foreign banking organization, ‘‘regulatory report’’ would mean a report of average total consolidated U.S. assets filed with the Board on a quarterly basis. For subsidiaries of national banks, Federal savings associations, and Federal branches or agencies of foreign banking organizations that are not brokers, dealers, persons providing insurance, investment companies, or investment advisers, ‘‘regulatory report’’ would mean a report of the subsidiary’s total consolidated assets prepared by the subsidiary, national bank, Federal 110 Specifically, the OCC will refer to item RCFD 2170 of Schedule RC. E:\FR\FM\10JNP2.SGM 10JNP2 37704 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules savings association, or Federal branch or agency in a form that is acceptable to the OCC. For a regulated institution that is a subsidiary of a bank holding company, savings and loan holding company, or a foreign banking organization, ‘‘regulatory report’’ would mean a report of the subsidiary’s total consolidated assets prepared by the bank holding company, savings and loan holding company, or subsidiary in a form that is acceptable to the Board. For FHFA’s proposed rule, ‘‘regulatory report’’ would mean the Call Report Statement of Condition. For a natural person credit union, ‘‘regulatory report’’ would mean the 5300 Call Report. For corporate credit unions, ‘‘regulatory report’’ would mean the 5310 Call Report. For a broker or dealer registered under section 15 of the Securities Exchange Act of 1934 (15 U.S.C. 78o), ‘‘regulatory report’’ would mean the FOCUS Report.111 For an investment adviser, as such term is defined in section 202(a)(11) of the Investment Advisers Act, and as discussed above, total consolidated assets would be determined by the investment adviser’s total assets (exclusive of non-proprietary assets) shown on the balance sheet for the adviser’s most recent fiscal year end.112 Vesting. Under the proposed rule, ‘‘vesting’’ of incentive-based compensation means the transfer of ownership 113 of the incentive-based compensation to the covered person to whom the incentive-based compensation was awarded, such that the covered person’s right to the incentive-based compensation is no longer contingent on the occurrence of any event. Amounts awarded under an incentive-based compensation arrangement may vest immediately—for example, when the amounts are paid out to a covered person immediately and are not subject to deferral and forfeiture. As explained above, before 111 17 CFR 240.17a–5(a); 17 CFR 249.617. proposed rule would not apply the concept of a regulatory report and the attendant mechanics provided in section ll.3 of the proposed rule to covered institutions that are investment advisers because such institutions are not currently required to report the amount of total consolidated assets to any Federal regulators in their capacities as investment advisers. See proposed definition of ‘‘average total consolidated assets’’ for the proposed method by which an investment adviser would determine its asset level for purposes of the proposed rule. 113 Compensation awarded to a trust or other entity at the direction of, or for the benefit of, a covered person would be treated as compensation awarded to that covered person. If incentive-based compensation awarded to the entity cannot be reduced by forfeiture, the amounts would be treated as having vested at the time of the award. mstockstill on DSK3G9T082PROD with PROPOSALS2 112 The VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 amounts awarded to a covered person vest, the amounts could also be deferred and at risk of forfeiture. After amounts awarded to a covered person vest, the amounts could be subject to clawback, but they would not be at risk of forfeiture. As described below in this SUPPLEMENTARY INFORMATION section, for incentive-based compensation to be counted toward the minimum deferral amount as discussed in section ll.7(a) of the proposed rule, a sufficient amount of time must elapse between the end of the performance period and the time when the deferred incentive-based compensation vests (and is no longer subject to forfeiture). During that deferral period, the award would be at risk of forfeiture. If, after the award date, the covered institution had the right to require forfeiture of the shares or units awarded, then the award would not be considered vested. If, after the award date, the covered institution does not have the right to require forfeiture of the shares or units awarded, then the award would be vested and therefore would not be able to be counted toward the minimum deferral amount even if the shares or units have not yet been transferred to the covered person. For example, a covered institution could award an employee 100 shares of stock appreciation rights that pay out five years after the award date. In other words, five years after the award date, the covered institution will pay the employee the difference between the value of 100 shares of the covered institution’s stock on the award date and the value of 100 shares of the covered institution’s stock five years later. The amount the covered institution pays the employee could vary based on the value of the institution’s shares. If the covered institution does not have the right to adjust the number of shares of stock appreciation rights before the payout, the stock appreciation rights would be considered vested as of the award date (even if the amount paid out could vary based on the value of the institution’s shares). If, however, the covered institution has the right to adjust the number of shares of stock appreciation rights until payout to account for risk outcomes that occur after the award date (for example, by reducing the number of shares of stock appreciation rights from 100 to 50 based on a failure to comply with the institution’s risk management policies), the stock appreciation rights would not be considered vested until payout. Similarly, amounts paid to a covered person pursuant to a dividend equivalent right would vest when the PO 00000 Frm 00036 Fmt 4701 Sfmt 4702 number of dividend equivalent rights cannot be adjusted by the covered institution on the basis of risk outcomes. 2.44. The Agencies invite comment generally on the proposed rule’s definitions. Relationship Between Defined Terms The relationship between some of these defined terms can best be explained chronologically. Under the proposed rule, a covered institution’s incentive-based compensation timeline would be as follows: • Performance period. A covered person may have incentive-based compensation targets based on performance measures that would apply during a performance period. A covered person’s performance or the performance of the covered institution during this period would influence the amount of incentive-based compensation awarded to the covered person. Before incentive-based compensation is awarded to a covered person, it should be subject to risk adjustments to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance, as described in section ll.4(d) of the proposed rule. In addition, at any time during the performance period, incentive-based compensation could be subject to downward adjustment, as described in section ll.7(b) of the proposed rule. • Downward adjustment (if needed). Downward adjustment could occur at any time during a performance period if a Level 1 or Level 2 covered institution conducts a forfeiture and downward adjustment review under section ll.7(b) of the proposed rule and the Level 1 or Level 2 covered institution determines that incentive-based compensation not yet awarded for the current performance period should be reduced. In other words, downward adjustment applies to plans where the performance period has not yet ended. • Award. At or near the end of a performance period, a covered institution would evaluate the covered person’s or institution’s performance, taking into account adjustments described in section ll.4(d)(3) of the proposed rule, and determine the amount of incentive-based compensation, if any, to be awarded to the covered person for that performance period. At that time, the covered institution would determine what portion of the incentive-based compensation that is awarded will be deferred, as well as the vesting schedule for that deferred incentive-based compensation. A Level 1 or Level 2 E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules covered institution could reduce the amount of incentive-based compensation payable to a senior executive officer or significant risk-taker depending on the outcome of a forfeiture and downward adjustment review, as described in section ll.7(b) of the proposed rule. • Deferral period. The deferral period for incentive-based compensation awarded for a particular performance period would begin at the end of such performance period, regardless of when a covered institution awards incentivebased compensation to a covered person for that performance period. At any time during a deferral period, a covered institution could require forfeiture of some or all of the incentive-based compensation that has been awarded to the covered person but has not yet vested. • Forfeiture (if needed). Forfeiture could occur at any time during the deferral period (after incentive-based compensation has been awarded but before it vests). A Level 1 or Level 2 covered institution could require forfeiture of unvested deferred incentive-based compensation payable to a senior executive officer or significant risk-taker based on the result of a forfeiture and downward adjustment review, as described in section ll.7(b) of the proposed rule. Depending on the outcome of a forfeiture and downward adjustment review under section ll.7(b) of the proposed rule, a covered institution could reduce, or eliminate, the unvested deferred incentive-based compensation of a senior executive officer or significant risk-taker. • Vesting. Vesting could occur annually, on a pro rata basis, throughout a deferral period. Vesting could also occur at a slower than pro rata schedule, such as entirely at the end of a deferral period (vesting entirely at the end of a deferral period is sometimes called ‘‘cliff vesting’’). The deferral period for a particular performance period would end when all incentive-based compensation awarded for that performance period has vested. A covered institution may also evaluate information that has arisen over the deferral period about financial losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance of the covered person at the time of vesting to determine if the amount that has been deferred should vest in full or should be reduced through forfeiture. • Clawback (if needed). Clawback could be used to recover incentivebased compensation that has already VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 vested. Clawback could be used after a deferral period has ended, and it also could be used to recover any portion of incentive-based compensation that vests before the end of a deferral period. A Level 1 or Level 2 covered institution would be required to include clawback provisions in incentive-based compensation arrangements for senior executive officers and significant risktakers, as described in section ll.7(c) of the proposed rule. 2.45. Is the interplay of the award date, vesting date, performance period, and deferral period clear? If not, why not? 2.46. Have the Agencies made clear the distinction between the proposed definitions of clawback, forfeiture, and downward adjustment? Do these definitions align with current industry practice? If not, in what way do they differ and what are the implications of such differences for both the operations of covered institutions and the effective supervision of compensation practices? § ll.3 Applicability Section ll.3 describes which provisions of the proposed rule would apply to an institution that is subject to the proposed rule when an increase or decrease in average total consolidated assets causes it to become a covered institution, transition to another level, or no longer meet the definition of covered institution. This process may differ somewhat depending on whether the institution is a subsidiary of, or affiliated with, another covered institution. As discussed above, for an institution that is not an investment adviser, average total consolidated assets would be determined by reference to the average of the total consolidated assets reported on regulatory reports for the four most recent consecutive quarters. The Agencies are proposing this calculation method because it is also used to calculate total consolidated assets for purposes of other rules that have $50 billion thresholds,114 and it is therefore expected to result in lower administrative burden on some institutions—particularly when those institutions move from Level 3 to Level 2—if the proposed rule requires total consolidated assets to be calculated in the same way as existing rules. As discussed above, average total consolidated assets for a covered institution that is an investment adviser would be determined by the investment adviser’s total assets (exclusive of non114 See, e.g., OCC’s Heightened Standards; 12 CFR 46.3; 12 CFR 225.8; 12 CFR 243.2; 12 CFR 252.30; 2 CFR 252.132; 12 CFR 325.202; 12 CFR 381.2. PO 00000 Frm 00037 Fmt 4701 Sfmt 4702 37705 proprietary assets) shown on the balance sheet for the adviser’s most recent fiscal year end. The proposed rule would not apply the concept of a regulatory report and the attendant mechanics provided in section ll.3 of the proposed rule to covered institutions that are investment advisers because such institutions are not currently required to report the amount of total consolidated assets to any Federal regulators in their capacities as investment advisers. (a) When Average Total Consolidated Assets Increase Section ll.3(a) of the proposed rule describes how the proposed rule would apply to institutions that are subject to the proposed rule when average total consolidated assets increase. It generally provides that an institution that is not a subsidiary of another covered institution becomes a Level 1, Level 2, or Level 3 covered institution when its average total consolidated assets increase to an amount that equals or exceeds $250 billion, $50 billion, or $1 billion, respectively. For subsidiaries of other covered institutions, the Agencies would generally look to the average total consolidated assets of the top-tier parent holding company to determine whether average total consolidated assets have increased. Given the unique characteristics of the different types of covered institutions subject to each Agency’s proposed rule, each Agency’s proposed rule contains specific language for subsidiaries that is consistent with the same general approach. For example, under the Board’s proposed rule, a regulated institution would become a Level 1, Level 2, or Level 3 covered institution when its average total consolidated assets or the average total consolidated assets of any of its affiliates, equals or exceeds $250 billion, $50 billion, or $1 billion, respectively. Under the OCC’s proposed rule, a national bank that is a subsidiary of a bank holding company would become a Level 1, Level 2, or Level 3 covered institution when the top-tier bank holding company’s average total consolidated assets equals or exceeds $250 billion, $50 billion, or $1 billion, respectively. Because the Federal Home Loan Banks have no subsidiaries, and subsidiaries of the Enterprises are included as affiliates as part of the definition of the Enterprises, FHFA’s proposed rule does not include specific language to address subsidiaries. Because the NCUA’s rule does not cover subsidiaries of credit unions and credit unions are not subsidiaries of other types of institutions, NCUA’s proposed E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37706 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules rule does not include specific language to address subsidiaries. More detail on each Agency’s proposed approach to subsidiaries is provided in the above discussion of definitions relating to covered institutions. For covered institutions other than investment advisers and the Federal Home Loan Banks, using a rolling average for asset size, rather than measuring asset size at a single point in time, should minimize the frequency with which an institution may fall into or out of a covered institution level. As explained above, if a covered institution has fewer than four regulatory reports, the institution would be required to use the average of its total consolidated assets from its existing regulatory reports for purposes of determining average total consolidated assets. If a covered institution has a mix of two or more different types of regulatory reports covering the relevant period, those would be averaged for purposes of determining average total consolidated assets. Section ll.3(a)(2) of the proposed rule provides a transition period for institutions that were not previously considered covered institutions and for covered institutions moving from a lower level to a higher level due to an increase in average total consolidated assets. Such covered institutions would be required to comply with the requirements for their new level not later than the first day of the first calendar quarter that begins at least 540 days after the date on which they become Level 1, Level 2, or Level 3 covered institutions. Prior to such date, the institutions would be required to comply with the requirements of the proposed rule, if any, that were applicable to them on the day before they became Level 1, Level 2, or Level 3 covered institutions as a result of the increase in assets. For example, if a Level 3 covered institution that is not a subsidiary of a depository institution holding company has average total consolidated assets that increase to more than $50 billion on December 31, 2015, then such institution would become a Level 2 covered institution on December 31, 2015. However, the institution would not be required to comply with the requirements of the proposed rule that are applicable to a Level 2 covered institution until July 1, 2017. Prior to July 1, 2017, (the compliance date), the institution would remain subject to the requirements of the proposed rule that are applicable to a Level 3 covered institution. The covered institution’s controls, risk management, and corporate governance also would be required to comply with VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 the provisions of the proposed rule that are applicable to a Level 2 covered institution no later than July 1, 2017. The Agencies are proposing this delay between the date when a covered institution’s average total consolidated assets increase and the date when the covered institution becomes subject to the requirements related to its new level to provide covered institutions with sufficient time to comply with the new requirements. The same general rule would apply to covered institutions that are subsidiaries (or, in the case of the Board’s proposed rule, affiliates) of other covered institutions. For example, a Level 3 state savings association that is a subsidiary of a Level 3 savings and loan holding company, and a Level 3 subsidiary of that state savings association, would become a Level 2 covered institution on December 31, 2015, if the average total consolidated assets of the savings and loan holding company increased to more than $50 billion on December 31, 2015, and would not be required to comply with the requirements of the proposed rule that are applicable to a Level 2 covered institution until July 1, 2017. Section ll.3(a)(3) of the proposed rule provides that incentive-based compensation plans with performance periods that begin before the compliance date described in section ll.3(a)(2) would not be required to comply with the requirements of the proposed rule that become applicable to the covered institution on the compliance date as a result of the change in its status as a Level 1, Level 2, or Level 3 covered institution. Incentive-based compensation plans with a performance period that begins on or after the compliance date described in section ll.3(a)(2) would be required to comply with the rules for the covered institution’s new level. In the example described in the previous paragraph, any incentive-based compensation plan with a performance period that begins before July 1, 2017, would not be required to comply with the requirements of the proposed rule that are applicable to a Level 2 covered institution (although any such plan would be required to comply with the requirements of the proposed rule that are applicable to a Level 3 covered institution). The Agencies have included this grandfathering provision so that covered institutions would not be required to modify incentive-based compensation plans that are already in place when a covered institution’s average total consolidated assets increase such that it PO 00000 Frm 00038 Fmt 4701 Sfmt 4702 moves to a higher level. However, incentive-based compensation plans with performance periods that begin after the compliance date would be subject to the rules that apply to the covered institution’s new level. In the previous example, any incentive-based compensation plan for a senior executive officer with a performance period that begins on or after July 1, 2017, would be required to comply with the requirements of the proposed rule that are applicable to a Level 2 covered institution, such as the deferral, forfeiture, downward adjustment, and clawback requirements contained in section ll.7 of the proposed rule. Because institutions that would be covered institutions under the proposed rule commonly use long-term incentive plans with overlapping performance periods or incentive-based compensation plans with performance periods of one year, the Agencies do not anticipate that the grandfathering provision would unduly delay the application of the proposed rule to individual incentive-based compensation arrangements. 3.1. The Agencies invite comment on whether a covered institution’s average total consolidated assets (a rolling average) is appropriate for determining a covered institution’s level when its total consolidated assets increase. Why or why not? Will 540 days provide covered institutions with adequate time to adjust incentive-based compensation programs to comply with different requirements? If not, why not? In the alternative, is 540 days too long to give covered institutions time to comply with the requirements of the proposed rule? Why or why not? 3.2. The Agencies invite comment on whether the date described in section ll.3(a)(2) should instead be the beginning of the first performance period that begins at least 365 days after the date on which the regulated institution becomes a Level 1, Level 2, or Level 3 covered institution in order to have the date on which the proposed rule’s corporate governance, policies, and procedures requirements begin coincide with the date on which the requirements applicable to plans begin. Why or why not? (b) When Total Consolidated Assets Decrease Section ll.3(b) of the proposed rule describes how the proposed rule would apply to an institution when assets decrease. A covered institution (other than an investment adviser) that is not a subsidiary of another covered institution would cease to be a Level 1, Level 2, or Level 3 covered institution E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules if its total consolidated assets, as reported on its regulatory reports, fell below the relevant total consolidated assets threshold for Level 1, Level 2, or Level 3 covered institutions, respectively, for four consecutive quarters. The calculation would be effective on the as-of date of the fourth consecutive regulatory report. For example, a bank holding company that is a Level 2 covered institution with total consolidated assets of $55 billion on January 1, 2016, might report total consolidated assets of $48 billion for the first quarter of 2016, $49 billion for the second quarter of 2016, $49 billion for the third quarter of 2016, and $48 billion for the fourth quarter of 2016. On the as-of date of the Y–9C submitted for the fourth quarter of 2016, that bank holding company would become a Level 3 covered institution because its total consolidated assets were less than $50 billion for four consecutive quarters. In contrast, if that same bank holding company reported total consolidated assets of $48 billion for the first quarter of 2016, $49 billion for the second quarter of 2016, $49 billion for the third quarter of 2016, and $51 billion for the fourth quarter of 2016, it would still be considered a Level 2 covered institution on the as-of date of the Y–9C submitted for the fourth quarter of 2016 because it had total consolidated assets of less than $50 billion for only 3 consecutive quarters. If the bank holding company had total consolidated assets of $49 billion in the first quarter of 2017, it still would not become a Level 3 covered institution at that time because it would not have four consecutive quarters of total consolidated assets of less than $50 billion. The bank holding company would only become a Level 3 covered institution if it had four consecutive quarters with total consolidated assets of less than $50 billion after the fourth quarter of 2016. As with section ll.3(a), a Level 1, Level 2, or Level 3 covered institution that is a subsidiary of another Level 1, Level 2, or Level 3 covered institution would cease to be a Level 1, Level 2, or Level 3 covered institution when the top-tier parent covered institution ceases to be a Level 1, Level 2, or Level 3 covered institution. As with section ll.3(a), each Agency’s proposed rule takes a slightly different approach that is consistent with the same general principle. For example, if a broker-dealer with less than $50 billion in average total consolidated assets is a Level 2 covered institution because its parent bank holding company has more than $50 billion in average total consolidated assets, the VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 broker-dealer would become a Level 3 covered institution if its parent bank holding company had less than $50 billion in total consolidated assets for four consecutive quarters, thus causing the parent bank holding company itself to become a Level 3 covered institution. The proposed rule would not require any transition period when a decrease in a covered institution’s total consolidated assets causes it to become a Level 2 or Level 3 covered institution or to no longer be a covered institution. The Agencies are not proposing to include a transition period in this case because the new requirements would be less stringent than the requirements that were applicable to the covered institution before its total consolidated assets decreased, and therefore a transition period should be unnecessary. Instead, the covered institution would immediately be subject to the provisions of the proposed rule, if any, that are applicable to it as a result of the decrease in its total consolidated assets. For example, if as a result of having four consecutive regulatory reports with total consolidated assets less than $50 billion, a bank holding company that was previously a Level 2 covered institution becomes a Level 3 covered institution as of June 30, 2017, then as of June 30, 2017 that bank holding company would no longer be subject to the requirements of the proposed rule that are applicable to Level 2 covered institutions. It would instead be subject to the requirements of the proposed rule that are applicable to Level 3 covered institutions. A covered institution that is an investment adviser would cease to be a Level 1, Level 2, or Level 3 covered institution effective as of the most recent fiscal year end in which its total consolidated assets fell below the relevant asset threshold for Level 1, Level 2, or Level 3 covered institutions, respectively. For example, an investment adviser that is a Level 1 covered institution during 2015 would cease to be a Level 1 covered institution effective on December 31, 2015 if its total assets (exclusive of non-proprietary assets) shown on its balance sheet for the year ended December 31, 2015 (assuming the investment adviser had a calendar fiscal year) were less than $250 billion. 3.3. The Agencies invite comment on whether four consecutive quarters is an appropriate period for determining a covered institution’s level when its total consolidated assets decrease. Why or why not? 3.4. Should the determination of total consolidated assets for covered PO 00000 Frm 00039 Fmt 4701 Sfmt 4702 37707 institutions that are investment advisers be by reference to a periodic report or similar concept? Why or why not? Should there be a concept of a rolling average for asset size for covered institutions that are investment advisers and, if so, how should this be structured? 3.5. Should the transition period for an institution that changes levels or becomes a covered institution due to a merger or acquisition be different than an institution that changes levels or becomes a covered institution without a change in corporate structure? If so, why? If so, what transition period would be appropriate and why? 3.6. The Agencies invite comment on whether covered institutions transitioning from Level 1 to Level 2 or Level 2 to Level 3 should be permitted to modify incentive-based compensation plans with performance periods that began prior to their transition in level in such a way that would cause the plans not to meet the requirements of the proposed rule that were applicable to the covered institution at the time when the performance periods for the plans commenced. Why or why not? (c) Compliance of Covered Institutions That Are Subsidiaries of Covered Institutions Section ll.3(c) of the Board’s, OCC’s, or FDIC’s proposed rules provide that a covered institution that is subject to the Board’s, OCC’s, or FDIC’s proposed rule, respectively, and that is a subsidiary of another covered institution may meet any requirement of the proposed rule if the parent covered institution complies with such requirement in a way that causes the relevant portion of the incentive-based compensation program of the subsidiary covered institution to comply with the requirement. The Board, the OCC, and the FDIC have included this provision in their proposed rules in order to reduce the compliance burden on subsidiaries that would be subject to the Board’s, OCC’s, and FDIC’s proposed rules and in recognition of the fact that holding companies, national banks, Federal savings associations, state nonmember banks, and state savings associations may perform certain functions on behalf of such subsidiaries. Subsidiary covered institutions subject to the Board’s, OCC’s, or FDIC’s proposed rule could rely on this provision to comply with, for example, the corporate governance or policies and procedures requirements of the proposed rule. For example, if a parent bank holding company has a compensation committee that performs the requirements of section ll.4(e) of E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37708 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules the proposed rule with respect to a subsidiary of the parent bank holding company that is a covered institution under the Board’s rule by (1) conducting oversight of the subsidiary’s incentivebased compensation program, (2) approving incentive-based compensation arrangements for senior executive officers of the subsidiary (including any individuals who are senior executive officers of the subsidiary but not senior executive officers of the parent bank holding company), and (3) approving any material exceptions or adjustments to incentive-based compensation policies or arrangements for such senior executive officers of the subsidiary, then the subsidiary would be deemed to have complied with the requirements of section ll.4(e) of the proposed rule. Similarly, under the OCC’s proposed rule, if an operating subsidiary of a national bank that is a Level 1 or Level 2 covered institution subject to the OCC’s proposed rule uses the policies and procedures for its incentive-based compensation program of its parent national bank that is also a Level 1 or Level 2 covered institution subject to the OCC’s proposed rule, and such policies and procedures satisfy the requirements of section ll.11 of the proposed rule, then the OCC would consider the subsidiary to have satisfied section ll.11 of the proposed rule. Under the FDIC’s proposed rule, if a subsidiary of a state nonmember bank or state savings association that is a covered institution subject to the FDIC’s proposed rule uses the policies and procedures for its incentive-based compensation program of its parent state nonmember bank or state savings association that is a Level 1 or Level 2 covered institution subject to the FDIC’s proposed rule, and such policies and procedures satisfy the requirements of section ll.11 of the proposed rule, then the FDIC would consider the subsidiary to have satisfied section ll.11 of the proposed rule. Many parent holding companies, particularly larger banking organizations, design and administer incentive-based compensation programs and associated policies and procedures. Smaller covered institutions that operate within a larger holding company structure may realize efficiencies by incorporating or relying upon their parent company’s incentivebased compensation program or certain components of the program, to the extent that the program or its components establish governance, risk management, and recordkeeping frameworks that are appropriate to the VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 smaller covered institutions and support incentive-based compensation arrangements that appropriately balance risks to the smaller covered institution and rewards for its covered persons. Therefore, it may be less burdensome for covered institution subsidiaries with risk profiles that are similar to those of their parent holding companies to use their parent holding companies’ program rather than their own. The Agencies recognize that the authority of each appropriate Federal regulator to examine and review compliance with the proposed rule, along with requiring corrective action when they deem appropriate, would not be affected by section ll.3(c) of the Board’s, OCC’s, or FDIC’s proposed rule. Each appropriate Federal regulator would be responsible for examining, reviewing, and enforcing compliance with the proposed rule by their covered institutions, including any that are owned or controlled by a depository institution holding company. For example, in the situation where a parent holding company controls a subsidiary national bank, state nonmember bank, or broker-dealer, it would be expected that the board of directors of the subsidiary will ensure that the subsidiary is in compliance with the proposed rule. Likewise, the board of directors of a broker-dealer operating subsidiary of a national bank would be expected to ensure that the brokerdealer operating subsidiary is in compliance with the proposed rule. § ll.4 Requirements and Prohibitions Applicable to All Covered Institutions Section ll.4 sets forth the general requirements that would be applicable to all covered institutions. Later sections establish more specific requirements that would be applicable for Level 1 and Level 2 covered institutions. Under the proposed rule, all covered institutions would be prohibited from establishing or maintaining incentivebased compensation arrangements, or any features of any such arrangements, that encourage inappropriate risks by the covered institution (1) by providing covered persons with excessive compensation, fees, or benefits or (2) that could lead to material financial loss to the covered institution. Section ll.4 includes considerations for determining whether an incentive-based compensation arrangement provides excessive compensation, fees, or benefits, as required by section 956(a)(1). Section ll.4 also establishes requirements that would apply to all covered institutions designed to prevent inappropriate risks that could lead to material financial loss, as required by PO 00000 Frm 00040 Fmt 4701 Sfmt 4702 section 956(a)(2).115 The general standards and requirements set forth in sections ll.4(a), (b), and (c) of the proposed rule would be consistent with the general standards and requirements set forth in sections ll.5(a) and (b) of the 2011 Proposed Rule. The Agencies do not intend to establish a rigid, one-size-fits-all approach to the design of incentivebased compensation arrangements. Thus, under the proposed rule, the structure of incentive-based compensation arrangements at covered institutions would be expected to reflect the proposed requirements set forth in section ll.4 of the proposed rule in a manner tailored to the size, complexity, risk tolerance, and business model of the covered institution. Subject to supervisory oversight, as applicable, each covered institution would be responsible for ensuring that its incentive-based compensation arrangements appropriately balance risk and reward. The methods by which this is achieved at one covered institution may not be effective at another, in part because of the importance of integrating incentive-based compensation arrangements and practices into the covered institution’s own riskmanagement systems and business model. The effectiveness of methods may differ across business lines and operating units as well, so the proposed rule would provide for considerable flexibility in how individual covered institutions approach the design and implementation of incentive-based compensation arrangements that appropriately balance risk and reward. (a) In General Section ll.4(a) of the proposed rule is derived from the text of section 956(b) which requires the Agencies to jointly prescribe regulations or guidelines that prohibit any type of incentive-based payment arrangement, or any feature of any such arrangement, that the Agencies determine encourages inappropriate risks by covered institutions (1) by providing an executive officer, employee, director, or principal shareholder of the covered institution with excessive compensation, fees, or benefits or (2) that could lead to material financial loss to the covered institution. (b) Excessive Compensation Section ll.4(b) of the proposed rule specifies that compensation, fees, and 115 In addition to the requirements outlined in section ll.4, Level 1 and Level 2 covered institutions would have to meet additional requirements set forth in section ll.5 and sections ll.7 through ll.11. E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 benefits would be considered excessive for purposes of section ll.4(a)(1) when amounts paid are unreasonable or disproportionate to the value of the services performed by a covered person, taking into account all relevant factors. Section 956(c) directs the Agencies to ‘‘ensure that any standards for compensation established under subsections (a) or (b) are comparable to the standards established under section [39] of the Federal Deposit Insurance Act (12 U.S.C. 2 [sic] 1831p–1) for insured depository institutions.’’ Under the proposed rule, the factors for determining whether an incentive-based compensation arrangement provides excessive compensation would be comparable to the Federal Banking Agency Safety and Soundness Guidelines that implement the requirements of section 39 of the FDIA.116 The proposed factors would include: (1) The combined value of all compensation, fees, or benefits provided to the covered person; (2) the compensation history of the covered person and other individuals with comparable expertise at the covered institution; (3) the financial condition of the covered institution; (4) compensation practices at comparable covered institutions, based upon such factors as asset size, geographic location, and the complexity of the covered institution’s operations and assets; (5) for post-employment benefits, the projected total cost and benefit to the covered institution; and (6) any connection between the covered person and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the covered institution. The inclusion of these factors is consistent with the requirement under section 956(c) that any standards for compensation under 116 The Federal Banking Agency Safety and Soundness Guidelines provide: Compensation shall be considered excessive when amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director, or principal shareholder, considering the following: (1) The combined value of all cash and non-cash benefits provided to the individual; (2) The compensation history of the individual and other individuals with comparable expertise at the institution; (3) The financial condition of the institution; (4) Comparable compensation practices at comparable institutions, based upon such factors as asset size, geographic location, and the complexity of the loan portfolio or other assets; (5) For postemployment benefits, the projected total cost and benefit to the institution; (6) Any connection between the individual and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the institution; and (7) Any other factors the Agencies determines to be relevant. See 12 CFR part 30, Appendix A, III.A; 12 CFR part 364, Appendix A, III.A; 12 CFR part 208, Appendix D–1. These factors are drawn directly from section 39(c)(2) of the FDIA (12 U.S.C. 1831p–1(c)(2)). VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 section 956(a) or (b) must be comparable to the standards established for insured depository institutions under the FDIA and that the Agencies must take into consideration the compensation standards described in section 39(c) of the FDIA. In response to similar language in the 2011 Proposed Rule, some commenters indicated that this list of factors should include additional factors or allow covered institutions to consider other factors that they deem appropriate. The proposed rule clarifies that all relevant factors would be taken into consideration, and that the list of factors in section ll.4(b) would not be exclusive. Commenters on the 2011 Proposed Rule expressed concern that it would be difficult for some types of institutions, such as grandfathered unitary savings and loan holding companies with retail operations, mutual savings associations, mutual savings banks, and mutual holding companies, to identify comparable covered institutions. Those commenters also expressed concern that it would be difficult for these institutions to identify the compensation practices of comparable institutions that are not public companies or that do not otherwise make public information about their compensation practices. The Agencies intend to work closely with these institutions to identify comparable institutions to help ensure compliance with the proposed rule. (c) Material Financial Loss Section 956(b)(2) of the Act requires the Agencies to adopt regulations or guidelines that prohibit any type of incentive-based payment arrangement, or any feature of any such arrangement, that the Agencies determine encourages inappropriate risks by a covered financial institution that could lead to material financial loss to the covered institution. In adopting such regulations or guidelines, the Agencies are required to ensure that any standards established under this provision of section 956 are comparable to the standards under Section 39 of the FDIA, including the compensation standards. However, section 39 of the FDIA does not include standards for determining whether compensation arrangements may encourage inappropriate risks that could lead to material financial loss.117 117 Section 39 of the FDIA requires only that the Federal banking agencies prohibit as an unsafe and unsound practice any employment contract, compensation or benefit agreement, fee arrangement, perquisite, stock option plan, postemployment benefit, or other compensatory arrangement that could lead to a material financial PO 00000 Frm 00041 Fmt 4701 Sfmt 4702 37709 Accordingly, as in the 2011 Proposed Rule, the Agencies have considered the language and purpose of section 956, existing supervisory guidance that addresses incentive-based compensation arrangements that may encourage inappropriate risk-taking,118 the FSB Principles and Implementation Standards, and other relevant material in considering how to implement this aspect of section 956. A commenter argued that the provisions of the 2011 Proposed Rule relating to incentive-based compensation arrangements that could encourage inappropriate risks that could lead to material financial loss were not comparable to the standards established under section 39 of the FDIA. More specifically, the commenter believed that the requirements of the 2011 Proposed Rule, including the mandatory deferral requirement, were more ‘‘detailed and prescriptive’’ than the standards established under section 39 of the FDIA. The Agencies intend that the requirements of the proposed rule implementing section 956(b)(2) of the Act would be comparable to the standards established under section 39 of the FDIA. Section 956(b)(2) of the Act requires that the Agencies prohibit incentive-based compensation arrangements that encourage inappropriate risks by covered institutions that could lead to material financial loss, a requirement that is not discussed in the standards established under section 39 of the FDIA, which, as discussed above, provide guidelines to determine when compensation paid to a particular executive officer, employee, director or principal shareholder would be excessive. In enacting section 956, Congress referred specifically to the standards established under section 39 of the FDIA, and was presumably aware that in the statute there were no such standards articulated that provide guidance for determining whether compensation arrangements could lead to a material financial loss. The provisions of the proposed rule implementing section 956(b)(2) reflect the Agencies’ intent to comply with the statutory mandate under section 956, while ensuring that the proposed rule is comparable to section 39 of the FDIA, which states that compensatory arrangements that could lead to a material financial loss are an unsafe and unsound practice. loss. See 12 U.S.C. 1831p–1(c)(1)(B). The Federal Banking Agency Safety and Soundness Guidelines satisfy this requirement. 118 2010 Federal Banking Agency Guidance. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37710 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules Section ll.4(c) of the proposed rule sets forth minimum requirements for incentive-based compensation arrangements that would be permissible under the proposed rule, because arrangements without these attributes could encourage inappropriate risks that could lead to material financial loss to a covered institution. These requirements reflect the three principles for sound incentive-based compensation policies contained in the 2010 Federal Banking Agency Guidance: (1) Balanced risk-taking incentives; (2) compatibility with effective risk management and controls; and (3) effective corporate governance.119 Similarly, section ll.4(c) of the proposed rule provides that an incentive-based compensation arrangement at a covered institution could encourage inappropriate risks that could lead to material financial loss to the covered institution, unless the arrangement: (1) Appropriately balances risk and reward; (2) is compatible with effective risk management and controls; and (3) is supported by effective governance. An example of a feature that could encourage inappropriate risks that could lead to material financial loss would be the use of performance measures that are closely tied to short-term revenue or profit of business generated by a covered person, without any adjustments for the longer-term risks associated with the business generated. Similarly, if there is no mechanism for factoring risk outcomes over a longer period of time into compensation decisions, traders who have incentivebased compensation plans with performance periods that end at the end of the calendar year, could have an incentive to take large risks towards the end of the calendar year to either make up for underperformance earlier in the performance period or to maximize their year-end profits. The same result could ensue if the performance measures themselves are poorly designed or can be manipulated inappropriately by the covered persons receiving incentivebased compensation. Incentive-based compensation arrangements typically attempt to encourage actions that result in greater revenue or profit for a covered institution. However, short-run revenue or profit can often diverge sharply from actual long-run profit because risk outcomes may become clear only over time. Activities that carry higher risk typically have the potential to yield higher short-term revenue, and a covered person who is given incentives to increase short-term revenue or profit, 119 See 75 FR 36407–36413. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 without regard to risk, would likely be attracted to opportunities to expose the covered institution to more risk that could lead to material financial loss. Section ll.4(c)(1) of the proposed rule would require all covered institutions to ensure that incentivebased compensation arrangements appropriately balance risk and reward. Incentive-based compensation arrangements achieve balance between risk and financial reward when the amount of incentive-based compensation ultimately received by a covered person depends not only on the covered person’s performance, but also on the risks taken in achieving this performance. Conversely, an incentivebased compensation arrangement that provides financial reward to a covered person without regard to the amount and type of risk produced by the covered person’s activities would not be considered to appropriately balance risk and reward under the proposed rule.120 Incentive-based compensation arrangements should balance risk and financial rewards in a manner that does not encourage covered persons to expose a covered institution to inappropriate risk that could lead to material financial loss. The incentives provided by an arrangement depend on how all features of the arrangement work together. For instance, how performance measures are combined, whether they take into account both current and future risks, which criteria govern the use of risk adjustment before the awarding and vesting of incentive-based compensation, and what form incentivebased compensation takes (i.e., equitybased vehicles or cash-based vehicles) can all affect risk-taking incentives and generally should be considered when covered institutions create such arrangements. The 2010 Federal Banking Agency Guidance outlined four methods that can be used to make compensation more sensitive to risk—risk adjustments of awards, deferral of payment, longer performance periods, and reduced sensitivity to short-term performance.121 Consistent with the 2010 Federal Banking Agency Guidance, under the proposed rule, an incentive-based compensation arrangement generally 120 For example, a covered person who makes a high-risk loan may generate more revenue in the short run than one who makes a low-risk loan. Incentive-based compensation arrangements that reward covered persons solely on the basis of shortterm revenue might pay more to the covered person taking more risk, thereby incentivizing employees to take more, and sometimes inappropriate, risk. See 2011 FRB Report at 11. 121 See 2010 Federal Banking Agency Guidance, 75 FR at 36396. PO 00000 Frm 00042 Fmt 4701 Sfmt 4702 would have to take account of the full range of current and potential risks that a covered person’s activities could pose for a covered institution. Relevant risks would vary based on the type of covered institution, but could include credit, market (including interest rate and price), liquidity, operational, legal, strategic, and compliance risks. Performance and risk measures generally should align with the broader risk management objectives of the covered institution and could be incorporated through use of a formula or through the exercise of judgment. Performance and risk measures also may play a role in setting amounts of incentive-based compensation pools (bonus pools), in allocating pools to individuals’ incentive-based compensation, or both. The effectiveness of different types of adjustments varies with the situation of the covered person and the covered institution, as well as the thoroughness with which the measures are implemented. The analysis and methods for ensuring that incentive-based compensation arrangements appropriately balance risk and reward should also be tailored to the size, complexity, business strategy, and risk tolerance of each institution. The manner in which a covered institution seeks to balance risk and reward in incentive-based compensation arrangements should account for the differences between covered persons— including the differences between senior executive officers and significant risk-takers and other covered persons. Activities and risks may vary significantly both among covered institutions and among covered persons within a particular covered institution. For example, activities, risks, and incentive-based compensation practices may differ materially among covered institutions based on, among other things, the scope or complexity of activities conducted and the business strategies pursued by the institutions. These differences mean that methods for achieving incentive-based compensation arrangements that appropriately balance risk and reward at one institution may not be effective in restraining incentives to engage in imprudent risk-taking at another institution. The proposed rule would require that incentive-based compensation arrangements contain certain features. Section ll.4(d) sets out specific requirements that would be applicable to arrangements for all covered persons at all covered institutions and that are intended to result in incentive-based compensation arrangements that E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules appropriately balance risk and reward. Sections ll.7 and ll.8 of the proposed rule provide more specific requirements that would be applicable to arrangements at Level 1 and Level 2 covered institutions. While the proposed rule would require incentive-based compensation arrangements for senior executive officers and significant risk-takers at Level 1 and Level 2 covered institutions to have certain features (such as a certain percentage of the award deferred), those features alone would not be sufficient to balance risk-taking incentives with reward. The extent to which additional balancing methods are required would vary with the size and complexity of a covered institution and with the nature of a covered person’s activities. Section ll.4(c)(2) of the proposed rule provides that an incentive-based compensation arrangement at a covered institution would encourage inappropriate risks that could lead to material financial loss to the covered institution unless the arrangement is compatible with effective risk management and controls. A covered institution’s risk management processes and internal controls would have to reinforce and support the development and maintenance of incentive-based compensation arrangements that appropriately balance risk and reward required under section ll.4(c)(1) of the proposed rule. One of the reasons risk management is important is that covered persons may seek to evade the processes established by a covered institution to achieve incentive-based compensation arrangements that appropriately balance risk and reward in an effort to increase their own incentive-based compensation. For example, a covered person might seek to influence the risk measures or other information or judgments that are used to make the covered person’s incentive-based compensation sensitive to risk. Such actions may significantly weaken the effectiveness of a covered institution’s incentive-based compensation arrangements in restricting inappropriate risk-taking and could have a particularly damaging effect if they result in the manipulation of measures of risk, information, or judgments that the covered institution uses for other risk-management, internal control, or financial purposes. In such cases, the covered person’s actions may weaken not only the balance of the covered institution’s incentive-based compensation arrangements but also the risk-management, internal controls, and VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 other functions that are supposed to act as a separate check on risk-taking. All covered institutions would have to have appropriate controls surrounding the design, implementation, and monitoring of incentive-based compensation arrangements to ensure that processes for achieving incentive-based compensation arrangements that appropriately balance risk and reward are followed, and to maintain the integrity of their risk-management and other control functions. The nature of controls likely would vary by size and complexity of the covered institution as well as the activities of the covered person. For example, under the proposed rule, controls surrounding incentive-based compensation arrangements at smaller covered institutions likely would be less extensive and less formalized than at larger covered institutions. Level 1 and Level 2 covered institutions would be more likely to have a systematic approach to designing and implementing their incentive-based compensation arrangements, and their incentive-based compensation programs would more likely be supported by formalized and well-developed policies, procedures, and systems. Level 3 covered institutions, on the other hand, might maintain less extensive and detailed incentive-based compensation programs. Section ll.9 of the proposed rule provides additional, specific requirements that would be applicable to Level 1 and Level 2 covered institutions designed to result in incentive-based compensation arrangements at Level 1 and Level 2 covered institutions that are compatible with effective risk management and controls. Incentive-based compensation arrangements also would have to be supported by an effective governance framework. Section ll.4(e) sets forth more detail on requirements for boards of directors of all covered institutions that would be designed to result in incentive-based compensation arrangements that are supported by effective governance, while section ll.10 of the proposed rule provides more specific requirements that would be applicable to Level 1 and Level 2 covered institutions. The proposed requirement for effective governance is an important foundation of incentive-based compensation arrangements that appropriately balance risk and reward. The involvement of the board of directors in oversight of the covered institution’s overall incentive-based compensation program should be scaled PO 00000 Frm 00043 Fmt 4701 Sfmt 4702 37711 appropriately to the scope of the covered institution’s incentive-based compensation arrangements and the number of covered persons who have incentive-based compensation arrangements. (d) Performance Measures The performance measures used in an incentive-based compensation arrangement have an important effect on the incentives provided to covered persons and thus affect the potential for the incentive-based compensation arrangement to encourage inappropriate risk-taking that could lead to material financial loss. Under section ll.4(d) of the proposed rule, an incentive-based compensation arrangement would not be considered to appropriately balance risk and reward unless: (1) It includes financial and non-financial measures of performance that are relevant to a covered person’s role and to the type of business in which the covered person is engaged and that are appropriately weighted to reflect risk-taking; (2) it is designed to allow non-financial measures of performance to override financial measures when appropriate; and (3) any amounts to be awarded under the arrangement are subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance. Each of these requirements is described more fully below. First, the arrangements would be required to include both financial and non-financial measures of performance. Financial measures of performance generally are measures tied to the attainment of strategic financial objectives of the covered institution, or one of its operating units, or to the contributions by covered persons towards attainment of such objectives, such as measures related to corporate sales, profit, or revenue targets. Nonfinancial measures of performance, on the other hand, could be assessments of a covered person’s risk-taking or compliance with limits on risk-taking. These may include assessments of compliance with the covered institution’s policies and procedures, adherence to the covered institution’s risk framework and conduct standards, or compliance with applicable laws. These financial and non-financial measures of performance should include considerations of risk-taking, and be relevant to a covered person’s role within the covered institution and to the type of business in which the covered person is engaged. They also should be appropriately weighted to E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37712 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules reflect the nature of such risk-taking. The requirement to include both financial and non-financial measures of performance would apply to forms of incentive-based compensation that set out performance measure goals and related amounts near the beginning of a performance period (such as long-term incentive plans) and to forms that do not necessarily specify performance measure goals and related amounts in advance of performance (such as certain bonuses). For example, a senior executive officer may have his or her performance evaluated based upon quantitative financial measures, such as return on equity, and on qualitative, non-financial measures, such as the extent to which the senior executive officer promoted sound risk management practices or provided strategic leadership through a difficult merger. The senior executive officer’s performance also may be evaluated on several qualitative non-financial measures that in some instances span multiple calendar and performance years. Incentive-based compensation should support prudent risk-taking, but should also allow covered institutions to hold covered persons accountable for inappropriate behavior. Reliable quantitative measures of risk and risk outcomes, where available, may be particularly useful in both developing incentive-based compensation arrangements that appropriately balance risk and reward and assessing the extent to which incentive-based compensation arrangements properly balance risk and reward. However, reliable quantitative measures may not be available for all types of risk or for all activities, and in many cases may not be sufficient to fully assess the risks that the activities of covered persons may pose to covered institutions. Poor performance, as assessed by non-financial measures such as quality of risk management, could pose significant risks for the covered institution and may itself be a source of potential material financial loss at a covered institution. For this reason, non-financial performance measures play an important role in reinforcing expectations on appropriate risk, control, and compliance standards and should form a significant part of the performance assessment process. Under certain circumstances, it may be appropriate for non-financial performance measures, which are the primary measures that relate to risktaking behavior, to override considerations of financial performance measures. An override might be appropriate when, for example, a covered person conducts trades or other VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 transactions that increase the covered institution’s profit but that create an inappropriate compliance risk for the covered institution. In such a case, an incentive-based compensation arrangement should allow for the possibility that the non-financial measure of compliance risk could override the financial measure of profit when the amount of incentive-based compensation to be awarded to the covered person is determined. The effective balance of risks and rewards may involve the use of both formulaic arrangements and discretion. At most covered institutions, management retains a significant amount of discretion when awarding incentive-based compensation. Although the use of discretion has the ability to reinforce risk balancing, when improperly utilized, discretionary decisions can undermine the goal of incentive-based compensation arrangements to appropriately balance risk and reward. For example, an incentive-based compensation arrangement that has a longer performance period that could allow risk events to manifest and for awards to be adjusted to reflect risk could be less effective if management makes a discretionary award decision that does not account for, or mitigates, the future impact of those risk events.122 Section ll.4(d)(3) of the proposed rule would also require that any amounts to be awarded under an incentive-based compensation arrangement be subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance. It is important that incentive-based compensation arrangements be balanced in design and implemented so that awards and actual amounts that vest actually vary based on risks or risk outcomes. If, for example, covered persons are awarded or paid substantially all of their potential incentive-based compensation even when they cause a covered institution to take a risk that is inappropriate given the institution’s size, nature of operations, or risk profile, or cause the covered institution to fail to comply with legal or regulatory obligations, then covered persons will have less incentive to avoid activities with substantial risk of financial loss or non-compliance with legal or regulatory obligations. 122 For Level 1 and Level 2 covered institutions, section ll.11 of the proposed rule would require policies and procedures that address the institution’s use of discretion. PO 00000 Frm 00044 Fmt 4701 Sfmt 4702 (e) Board of Directors Under section ll.4(e) of the proposed rule, the board of directors, or a committee thereof, would be required to: (1) Conduct oversight of the covered institution’s incentive-based compensation program; (2) approve incentive-based compensation arrangements for senior executive officers, including the amounts of all awards and, at the time of vesting, payouts under such arrangements; and (3) approve any material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers. Section ll.4(e)(1) of the proposed rule would require the board of directors, or a committee thereof, of a covered institution to conduct oversight of the covered institution’s incentivebased compensation program. Such oversight generally should include overall goals and purposes. For example, boards of directors, or a committee thereof, of covered institutions generally should oversee senior management in the development of an incentive-based compensation program that incentivizes behaviors consistent with the long-term health of the covered institution, and provide sufficient detail to enable senior management to translate the incentivebased compensation program into objectives, plans, and arrangements for each line of business and control function. Such oversight also generally should include holding senior management accountable for effectively executing the covered institution’s incentive-based compensation program and for communicating expectations regarding acceptable behaviors and business practices to covered persons. Boards of directors should actively engage with senior management, including challenging senior management’s incentive-based compensation assessments and recommendations when warranted. In addition to the general program oversight requirement set forth in section ll.4(e)(1) of the proposed rule, a board of directors, or a committee thereof, would also be required by sections ll.4(e)(2) and ll.4(e)(3) to approve incentive-based compensation arrangements for senior executive officers, including the amounts of all awards and payouts, at the time of vesting, under such arrangements, and to approve any material exceptions or adjustments to those arrangements. Although risk-adjusting incentivebased compensation for senior executive officers responsible for the covered institution’s overall risk posture and E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 performance may be challenging given that quantitative measures of institution-wide risk are difficult to produce and allocating responsibility among the senior executive team for achieving risk objectives can be a complex task, the role of senior executive officers in managing the overall risk-taking activities of an institution is important. Accordingly the proposed rule would require the board of directors, or a committee thereof, to approve compensation arrangements involving senior executive officers. When a board of directors, or a committee thereof, is considering an award or a payout, it should consider risks to ensure that the award or payout is consistent with broader risk management and strategic objectives. (f) Disclosure and Recordkeeping Requirements and (g) Rule of Construction Section ll.4(f) of the proposed rule would establish disclosure and recordkeeping requirements for all covered institutions, as required by section 956(a)(1).123 Under the proposed rule, each covered institution would be required to create and maintain records that document the structure of all of the institution’s incentive-based compensation arrangements and demonstrate compliance with the proposed rule, and to disclose these records to the appropriate Federal regulator upon request. The proposed rule would require covered institutions to create such records on an annual basis and to maintain such records for at least seven years after they are created. The Agencies recognize that the exact timing for recordkeeping will vary from institution to institution, but this requirement would ensure that covered institutions create such records for their incentive-based compensation arrangements at least once every 12 months. The requirement to maintain records for at least seven years generally aligns with the clawback period described in section ll.7(c) of the proposed rule. The proposed rule would require that the records maintained by a covered institution, at a minimum, include copies of all incentive-based compensation plans, a list of who is subject to each plan, and a description of how the covered institution’s incentive-based compensation program is compatible with effective risk management and controls. These records would be the minimum required information to determine whether the structure of the covered institution’s 123 12 U.S.C. 5641(a)(1). VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 incentive-based compensation arrangements provide covered persons with excessive compensation or could lead to material financial loss to the covered institution. As specified in section 956(a)(2) and section ll.4(g) of the proposed rule, a covered institution would not be required to report the actual amount of compensation, fees, or benefits of individual covered persons as part of this requirement.124 The 2011 Proposed Rule would have implemented section 956(a)(1) by requiring all covered financial institutions to submit an annual report to their appropriate Federal regulator, in a format specified by their appropriate Federal regulator, that described in narrative form the structure of the covered financial institution’s incentivebased compensation arrangements for covered persons and the policies governing such arrangements.125 Some commenters on the 2011 Proposed Rule favored annual reporting requirements, while other commenters opposed any requirement for institutions to make periodic submissions of information about incentive-based compensation arrangements to regulators, noting concerns about burden, particularly for smaller covered financial institutions. A few commenters requested an annual certification requirement instead of a reporting requirement. While there is value in receiving reports, the burden of producing them would potentially be great on smaller covered institutions. Accordingly, the Agencies determined not to include a requirement for covered institutions to submit annual narrative reports. Given the variety of covered institutions and asset sizes, the Agencies are not proposing a specific format or template for the records that 124 The Agencies note that covered institutions may be required to report actual compensation under other provisions of law. For example, corporate credit unions must disclose compensation of certain executive officers to their natural person credit union members under NCUA’s corporate credit union rule. 12 CFR 704.19. The proposed rule would not affect the requirements in 12 CFR 704.19 or in any other reporting provision under any other law or regulation. The SEC requires an issuer that is subject to the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)) to disclose information regarding the compensation of its principal executive officer, principal financial officer, and three other most highly compensated executive officers, as well as its directors, in the issuer’s proxy statement, its annual report on Form 10–K, and registration statements for offerings of securities. The requirements are generally found in Item 402 of Regulation S–K (17 CFR 229.402). 125 See 2011 Proposed Rule, at 21177. The 2011 Proposed Rule also would have set forth additional more detailed requirements for covered financial institutions with total consolidated assets of $50 billion or more. PO 00000 Frm 00045 Fmt 4701 Sfmt 4702 37713 must be maintained by all covered institutions. According to the Agencies’ supervisory experience, as discussed further above, many covered institutions already maintain information about their incentive-based compensation programs comparable to the types of information described above (e.g., in support of public company filings). Several commenters on the 2011 Proposed Rule expressed concern regarding the confidentiality of the reported compensation information. In light of the nature of the information that would be provided to the Agencies under section ll.4(f) of the proposed rule, and the purposes for which the Agencies are requiring the information, the Agencies would view the information disclosed to the Agencies as nonpublic and expect to maintain the confidentiality of that information, to the extent permitted by law.126 When providing information to one of the Agencies pursuant to the proposed rule, covered institutions should request confidential treatment by that Agency. 4.1. The Agencies invite comment on the requirements for performance measures contained in section ll.4(d) of the proposed rule. Are these measures sufficiently tailored to allow for incentive-based compensation arrangements to appropriately balance risk and reward? If not, why? 4.2. The Agencies invite comment on whether the terms ‘‘financial measures of performance’’ and ‘‘non-financial measures of performance’’ should be defined. If so, what should be included in the defined terms? 4.3. Would preparation of annual records be appropriate or should another method be used? Would covered institutions find a more specific list of topics and quantitative information for the content of required records helpful? Should covered institutions be required to maintain an inventory of all such records and to maintain such records in a particular format? If so, why? How would such specific requirements increase or decrease burden? 126 For example, Exemption 4 of the Freedom of Information Act (‘‘FOIA’’) provides an exemption for ‘‘trade secrets and commercial or financial information obtained from a person and privileged or confidential.’’ 5 U.S.C. 552(b)(4). FOIA Exemption 6 provides an exemption for information about individuals in ‘‘personnel and medical files and similar files’’ when the disclosure of such information ‘‘would constitute a clearly unwarranted invasion of personal privacy.’’ 5 U.S.C. 552(b)(6). FOIA Exemption 8 provides an exemption for matters that are ‘‘contained in or related to examination, operating, or condition reports prepared by, on behalf of, or for the use of an agency responsible for the regulation or supervision of financial institutions.’’ 5 U.S.C. 552(b)(8). E:\FR\FM\10JNP2.SGM 10JNP2 37714 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 4.4. Should covered institutions only be required to create new records when incentive-based compensation arrangements or policies change? Should the records be updated more frequently, such as promptly upon a material change? What should be considered a ‘‘material change’’? 4.5. Is seven years a sufficient time to maintain the records required under section ll.4(f) of the proposed rule? Why or why not? 4.6. Do covered institutions generally maintain records on incentive-based compensation arrangements and programs? If so, what types of records and related information are maintained and in what format? What are the legal or institutional policy requirements for maintaining such records? 4.7. For covered institutions that are investment advisers or broker-dealers, is there particular information that would assist the SEC in administering the proposed rule? For example, should the SEC require its reporting entities to report whether they utilize incentivebased compensation or whether they are Level 1, Level 2 or Level 3 covered institutions? § ll.5 Additional Disclosure and Recordkeeping Requirements for Level 1 and Level 2 Covered Institutions Section ll.5 of the proposed rule would establish additional and more detailed recordkeeping requirements for Level 1 and Level 2 covered institutions. Under section ll.5(a) of the proposed rule, a Level 1 or Level 2 covered institution would be required to create annually, and maintain for at least seven years, records that document: (1) Its senior executive officers and significant risk-takers listed by legal entity, job function, organizational hierarchy, and line of business; (2) the incentive-based compensation arrangements for senior executive officers and significant risktakers, including information on percentage of incentive-based compensation deferred and form of award; (3) any forfeiture and downward adjustment or clawback reviews and decisions for senior executive officers and significant risk-takers; and (4) any material changes to the covered institution’s incentive-based compensation arrangements and policies. The proposed recordkeeping and disclosure requirements at Level 1 and Level 2 covered institutions would assist the appropriate Federal regulator in monitoring whether incentive-based compensation structures, and any changes to such structures, could result in Level 1 and Level 2 covered VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 institutions maintaining incentive-based compensation structures that encourage inappropriate risks by providing excessive compensation, fees, or benefits or could lead to material financial loss. The more detailed reporting requirement for Level 1 and Level 2 covered institutions under section ll.5(a) of the proposed rule reflects the information that would assist the appropriate Federal regulator in most effectively evaluating the covered institution’s compliance with the proposed rule and identifying areas of potential concern with respect to the structure of the covered institution’s incentive-based compensation arrangements. For example, the recordkeeping requirement in section ll.5(a)(2) of the proposed rule regarding amounts of incentive-based compensation deferred and the form of payment of incentivebased compensation for senior executive officers and significant risk-takers would help Federal regulators determine compliance with the requirement in section ll.7(a) of the proposed rule for certain amounts of incentive-based compensation of senior executive officers and significant risktakers to be deferred for specific periods of time. Similarly, the recordkeeping requirement in section ll.5(a)(3) of the proposed rule would require Level 1 and Level 2 covered institutions to document the rationale for decisions under forfeiture and downward adjustment reviews and to keep timely and accurate records of the decision. This documentation would provide information useful to Federal regulators for determining compliance with the requirements in sectionsll.7(b) and (c) of the proposed rule regarding specific forfeiture and clawback policies at Level 1 and Level 2 covered institutions that are further discussed below. The proposed recordkeeping requirements in section ll.5(a) of the proposed rule relate to the proposed substantive requirements in section ll.7 of the proposed rule and would help the appropriate Federal regulator to closely monitor incentivebased compensation payments to senior executive officers and significant risktakers and to determine whether those payments have been adjusted to reflect risk outcomes. This approach also would be responsive to comments received on the 2011 Proposed Rule suggesting that specific qualitative and quantitative information, instead of a narrative description, be the basis of a reporting requirement for larger covered institutions. PO 00000 Frm 00046 Fmt 4701 Sfmt 4702 Section ll.5(b) of the proposed rule would require a Level 1 or Level 2 covered institution to create and maintain records sufficient to allow for an independent audit of incentive-based compensation arrangements, policies, and procedures, including those required under section ll.11 of the proposed rule. A standard which reflects the level of detail required in order to perform an independent audit of incentive-based compensation would be appropriate given the importance of regular monitoring of incentive-based compensation programs by independent control functions. Such a standard also would be consistent with the monitoring requirements set out in section ll.11 of the proposed rule. As with the requirements applicable to all covered institutions under section ll.4(f) of the proposed rule, the Agencies are not proposing to require that a Level 1 or Level 2 covered institution annually file a report with the appropriate Federal regulator. Instead, section ll.5(c) of the proposed rule would require a Level 1 or Level 2 covered institution to disclose its records to the appropriate Federal regulator in such form and with such frequency as requested by the appropriate Federal regulator. The required form and frequency of recordkeeping may vary among the Agencies and across categories of covered institutions, although the records described in section ll.5(a) of the proposed rule, along with any other records a covered institution creates to satisfy the requirements of section ll .5(f) of the proposed rule, would be required to be created at least annually. Some Agencies may require Level 1 and Level 2 covered institutions to provide their records on an annual basis, alone or with a standardized form of report. Level 1 and Level 2 covered institutions should seek guidance concerning the reporting requirement from their appropriate Federal regulator. Generally, the Agencies would expect the volume and detail of information disclosed by a covered institution under section ll.5 of the proposed rule to be tailored to the nature and complexity of business activities at the covered institution, and to the scope and nature of its use of incentive-based compensation arrangements. The Agencies recognize that smaller covered institutions with less complex and less extensive incentive-based compensation arrangements likely would not create or retain records that are as extensive as those that larger covered institutions with relatively complex programs and business activities would likely create. The tailored recordkeeping and E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 disclosure provisions for Level 1 and Level 2 covered institutions in the proposed rule are designed to provide the Agencies with streamlined and wellfocused records that would allow the Agencies to promptly and effectively identify and address any areas of concern. Similar to the provision of information under section ll.4(f) of the proposed rule, the Agencies expect to treat the information provided to the Agencies under section ll.5 of the proposed rule as nonpublic and to maintain the confidentiality of that information to the extent permitted by law.127 When providing information to one of the Agencies pursuant to the proposed rule, covered institutions should request confidential treatment by that Agency. 5.1. Should the level of detail in records created and maintained by Level 1 and Level 2 covered institutions vary among institutions regulated by different Agencies? If so, how? Or would it be helpful to use a template with a standardized information list? 5.2. In addition to the proposed records, what types of information should Level 1 and Level 2 covered institutions be required to create and maintain related to deferral and to forfeiture, downward adjustment, and clawback reviews? § ll.6 Reservation of Authority for Level 3 Covered Institutions Section ll.6 of the proposed rule would allow the appropriate Federal regulator to require certain Level 3 covered institutions to comply with some or all of the more rigorous requirements applicable to Level 1 and Level 2 covered institutions. Specifically, an Agency would be able to require a covered institution with average total consolidated assets greater than or equal to $10 billion and less than $50 billion to comply with some or all of the more rigorous provisions of section ll.5 and sections ll.7 through ll.11 of the proposed rule, if the appropriate Federal regulator determined that the covered institution’s complexity of operations or compensation practices are consistent with those of a Level 1 or Level 2 covered institution, based on the covered institution’s activities, complexity of operations, risk profile, or compensation practices. In such cases, the Agency that is the Level 3 covered institution’s appropriate Federal regulator, in accordance with procedures established by the Agency, would notify the institution in writing 127 See supra note 126. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 that it must satisfy the requirements and other standards contained in section ll.5 and sections ll.7 through ll.11 of the proposed rule. As with the designation of significant risk-takers discussed above, each Agency’s procedures generally would include reasonable advance written notice of the proposed action, including a description of the basis for the proposed action, and opportunity for the covered institution to respond. As noted previously, the Agencies have determined that it may be appropriate to apply only basic prohibitions and disclosure requirements to Level 3 covered institutions, in part because these institutions generally have less complex operations, incentive-based compensation practices, and risk profiles than Level 1 and Level 2 covered institutions.128 However, the Agencies recognize that there is a wide spectrum of business models and risk profiles within the $10 to $50 billion range and believe that some Level 3 covered institutions with between $10 and $50 billion in total consolidated assets may have incentive-based compensation practices and operational complexity comparable to those of a Level 1 or Level 2 covered institution. In such cases, it may be appropriate for the Agencies to provide a process for determining that such institutions should be held to the more rigorous standards. The Agencies are proposing $10 billion as the appropriate threshold for the low end of this range based upon the general complexity of covered institutions above this size. The threshold is also used in other statutory and regulatory requirements. For example, the stress testing provisions of the Dodd-Frank Act require banking organizations with total consolidated assets of more than $10 billion to conduct annual stress tests.129 For deposit insurance assessment purposes, the FDIC distinguishes between small and large banks based on a $10 billion asset size.130 For supervisory purposes, the Board defines community banks by reference to the $10 billion asset size threshold.131 The Agencies would consider the activities, complexity of operations, risk profile, and compensation practices to 128 See section 3 of Part II of this Supplementary Information for more discussions on Level 1, Level 2, and Level 3 covered institutions. 129 12 U.S.C. 5365(i)(2). 130 See 12 CFR 327.8(e) and (f). 131 See Federal Reserve SR Letter 12–7, ‘‘Supervisory Guidance on Stress Testing for Banking Organizations with More Than $10 Billion in Total Consolidated Assets’’ (May 14, 2012). PO 00000 Frm 00047 Fmt 4701 Sfmt 4702 37715 determine whether a Level 3 covered institution’s operations or compensation practices warrant application of additional standards pursuant to the proposed rule. For example, a Level 3 covered institution could have significant levels of off-balance sheet activities, such as derivatives that may entail complexities of operations and greater risk than balance sheet measures would indicate, making the institution’s risk profile more akin to that of a Level 1 or Level 2 covered institution. Additionally, a Level 3 covered institution might be involved in particular high-risk business lines, such as lending to distressed borrowers or investing or trading in illiquid assets, and make significant use of incentivebased compensation to reward risktakers. Still other Level 3 covered institutions might have or be part of a complex organizational structure, such as operating with multiple legal entities in multiple foreign jurisdictions. Section ll.6 of the proposed rule would permit the appropriate Federal regulator of a Level 3 covered institution with total consolidated assets of between $10 and $50 billion to require the institution to comply with some or all of the provisions of section ll.5 and sections ll.7 through ll.11 of the proposed rule. This approach would allow the Agencies to take a flexible approach in the proposed rule provisions applicable to all Level 3 covered institutions while retaining authority to apply more rigorous standards where the Agencies determine appropriate based on the Level 3 covered institution’s complexity of operations or compensation practices. The Agencies expect they only would use this authority on an infrequent basis. This approach has been used in other rules for purposes of tailoring the application of requirements and providing flexibility to accommodate the variations in size, complexity, and overall risk profile of financial institutions.132 6.1. The Agencies invite general comment on the reservation of authority in section ll.6 of the proposed rule. 132 For example, the OCC, FDIC, and Board’s domestic capital rules include a reservation of authority whereby the agency may require an institution to hold an amount of regulatory capital greater than otherwise required under the capital rules. 12 CFR 3.1(d) (OCC); 12 CFR 324.1(d)(1) through (6) (FDIC); 12 CFR 217.1(d) (Board). The OCC, FDIC, and the Board’s Liquidity Coverage Ratio rule includes a reservation of authority whereby each agency may impose heightened standards on an institution. 12 CFR 50.2 (OCC); 12 CFR 329.2 (FDIC); 12 CFR 249.2 (Board). The FDIC’s stress testing rules include a reservation of authority to require a $10 billion to $50 billion covered bank to use reporting templates for larger banks. 12 CFR 325.201. E:\FR\FM\10JNP2.SGM 10JNP2 37716 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 6.2. The Agencies based the $10 billion dollar floor of the reservation of authority on existing similar reservations of authority that have been drawn at that level. Did the Agencies set the correct threshold or should the floor be set lower or higher than $10 billion? If so, at what level and why? 6.3. Are there certain provisions in section ll.5 and sections ll.7 through ll.11 of the proposed rule that would not be appropriate to apply to a covered institution with total consolidated assets of $10 billion or more and less than $50 billion regardless of its complexity of operations or compensation practices? If so, which provisions and why? 6.4. The Agencies invite comment on the types of notice and response procedures the Agencies should use in determining that the reservation of authority should be used. The SEC invites comment on whether notice and response procedures based on the procedures for a proceeding initiated upon the SEC’s own motion under Advisers Act rule 0–5 would be appropriate for this purpose. 6.5. What specific features of incentive-based compensation programs or arrangements at a Level 3 covered institution should the Agencies consider in determining such institution should comply with some or all of the more rigorous requirements within the rule and why? What process should be followed in removing such institution from the more rigorous requirements? § ll.7 Deferral, Forfeiture and Downward Adjustment, and Clawback Requirements for Level 1 and Level 2 Covered Institutions As discussed above, allowing covered institutions time to measure results with the benefit of hindsight allows for a more accurate assessment of the consequences of risks to which the institution has been exposed. This approach may be particularly relevant, for example, where performance is difficult to measure because performance results and risks take time to observe (e.g., assessing the future repayment prospects of loans written during the current year). In order to achieve incentive-based compensation arrangements that appropriately balance risk and reward, including closer alignment between the interests of senior executive officers and significant risk-takers within the covered institution and the longer-term interests of the covered institution itself, it is important for information on performance, including information on misconduct and inappropriate risktaking, to affect the incentive-based VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 compensation amounts received by covered persons. Covered institutions may use deferral, forfeiture and downward adjustment, and clawback to address information about performance that comes to light after the conclusion of the performance period, so that incentive-based compensation arrangements are able to appropriately balance risk and reward. Section ll.7 of the proposed rule would require Level 1 and Level 2 covered institutions to incorporate these tools into the incentive-based compensation arrangements of senior executive officers and significant risk-takers. Under the proposed rule, an incentive-based compensation arrangement at a Level 1 or Level 2 covered institution would not be considered to appropriately balance risk and reward, as would be required by section ll.4(c)(1), unless the deferral, forfeiture, downward adjustment, and clawback requirements of section ll.7 are met. These requirements would apply to incentive-based compensation arrangements provided to senior executive officers and significant risktakers at Level 1 and Level 2 covered institutions. Institutions may, of course, take additional steps to address risks that may mature after the performance period. The requirements of section ll.7 of the proposed rule would apply to Level 1 and Level 2 covered institutions; that is, to covered institutions with $50 billion or more in average total consolidated assets. The requirements of section ll.7 would not be applicable to Level 3 covered institutions.133 As discussed above, the Agencies recognize that larger covered institutions have more complex business activities and generally rely more on incentive-based compensation programs, and, therefore, it is appropriate to impose specific deferral, forfeiture and downward adjustment reviews and clawback requirements on these institutions. It has been recognized that larger financial institutions can present greater potential systemic risks. The Board, for example, has expressed the view that institutions with more than $250 billion in total consolidated assets are more likely than other institutions to pose systemic risk 133 As explained earlier in this Supplementary Information section, the appropriate Federal regulator of a Level 3 covered institution with average total consolidated assets greater than or equal to $10 billion and less than $50 billion may require the covered institution to comply with some or all of the provisions of section ll.5 and sections ll.7 through ll.11 of the proposed rule if the Agency determines that the complexity of operations or compensation practices of the Level 3 covered institution are consistent with those of a Level 1 or 2 covered institution. PO 00000 Frm 00048 Fmt 4701 Sfmt 4702 to U.S. financial stability.134 Because of these risks that could be created by excessive risk-taking at the largest covered institutions, additional safeguards are needed against inappropriate risk-taking at Level 1 covered institutions. For these reasons, the Agencies are proposing a required minimum deferral percentage and a required minimum deferral period for Level 1 covered institutions that are greater than those for Level 2 covered institutions. The requirements of section ll.7 of the proposed rule would apply to incentive-based compensation arrangements for senior executive officers and significant risk-takers of Level 1 and Level 2 covered institutions. The decisions of senior executive officers can have a significant impact on the entire consolidated organization and often involve substantial strategic or other risks that can be difficult to measure and model—particularly at larger covered institutions—during or at the end of the performance period, and therefore can be difficult to address adequately by risk adjustments in the awarding of incentive-based compensation.135 Supervisory experience and a review of the academic literature 136 suggest that incentivebased compensation arrangements for the most senior decision-makers and risk-takers at the largest institutions appropriately balance risk and reward when a significant portion of the incentive-based compensation awarded under those arrangements is deferred for an adequate amount of time. As discussed above, in addition to the institution’s senior executive officers, the significant risk-takers at Level 1 and Level 2 covered institutions may have the ability to expose the institution to the risk of material financial loss. In order to help ensure that the incentivebased compensation arrangements for these individuals appropriately balance risk and reward and do not encourage 134 Board, Regulatory Capital Rules: Implementation of Risk-Based Capital Surcharges for Global Systemically Important Bank Holding Companies, 80 FR 49082, 49084 (August 14, 2015). 135 This premise was identified in the 2010 Federal Banking Agency Guidance, 75 FR at 36409, and was highlighted in the 2011 FRB White Paper. The report reiterated the recommendation that ‘‘[a] substantial fraction of incentive compensation awards should be deferred for senior executives of the firm because other methods of balancing risk taking incentives are less likely to be effective by themselves for such individuals.’’ 2011 FRB White Paper, at 15. 136 Gopalan, Milbourn, Song and Thakor, ‘‘Duration of Executive Compensation’’ (December 18, 2012), at 29–30, available at https://apps.olin. wustl.edu/faculty/thakor/Website%20Papers/ Duration%20of%20Executive%20 Compensation.pdf. E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules them to engage in inappropriate risktaking that could lead to material financial loss, the proposed rule would extend the deferral requirement to significant risk-takers at Level 1 and Level 2 covered institutions. Deferral for significant risk-takers as well as executive officers helps protect against material financial loss at the largest covered institutions. mstockstill on DSK3G9T082PROD with PROPOSALS2 § ll.7(a) Deferral As a tool to balance risk and reward, deferral generally consists of four components: the proportion of incentive-based compensation required to be deferred, the time horizon of the deferral, the speed at which deferred incentive-based compensation vests, and adjustment during the deferral period to reflect risks or inappropriate conduct that manifest over that period of time. Section ll.7(a) of the proposed rule would require Level 1 and Level 2 covered institutions, at a minimum, to defer the vesting of a certain portion of all incentive-based compensation awarded (the deferral amount) to a senior executive officer or significant risk-taker for at least a specified period of time (the deferral period). The minimum required deferral amount and minimum required deferral period would be determined by the size of the covered institution, by whether the covered person is a senior executive officer or significant risk-taker, and by whether the incentive-based compensation was awarded under a long-term incentive plan or is qualifying incentive-based compensation. Minimum required deferral amounts range from 40 percent to 60 percent of the total incentive-based compensation award, and minimum required deferral periods range from one year to four years, as detailed below. Deferred incentive-based compensation of senior executive officers and significant risk-takers at Level 1 and Level 2 covered institutions would also be required to meet the following other requirements: • Vesting of deferred amounts may occur no faster than on a pro rata annual basis beginning on the one-year anniversary of the end of the performance period; • Unvested deferred amounts may not be increased during the deferral period; • For most Level 1 and Level 2 covered institutions, substantial portions of deferred incentive-based compensation must be paid in the form of both equity-like instruments and deferred cash; VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 • Vesting of unvested deferred amounts may not be accelerated except in the case of death or disability; 137 and • All unvested deferred amounts must be placed at risk of forfeiture and subject to a forfeiture and downward adjustment review pursuant to section ll.7(b). Except for the prohibition against accelerated vesting, the prohibitions and requirements in section ll.7(a) of the proposed rule would apply to all unvested deferred incentive-based compensation, regardless of whether the deferral of the incentive-based compensation was necessary to meet the requirements of the proposed rule. For example, if a covered institution chooses to defer incentive-based compensation above the amount required to be deferred under the rule, the additional amount would be required to be subject to forfeiture. In another example, if a covered institution would be required to defer a portion of a particular covered person’s incentivebased compensation for four years, but chooses to defer that compensation for ten years, the deferral would be subject to forfeiture during the entire ten-year deferral period. Applying the requirements and prohibitions of section ll.7(a) to all unvested deferred incentive-based compensation is intended to maximize the balancing effect of deferred incentive-based compensation, to make administration of the requirements and prohibitions easier for covered institutions, and to facilitate the Agencies’ supervision for compliance. Compensation that is not incentivebased compensation and is deferred only for tax purposes would not be considered ‘‘deferred incentive-based compensation’’ for purposes of the proposed rule. § ll.7(a)(1) and § ll.7(a)(2) Minimum Deferral Amounts and Deferral Periods for Qualifying Incentive-Based Compensation and Incentive-Based Compensation Awarded Under a Long-Term Incentive Plan The proposed rule would require a Level 1 covered institution to defer at least 60 percent of each senior executive officer’s qualifying incentive-based compensation 138 for at least four years, 137 For covered persons at credit unions, NCUA’s rule also permits acceleration of payment if the covered person must pay income taxes on the entire amount of an award, including deferred amounts, at the time of award. 138 As described above, incentive-based compensation that is not awarded under a longterm incentive plan would be defined as qualifying incentive-based compensation under the proposed rule. PO 00000 Frm 00049 Fmt 4701 Sfmt 4702 37717 and at least 60 percent of each senior executive officer’s incentive-based compensation awarded under a longterm incentive plan for at least two years beyond the end of that plan’s performance period. A Level 1 covered institution would be required to defer at least 50 percent of each significant risktaker’s qualifying incentive-based compensation for at least four years, and at least 50 percent of each significant risk-taker’s incentive-based compensation awarded under a longterm incentive plan for at least two years beyond the end of that plan’s performance period. Similarly, the proposed rule would require a Level 2 covered institution to defer at least 50 percent of each senior executive officer’s qualifying incentivebased compensation for at least three years, and at least 50 percent of each senior executive officer’s incentivebased compensation awarded under a long-term incentive plan for at least one year beyond the end of that plan’s performance period. A Level 2 covered institution would be required to defer at least 40 percent of each significant risktaker’s qualifying incentive-based compensation for at least three years, and at least 40 percent of each significant risk-taker’s incentive-based compensation awarded under a longterm incentive plan for at least one year beyond the end of that plan’s performance period. In practice, a Level 1 or Level 2 covered institution typically evaluates the performance of a senior executive officer or significant risk-taker during and after the performance period. As the performance period comes to a close, the covered institution determines an amount of incentive-based compensation to award the covered person for that performance period. Senior executive officers and significant risk-takers may be awarded incentivebased compensation at a given time under multiple incentive-based compensation plans that have performance periods that come to a close at that time. Although they end at the same time, those performance periods may have differing lengths, and therefore may not completely overlap. For example, long-term incentive plans, which have a minimum performance period of three years, would consider performance in at least two years prior to the year the performance period ends, while annual incentive plans would only consider performance in the year of the performance period. For purposes of determining the amount of incentive-based compensation that would be required to be deferred and the actual amount that E:\FR\FM\10JNP2.SGM 10JNP2 37718 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 would be deferred, a Level 1 or Level 2 covered institution generally should use the present value of the incentive-based compensation at the time of the award. In determining the value of awards for this purpose, Level 1 and Level 2 covered institutions generally should use reasonable valuation methods consistent with methods used in other contexts.139 Pro Rata Vesting The requirements of this section would permit the covered institution to immediately pay, or allow to vest, all of the incentive-based compensation that is awarded that is not required to be deferred. All incentive-based compensation that is deferred would be subject to a deferral period that begins only once the performance period comes to a close. During this deferral period, indications of inappropriate risk-taking may arise, leading the covered institution to consider whether the covered person should not be paid the entire amount originally awarded. The incentive-based compensation that would be required by the rule to be deferred would not be permitted to vest faster than on a pro rata annual basis beginning no earlier than the first anniversary of the end of the performance period for which the compensation was awarded. In other words, a covered institution would be allowed to make deferred incentivebased compensation eligible for vesting during the deferral period on a schedule that paid out equal amounts on each anniversary of the end of the relevant performance period. A covered institution would also be permitted to make different amounts eligible for vesting each year, so long as the cumulative total of the deferred incentive-based compensation that has been made eligible for vesting on each anniversary of the end of the performance period is not greater than the cumulative total that would have been eligible for vesting had the covered institution made equal amounts eligible for vesting each year. For example, if a Level 1 covered institution is required to defer $100,000 of a senior executive officer’s incentivebased compensation for four years, the covered institution could choose to make $25,000 available for vesting on each anniversary of the end of the performance period for which the $100,000 was awarded. The Level 1 covered institution could also choose to make different amounts available for 139 See, e.g., Topic 718 of the FASB Accounting Standards Codification (formerly FAS 123(R); Black-Scholes method for valuing options. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 vesting at different times during the deferral period, as long as: The total amount that is made eligible for vesting on the first anniversary is not more than $25,000; the total amount that has been made eligible for vesting by the second anniversary is not more than $50,000; and the total amount that has been made eligible for vesting by the third anniversary is not more than $75,000. In this example, the Level 1 covered institution would be permitted to make eligible for vesting $10,000 on the first anniversary, $30,000 on the second anniversary (bringing the total for the first and second anniversaries to $40,000), $30,000 on the third anniversary (bringing the total for the first, second, and third anniversaries to $70,000), and $30,000 on the fourth anniversary. A Level 1 or Level 2 covered institution should consider the vesting schedule at the time of the award, and the present value at time of award of each form of incentive-based compensation, for the purposes of determining compliance with this requirement. Level 1 and Level 2 covered institutions generally should use reasonable valuation methods consistent with methods used in other contexts in valuing awards for purposes of this rule. This approach would provide a covered institution with some flexibility in administering its specific deferral program. For example, a covered institution would be permitted to make the full deferred amount of incentivebased compensation awarded for any given year eligible for vesting in a lump sum at the conclusion of the deferral period (i.e., ‘‘cliff vesting’’). Alternatively, a covered institution would be permitted to make deferred amounts eligible for vesting in equal increments at the end of each year of the deferral period. Except in the case of acceleration allowed in sections ll.7(a)(1)(iii)(B) and ll.7(a)(2)(iii)(B), the proposed rule does not allow for vesting of amounts required to be deferred (1) faster than on a pro rata annual basis; or (2) beginning earlier than the first anniversary of the award date. The Agencies recognize that some or all of the incentive-based compensation awarded to a senior executive officer or significant risk-taker may be forfeited before it vests. For an example of how these requirements would work in practice, please see Appendix A of this Supplementary Information section. This restriction is intended to prevent covered institutions from defeating the purpose of the deferral requirement by allowing vesting of most of the required PO 00000 Frm 00050 Fmt 4701 Sfmt 4702 deferral amounts immediately after the award date. In addition, the proposed approach aligns with both what the Agencies understand is common practice in the industry and with the requirements of many foreign supervisors. Acceleration of Payments The Agencies propose that the acceleration of vesting and subsequent payment of incentive-based compensation that is required to be deferred under this proposed rule generally be prohibited for covered persons at Level 1 and Level 2 covered institutions. This restriction would apply to all deferred incentive-based compensation required to be deferred under the proposed rule, whether it was awarded as qualifying incentive-based compensation or under a long-term incentive plan. This prohibition on acceleration would not apply to compensation that the employee or the employer elects to defer in excess of the amounts required under the proposed rule or for time periods that exceed the required deferral periods or in certain other limited circumstances, such as the death or disability of the covered person. NCUA’s proposed rule would permit acceleration of payment if covered persons at credit unions were subject to income taxes on the entire amount of an incentive-based compensation award even before deferred amounts vest. Incentive-based compensation for executives of not-for-profit entities is subject to income taxation under a different provision of the Internal Revenue Code 140 than that applicable to executives of other covered institutions. The result is that credit union executives’ incentive-based compensation awards may be subject to immediate taxation on the entire award, even deferred amounts.141 The ability to accelerate payment would be a limited exception only applicable to income tax liability and would only apply to the extent credit union executives must pay income tax on unvested amounts during the deferral period. Also, any amounts advanced to pay income tax liabilities for deferrals must be taken in proportion to the vesting schedule. For example, a credit union executive may have deferrals of $200,000 for each of three years ($600,000 total) and a total tax liability of $240,000 for the deferred amount of an award. The advanced tax 140 26 U.S.C. 457(f). Agencies understand that the taxation of unvested deferred awards of covered persons at other covered institutions is based on other provisions of the Internal Revenue Code. See, e.g., 26 U.S.C. 409A. 141 The E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 payments would result in an annual reduction of $80,000 per deferred payment, resulting in a new vesting amount of $120,000 for each year of the deferral period. Many institutions currently allow for accelerated vesting in the case of death or disability. Some current incentivebased compensation arrangements, such as separation agreements, between covered persons and covered institutions provide for accelerated vesting and payment of deferred incentive-based compensation that has not yet vested upon the occurrence of certain events.142 Many institutions also currently provide for the accelerated vesting of deferred incentive-based compensation awarded to their senior executive officers, particularly compensation awarded in the form of equity, in connection with a change in control of the company 143 (sometimes as part of a ‘‘golden parachute’’). Shareholder proxy firms and some institutional investors have raised concerns about such golden parachutes,144 and golden parachutes are restricted by law under certain circumstances, including if an institution is in troubled condition.145 Finally, in current incentive-based compensation arrangements, events triggering acceleration commonly include leaving the employment of a covered institution for a new position (either any new position or only certain new positions, such as employment at a government agency), an acquisition or change in control of the covered 142 Several commenters argued that the 2011 Proposed Rule’s deferral requirements should not apply upon the death, disability, retirement, or acceptance of government employment of covered persons, or a change in control of the covered institution, effectively arguing for the ability of covered institutions to accelerate incentive-based compensation under these circumstances. 143 See, e.g., Equilar, ‘‘Change-in-Control Equity Acceleration Triggers’’ (March 19, 2014), available at https://www.equilar.com/reports/8-change-incontrol-equity-acceleration-triggers.html (Noting that although neither Institutional Shareholder Services (ISS) nor Glass Lewis state that a single trigger plan will automatically result in an ‘‘against’’ recommendation, both make it clear that they view the single versus double trigger issue as an important factor in making their decisions. ISS, in particular, suggests in its policies that double trigger vesting of equity awards is currently the best market practice). 144 Institutional Shareholders Services, ‘‘2015 U.S. Compensation Policies, Frequently Asked Questions’’ (February 9, 2015) (‘‘ISS Compensation FAQs’’), available at https:// www.issgovernance.com/file/policy/2015-us-compfaqs.pdf; and Institutional Shareholders Services, ‘‘U.S. Corporate Governance Policy: 2013 Updates’’ (November 16, 2012), available at https:// www.issgovernance.com/file/files/2013USPolicy Updates.pdf. 145 See 12 U.S.C. 1828(k) and 12 CFR part 359 (generally applicable to banks and holding companies). VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 institution, or upon the death or disability of the employee.146 The Federal Banking Agencies have found that the acceleration of deferred incentive-based compensation to covered persons is generally inappropriate because it weakens the balancing effect of deferral and eliminates the opportunity for forfeiture during the deferral period as information concerning risks taken during the performance period becomes known. The acceleration of vesting and payment of deferred incentive-based compensation in other circumstances, such as when the covered person voluntarily leaves the institution, could also provide covered persons with an incentive to retire or leave a covered institution if the covered person is aware of risks posed by the covered person’s activities that are not yet apparent to or fully understood by the covered institution. Acceleration of payment could skew the balance of risktaking incentives provided to the covered person if the circumstances under which acceleration is allowed are within the covered person’s control. The proposed rule would prohibit acceleration of deferred compensation that is required to be deferred under this proposed rule in most circumstances given the potential to undermine risk balancing mechanisms. In contrast, the circumstances under which the Agencies would allow acceleration of payment, namely death or disability of the covered person, generally are not subject to the covered person’s control, and, therefore, are less likely to alter the balance of risk-taking incentives provided to the covered person. In other cases where acceleration is permitted, effective governance and careful assessment of potential risks, as well as specific facts and circumstances are necessary in order to protect against creating precedents that could undermine more generally the risk balancing effects of deferral. Therefore, the Agencies have proposed to permit only these limited exceptions. Under the proposed rule, the prohibition on acceleration except in cases of death or disability would apply only to deferred amounts that are required by the proposed rule so as not to discourage additional deferral, or affect institutions that opt to defer 146 See, e.g., 2012 James F. Reda & Associates, ‘‘Study of Executive Termination Provisions Among Top 200 Public Companies (December 2012), available at www.jfreda.com; Equilar, ‘‘Change-inControl Equity Acceleration Triggers’’ (March 19, 2014), available athttps://www.equilar.com/reports/ 8-change-in-control-equity-accelerationtriggers.html. PO 00000 Frm 00051 Fmt 4701 Sfmt 4702 37719 incentive-based compensation exceeding the requirements. For example, if an institution defers compensation until retirement as a retention tool, but the institution then merges into another company and ceases to exist, retention may not be a priority. Thus, acceleration would be permitted for any deferred incentivebased compensation amounts above the amount required to be deferred or that was deferred longer than the minimum deferral period to allow those amounts to be paid out closer in time to the merger. Similarly, the acceleration of payment NCUA’s rule permits if a covered person of a credit union faces up-front income tax liability on the deferred amounts of an award is not an event subject to the covered person’s control. This exception will not apply unless the covered person is actually subject to income taxes on deferred amounts for which the covered person has not yet received payment, and equalizes the effect of deferral for covered persons at credit unions and covered persons at most other covered institutions. This limited exception is not intended to alter the balance of risk-taking incentives. Qualifying Incentive-Based Compensation and Incentive-Based Compensation Awarded Under a LongTerm Incentive Plan The minimum required deferral amounts would be calculated separately for qualifying incentive-based compensation and incentive-based compensation awarded under a longterm incentive plan, and those amounts would be required to be deferred for different periods of time. For the purposes of calculating qualifying incentive-based compensation awarded for any performance period, a covered institution would aggregate incentivebased compensation awarded under any incentive-based compensation plan that is not a long-term incentive plan. The required deferral percentage (40, 50, or 60 percent) would be multiplied by that total amount to determine the minimum deferral amount. In a given year, if a senior executive officer or significant risk-taker is awarded qualifying incentive-based compensation under multiple plans that have the same performance period (which is less than three years), the award under each plan would not be required to meet the minimum deferral requirement, so long as the total amount that is deferred from all of the amounts awarded under those plans meets the minimum required percentage of total qualifying incentivebased compensation relevant to that covered person. E:\FR\FM\10JNP2.SGM 10JNP2 37720 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 For example, under the proposal, a significant risk-taker at a Level 2 covered institution might be awarded $60,000 under a plan with a one-year performance period that applies to all employees in her line of business and $40,000 under a plan with a one-year performance period that applies to all employees of the covered institution. For that performance period, the significant risk-taker has been awarded a total of $100,000 in qualifying incentive-based compensation, so she would be required to defer a total of $40,000. The covered institution could defer amounts awarded under either plan or under both plans, so long as the total amount deferred was at least $40,000. For example, the covered institution could choose to defer $20,000 from the first plan and $20,000 from the second plan. The covered institution could also choose to defer nothing awarded under the first plan and the entire $40,000 awarded under the second plan. For a full example of how these requirements would work in the context of a more complete incentive-based compensation arrangement, please see Appendix A of this preamble. In contrast, the minimum required deferral percentage would apply to all incentive-based compensation awarded under each long-term incentive plan separately. In a given year, if a senior executive officer or significant risk-taker is awarded incentive-based compensation under multiple long-term incentive plans that have performance periods of three years or more, each award under each plan would be required to meet the minimum deferral requirement.147 Based on supervisory experience, the Federal Banking Agencies have found that it would be extremely rare for a covered person to be awarded incentive-based compensation under multiple long-term incentive plans in one year. The proposed rule would require deferral for the same percentage of qualifying incentive-based compensation as of incentive-based compensation awarded under a longterm incentive plan. However, the 147 For example, if a Level 1 covered institution awarded a senior executive officer $100,000 under one long-term incentive plan and $200,000 under another long-term incentive-plan, the covered institution would be required to defer at least $60,000 of the amount awarded under the first longterm incentive plan and at least $120,000 of the amount awarded under the second long-term incentive plan. The Level 1 covered institution would not be permitted to meet the deferral requirements by deferring, for example, $10,000 awarded under the first long-term incentive plan and $170,000 awarded under the second long-term incentive plan. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 proposed rule would require that deferred qualifying incentive-based compensation meet a longer minimum deferral period than deferred incentivebased compensation awarded under a long-term incentive plan. As with the shorter performance period for qualifying incentive-based compensation, the period over which performance is measured under a longterm incentive plan is not considered part of the deferral period. Under the proposed rule, both deferred qualifying incentive-based compensation and deferred incentivebased compensation awarded under a long-term incentive plan would be required to meet the vesting requirements separately. In other words, deferred qualifying incentive-based compensation would not be permitted to vest faster than on a on a pro rata annual basis, even if deferred incentivebased compensation awarded under a long-term incentive plan vested on a slower than pro rata basis. Each deferred portion is bound by the pro rata requirement. For an example of how these requirements would work in practice, please see Appendix A of this Supplementary Information section. Incentive-based compensation provides an inducement for a covered person at a covered institution to advance the strategic goals and interests of the covered institution while enabling the covered person to share in the success of the covered institution. Incentive-based compensation may also encourage covered persons to take undesirable or inappropriate risks, or to sell unsuitable products in the hope of generating more profit and thereby increasing the amount of incentivebased compensation received. Covered persons may also be tempted to manipulate performance results in an attempt to make performance measurements look better or to understate the actual risks such activities impose on the covered institution’s balance sheet.148 Incentivebased compensation should therefore also provide incentives for prudent risktaking in the long term and for sound risk management. Deferral of incentive-based compensation awards involves a delay in the vesting and payout of an award 148 For example, towards the end of the performance period, covered persons who have not yet met the target performance measures could be tempted to amplify risk taking or take other actions to meet those targets and receive the maximum incentive-based compensation. Without deferral, there would be no additional review applied to the risk-taking activities that were taken during the defined performance period to achieve those target performance measures. PO 00000 Frm 00052 Fmt 4701 Sfmt 4702 to a covered person beyond the end of the performance period. The deferral period allows for amounts of incentivebased compensation to be adjusted for actual losses to the covered institution or for other aspects of performance that become clear during the deferral period before those amounts vest or are paid. These aspects include inappropriate risk-taking and misconduct on the part of the covered person. More generally, deferral periods that lengthen the time between the award of incentive-based compensation and vesting, combined with forfeiture, are important tools for aligning the interests of risk-takers with the longer-term interests of covered institutions.149 Deferral periods that are sufficiently long to allow for a substantial portion of the risks from the covered person’s activities to manifest are likely to be most effective in ensuring that risks and rewards are adequately balanced.150 Deferral periods allow covered institutions an opportunity to more accurately judge the nature and scale of risks imposed on covered institutions’ balance sheets by a covered person’s performance for which incentive-based compensation has been awarded, and to better understand and identify risks that 149 There have been a number of academic papers that argue that deferred compensation provides incentives for executives to consider the long-term health of the firm. For example, Eaton and Rosen (1983) note that delaying compensation is a way of bonding executives to the firm and providing incentives for them to focus on long-term performance of the firm. See Eaton and Rosen, ‘‘Agency, Delayed Compensation, and the Structure of Executive Remuneration,’’ 38 Journal of Finance 1489, at 1489–1505; see also Park and Sturman, ‘‘How and What You Pay Matters: The Relative Effectiveness of Merit Pay, Bonus, and Long-Term Incentives on Future Job Performance’’ (2012), available at https://scholarship.sha.cornell.edu/cgi/ viewcontent.cgi?article=1121&context=articles. 150 The length of the deferral period has been a topic of discussion in the literature. Edmans (2012) argues that deferral periods of two to three years are too short. He also argues that deferral should be longer for institutions where the decisions of the executives have long-term consequences. Bebchuk et al (2010) argue that deferral provisions alone will not prevent executives from putting emphasis on short-term prices because executives that have been in place for many years will have the opportunity to regularly cash out. They argue that executives should be required to hold a substantial number of shares and options until retirement. See also Edmans, Alex, ‘‘How to Fix Executive Compensation,’’ The Wall Street Journal (February 27, 2012); Bebchuk, Lucian, Cohen, and Spamann, ‘‘The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000–2008,’’ 27 Yale Journal on Regulation 257, 257–282 (2010); Bhagat, Sanjai, Bolton and Romano, ‘‘Getting Incentives Right: Is Deferred Bank Executive Compensation Sufficient?,’’ 31 Yale Journal on Regulation 523 (2014); Bhagat, Sanjai and Romano, ‘‘Reforming Financial Executives’ Compensation for the Long Term,’’ Research Handbook on Executive Pay (2012); Bebchuk and Fried, ‘‘Paying for Long-Term Performance,’’ 158 University of Pennsylvania Law Review, 1915 (2010). E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 result from such activities as they are realized. These include risks imposed by inappropriate risk-taking or misconduct, and risks that may manifest as a result of lapses in risk management or risk oversight. For example, the risks associated with some business lines, such as certain types of lending, may require many years before they materialize. Though it is difficult to set deferral periods that perfectly match the time it takes risks undertaken by the covered persons of covered institutions to become known, longer periods allow more time for incentive-based compensation to be adjusted between the time of award and the time incentive-based compensation vests.151 At the same time, deferral periods that are inordinately long may reduce the effectiveness of incentive-based compensation arrangements because employees more heavily discount the potential impact of such arrangements. Thus, it is important to strike a reasonable balance between providing effective incentives and allowing sufficient time to validate performance measures over a reasonable period of deferral. The specific deferral periods and amounts proposed in the proposed rule are also consistent with current practice at many institutions that would be Level 1 or Level 2 covered institutions, and with compensation requirements in other countries.152 In drafting the requirements in sections ll.7(a)(1) and ll.7(a)(2), the Agencies took into account the comments received regarding similar requirements in the 2011 Proposed Rule.153 151 Some empirical literature has found a link between the deferral of compensation and firm value, firm performance, risk, and the manipulation of earnings. Gopalan et al (2014) measure the duration of executive compensation by accounting for the vesting schedules in compensation. They argue that the measure is a proxy for the executives’ horizon. They find that longer duration of compensation is present at less risky institutions and institutions with better past stock performance. They also find that longer duration is associated with less manipulation of earnings. Chi and Johnson (2009) find that longer vesting periods for stocks and options are related to higher firm value. See Gopalan, Radhakrishnan, Milbourn, Song and Thakor, ‘‘Duration of Executive Compensation,’’ 59 The Journal of Finance 2777 (2014); Chi, Jianxin, and Johnson, ‘‘The Value of Vesting Restrictions on Managerial Stock and Option Holdings’’ (March 9, 2009) available at https://papers.ssrn.com/sol3/ papers.cfm?abstractlid=1136298. 152 Moody’s Investor Service, ‘‘Global Investment Banks: Reformed Pay Policies Still Pose Risks to Bondholders’’ (‘‘Moody’s Report’’) (December 9, 2014); McLagan, ‘‘Mandatory Deferrals in Incentive Programs’’ (March 2013), available at https:// www.mclagan.com/crb/downloads/McLaganl MandatorylDeferrallFlashlSurveylReportl329-2013.pdf. 153 Commenters on the 2011 Proposed Rule expressed differing views on the proposed deferral VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 The Agencies have proposed the three- and four-year minimum deferral periods because these deferral periods, taken together with the typically oneyear performance period, would allow a Level 1 or Level 2 covered institution four to five years, or the majority of a traditional business cycle, to identify outcomes associated with a senior executive officer’s or significant risktaker’s performance and risk-taking activities. The business cycle reflects periods of economic expansion or recession, which typically underpin the performance of the financial sector. The Agencies recognize that credit cycles, which revolve around access to and demand for credit and are influenced by various economic and financial factors, can be longer.154 requirements and the deferral-related questions posed by the Agencies. For example, some commenters expressed the view that the deferral requirements for incentive-based compensation awards for executive officers were appropriate. Some commenters argued that deferral would create a longer-term focus for executives and help to ensure they are not compensated on the basis of short-term returns that fail to account for long-term risks. Many commenters also argued that the deferral requirements should be strengthened by extending the required minimum deferral period or minimum percentage of incentive compensation deferred. For example, these commenters urged the Agencies to require a five-year deferral period, instead of the three-year period that was proposed, or to disallow ‘‘pro rata’’ payments within the proposed three-year deferral period. These commenters also expressed the view that the Agencies’ proposal to require covered financial institutions to defer 50 percent of their annual compensation would result in an insufficient amount of incentive-based compensation being at risk of potential adjustment, because the risks posed by those executive officer can take longer to become apparent. Other commenters argued that all covered institutions subject to this rulemaking should comply with the deferral requirements regardless of their size. On the other hand, many commenters recommended that deferral not be required or argued that, if deferral were to be required, the three-year and 50 percent deferral minimums provided in the 2011 Proposed Rule were sufficient. Some commenters recommended that the deferral requirements not be applied to smaller covered institutions. Some commenters also suggested that unique aspects of certain types of covered institutions, such as investment advisers or smaller banks within a larger consolidated organization, should be considered when imposing deferral and other requirements on incentive-based compensation arrangements. A number of commenters suggested that applying a prescriptive deferral requirement, together with other requirements under the 2011 Proposed Rule, would make it more difficult for covered institutions to attract and retain key employees in comparison to the ability of organizations not subject to such requirements to recruit and retain the same employees. 154 From 1945 to 2009, the average length of the business cycle in the U.S. was approximately 5.7 years. See The National Bureau of Economic Research, ‘‘U.S. Business Cycle Expansions and Contractions, available at https://www.nber.org/ cycles/cyclesmain.html. Many researchers have found that credit cycles are longer than business cycles. For example, Drehmann et al (2012) estimate PO 00000 Frm 00053 Fmt 4701 Sfmt 4702 37721 However, the Agencies are also concerned with striking the right balance between allowing covered persons to be fairly compensated and not encouraging inappropriate risktaking. The Agencies are concerned that extending deferral periods for too long may lead to a covered person placing little or no value on the incentive-based compensation that only begins to vest far out in the future. This type of discounting of the value of longdeferred awards may be less effective as an incentive, positive or negative, and consequently for balancing the benefit of these types of awards.155 As described above, since the Agencies proposed the 2011 Proposed Rule, the Agencies have gained significant supervisory experience while encouraging covered institutions to adopt improved incentive-based compensation practices. The Federal Banking Agencies note in particular improvements in design of incentivebased compensation arrangements that help to more appropriately balance risk and reward. Regulatory requirements for sound incentive-based compensation arrangements at financial institutions have continued to evolve, including those being implemented by foreign regulators. Consideration of international practices and standards is particularly relevant in developing incentive-based compensation standards for large financial institutions because they often compete for talented personnel internationally. Based on supervisory experience, although exact amounts deferred may vary across employee populations at large covered institutions, the Federal Banking Agencies have observed that, since the financial crisis that began in 2007, most deferral periods at financial institutions range from three to five years, with three years being the most common deferral period.156 Consistent with this observation, the FSB standards suggest deferral periods ‘‘not less than an average duration of credit cycles from 10 to 20 years. See Drehmann, Mathias, Borio and Tsatsaronis, ‘‘Characterising the Financial Cycle: Don’t Lose Sight of the Medium Term!’’ Bank for International Settlements, Working Paper, No. 380 (June 2012), available at https://www.bis.org/publ/ work380.htm. Aikman et al (2015) found that the credit cycle ranges from eight to 20 years. See Aikman, Haldane, and Nelson, ‘‘Curbing the Credit Cycle,’’ 125 The Economic Journal 1072 (June 2015). 155 See Pepper and Gore, ‘‘The Economic Psychology of Incentives: An International Study of Top Managers,’’ 49 Journal of World Business 289 (2014); PRA, Consultation Paper PRA CP15/14/FCA CP14/14: Strengthening the alignment of risk and reward: new remuneration rules (July 2014) available at https://www.bankofengland.co.uk/pra/ Documents/publications/cp/2014/cp1514.pdf. 156 See 2011 FRB White Paper, at 15. E:\FR\FM\10JNP2.SGM 10JNP2 37722 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 three years,’’ and the average deferral period at significant institutions in FSB member countries is now between three and four years.157 The PRA requires deferral of seven years for senior managers as defined under the Senior Managers Regime, five years for risk managers as defined under the EBA regulatory technical standard on identification of material risk-takers, and three to five years as per the CRD IV minimum for all other material risktakers.158 CRD IV sets a minimum deferral period of ‘‘at least three to five years.’’ For senior management, significant institutions 159 are expected to apply deferral of ‘‘at least five years.’’ 160 Swiss regulations 161 require that for members of senior management, persons with relatively high total remuneration, and persons whose activities have a significant influence on the risk profile of the firm, the time period for deferral should last ‘‘at least three years.’’ The requirements in the proposed rule regarding amounts deferred are also consistent with observed better practices and the standards established by foreign regulators. The Board’s summary overview of findings during the early stages of the 2011 FRB White Paper 162 observed that ‘‘deferral fractions set out in the FSB Principles and Implementation Standards 163 are 157 FSB, Implementing the FSB Principles for Sound Compensation Practices and their Implementation Standards: Fourth Progress Report (‘‘2015 FSB Compensation Progress Report’’) (2015), available at https://www.fsb.org/2015/11/fsbpublishes-fourth-progress-report-on-compensationpractices. 158 See UK Remuneration Rules. The United Kingdom deferral standards apply on a group-wide basis and apply to banks, building societies, and PRA-designated investment firms, but do not currently cover investment advisors outside of consolidated firms. 159 CRD IV defines institutions that are significant ‘‘in terms of size, internal organisation and nature, scope and complexity of their activities.’’ Under the EBA Guidance on Sound Remuneration Policies, significant institutions means institutions referred to in Article 131 of Directive 2013/36/EU (global systemically important institutions or ‘G–SIIs,’ and other systemically important institutions or ‘O–SIIs’), and, as appropriate, other institutions determined by the competent authority or national law, based on an assessment of the institutions’ size, internal organisation and the nature, the scope and the complexity of their activities. Some, but not all, national regulators have provided further guidance on interpretation of that term, including the FCA which provides a form of methodology to determine if a firm is ‘‘significant’’ based on quantitative tests of balance sheet assets, liabilities, annual fee commission income, client money and client assets. 160 See EBA Remuneration Guidelines. 161 See FINMA Remuneration Circular 2010. 162 See FRB 2011 Report, at 31. 163 Specifically, the FSB Implementation Standards encourage that ‘‘a substantial portion of variable compensation, such as 40 to 60 percent, should be payable under deferral arrangements over VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 sometimes used as a benchmark (60 percent or more for senior executives, 40 percent or more for other individual ‘‘material risk takers,’’ which are not the same as ‘‘covered employees’’) and concluded that deferral fractions were at or above these benchmarks at both the U.S. banking organizations and foreign banking organizations that participated in the horizontal review. The proportion of incentive-based compensation awards observed to be deferred at financial institutions during the Board’s horizontal review was substantial. For example, on average senior executives report more than 60 percent of their incentive-based compensation is deferred,164 and some of the most senior executives had more than 80 percent of their incentive-based compensation deferred with additional stock retention requirements after deferred stock vests. Most institutions assigned deferral rates to employees using a fixed schedule or ‘‘cash/stock table’’ under which employees that received higher incentive-based compensation awards generally were subject to higher deferral rates, although deferral rates for the most senior executives were often set separately and were higher than those for other employees.165 The proposed rule’s higher deferral rates for senior executive officers would be consistent with this observed industry practice of requiring higher deferral rates for the most senior executives. Additionally, by their very nature, senior executive officer positions tend to have more responsibility for strategic decisions and oversight of multiple areas of operations, and these responsibilities warrant requiring higher percentages of deferral and longer deferral periods to safeguard against inappropriate risktaking. This proposed rule is also consistent with standards being developed internationally. The PRA expects that ‘‘where any employee’s variable remuneration component is £500,000 or more, at least 60 percent should be deferred.’’ 166 European Union regulations require that ‘‘institutions a period of years’’ and that ‘‘proportions should increase significantly along with the level of seniority and/or responsibility . . . for the most senior management and the most highly paid employees, the percentage of variable compensation that is deferred should be substantially higher, for instance, above 60 percent.’’ 164 ‘‘Deferral’’ for these reports is defined by the institutions and may include long-term incentive plans without additional deferral. 165 See 2011 FRB White Paper, at 15. 166 See PRA, Supervisory Statement SS27/15: Remuneration (June 2015), available at https:// www.bankofengland.co.uk/pra/Documents/ publications/ss/2015/ss2715.pdf. PO 00000 Frm 00054 Fmt 4701 Sfmt 4702 should set an appropriate portion of remuneration that should be deferred for a category of identified staff or a single identified staff member at or above the minimum proportion of 40 percent or respectively 60 percent for particularly high amounts.’’ 167 The EU also publishes a report on Benchmarking of Remuneration Practices at Union Level and Data on High Earners 168 that provides insight into amounts deferred across various lines of business within significant institutions across the European Union. While amounts varied by areas of operations, average deferral levels for identified staff range from 54 percent in retail banking to more than 73 percent in investment banking. The proposed rule’s enhanced requirements for Level 1 institutions are consistent with international standards. Many regulators apply compensation standards in a proportional or tiered fashion. The PRA, for example, classifies three tiers of firms based on asset size and applies differentiated standards across this population. Proportionality Level 1 includes firms with greater than £50 billion in consolidated assets; Proportionality Level 2 includes firms with between £15 billion and £50 billion in consolidated assets; and Proportionality Level 3 includes firms with less than £15 billion in consolidated assets. The PRA also recognizes ‘‘significant’’ firms. Proportionality Level 3 firms are typically not subject to provisions on retained shares, deferral, or performance adjustment. Under the proposed rule, incentivebased compensation awarded under a long-term incentive plan would be treated separately and differently than amounts of incentive-based compensation awarded under annual performance plans (and other qualifying incentive-based compensation) for the purposes of the deferral requirements. Deferral of incentive-based compensation and the use of longer performance periods (which is the hallmark of a long-term incentive plan) both are useful tools for balancing risk and reward in incentive-based compensation arrangements because both allow for the passage of time that allows the covered institution to have more information about a covered person’s risk-taking activity and its possible outcomes. Both methods allow 167 See EBA Remuneration Guidelines. e.g., EBA, Benchmarking of Remuneration Practices at Union Level and Data on High Earners, at 39, Figure 46 (September 2015), available at https://www.eba.europa.eu/-/eba-updates-onremuneration-practices-and-high-earners-data-for2013-across-the-eu. 168 See, E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 awards or payments to be made after some or all risk outcomes are realized or better known. However, longer performance periods and deferral of vesting are distinct risk balancing methods.169 As noted above, the Agencies took into account the comments received regarding similar deferral requirements in the 2011 Proposed Rule. In response to the proposed deferral requirement in the 2011 Proposed Rule, which did not distinguish between incentive-based compensation awarded under a longterm incentive plan and other incentivebased compensation, several commenters argued that the Agencies should allow incentive-based compensation arrangements that use longer performance periods, such as a three-year performance period, to count toward the mandatory deferral requirement. In particular, some commenters argued that institutions that use longer performance periods should be allowed to start the deferral period at the beginning of the performance period. In this way, they argued, a payment made at the end of a three-year performance period has already been deferred for three years for the purposes of the deferral requirement. As discussed above, deferral allows for time to pass after the conclusion of the performance period. It introduces a period of time in between the end of the performance period and vesting of the incentive-based compensation during which risks may mature without the employee taking additional risks to affect that earlier award. Currently, institutions commonly use long-term incentive plans without subsequent deferral and thus there is no period following the multi-year performance period that would permit the covered institution to apply forfeiture or other reductions should it become clear that the covered person engaged in inappropriate risk-taking. Without deferral, the incentive-based compensation is awarded and vests at the end of the multi-year performance period.170 In contrast, during the 169 The 2011 Proposed Rule expressly recognized this distinction (‘‘The Proposed Rule identifies four methods that currently are often used to make compensation more sensitive to risk. These methods are Risk Adjustment of Awards . . . Deferral of Payment . . . Longer Performance Periods . . . Reduced Sensitivity to Short-Term Performance.’’). See 76 FR at 21179. 170 An employee may be incentivized to take additional risks near the end of the performance period to attempt to compensate for poor performance early in the period of the long-term incentive compensation plan. For example, as noted above, towards the end of a multi-year performance period, covered persons who have not yet met the target performance measures could be tempted to amplify risk taking or take other actions to meet VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 37723 deferral period, the covered person’s incentive-based compensation award is fixed and the vesting could be affected by information about a covered person’s risk-taking activities during the performance period that becomes known during the deferral period. For a long-term incentive plan, the period of time between the beginning of the performance period and when incentive-based compensation is awarded is longer than that of an annual plan. However, the period of time between the end of the performance period and when incentive-based compensation is awarded is the same for both the long-term incentive plan and for the annual plan. Consequently, while a covered institution may have more information about the risk-taking activities of a covered person that occurred near the beginning of the performance period for a long-term incentive plan than for an annual plan, the covered institution would have no more information about risk-taking activities that occur near the end of the performance period. The incentivebased compensation awarded under the long-term incentive plan would be awarded without the benefit of additional information about risk-taking activities near the end of the performance period. Therefore, the proposed rule would treat incentive-based compensation awarded under a long-term incentive plan similarly to, but not the same as, qualifying incentive-based compensation for purposes of the deferral requirement. Under the proposed rule, the incentive-based compensation awarded under a longterm incentive plan would be required to be deferred for a shorter amount of time than qualifying incentive-based compensation, although the period of time elapsing between the beginning of the performance period and the actual vesting would be longer. A shorter deferral period would recognize the fact that the longer performance period of a long-term incentive plan allows some time for information to surface about risk-taking activities undertaken at the beginning of the performance period. The longer performance period allows covered institutions to adjust the amount awarded under long-term incentive plans for poor performance during the performance period. Yet, since no additional time would pass between risk-taking activities at the end of the performance period and the award date, the proposed rule would allow a shorter deferral period than would be necessary for qualifying incentive-based compensation. The percentage of incentive-based compensation awarded that would be required to be deferred would be the same for incentive-based compensation awarded under a long-term incentive plan and for qualifying incentive-based compensation. However, because of the difference in the minimum required deferral period, the minimum deferral amounts for qualifying incentive-based compensation and for incentive-based compensation awarded under a longterm incentive plan would be required to be calculated separately. In other words, any amount of qualifying incentive-based compensation that a covered institution chooses to defer above the minimum required would not decrease the minimum amount of incentive-based compensation awarded under a long-term plan that would be required to be deferred, and vice versa. For example, a Level 2 covered institution that awards a senior executive officer $50,000 of qualifying incentive-based compensation and $20,000 under a long-term incentive plan would be required to defer at least $25,000 of the qualifying incentivebased compensation and at least $10,000 of the amounts awarded under the long-term incentive plan. The Level 2 covered institution would not be permitted to defer, for example, $35,000 of qualifying incentive-based compensation and no amounts awarded under the long-term incentive plan, even though that would result in the deferral of 50 percent of the senior executive officer’s total incentive-based compensation. For a full example of how these requirements would work in the context of a more complete incentive-based compensation arrangement, please see Appendix A of this preamble. For incentive-based compensation awarded under a long-term incentive plan, section ll.7(a)(2) of the proposed rule would require that minimum deferral periods for senior executive officers and significant risktakers at a Level 1 covered institution extend to two years after the award date and minimum deferral periods at a Level 2 covered institution extend to one year after the award date. For longterm incentive plans with performance periods of three years,171 this those targets and receive the maximum long-term incentive plan award with no additional review applied to the risk-taking activities that were taken during the defined performance period to achieve those target performance measures. 171 Many studies of incentive-based compensation at large institutions have found that long-term incentive plans commonly have performance periods of three years. See Cook Report; Moody’s Report. PO 00000 Frm 00055 Fmt 4701 Sfmt 4702 E:\FR\FM\10JNP2.SGM 10JNP2 37724 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 requirement would delay the vesting of the last portion of this incentive-based compensation until five years after the beginning of the performance period at Level 1 covered institutions and four years after the beginning of the performance period at Level 2 covered institutions. Thus, while the deferral period from the award date is shorter for incentive-based compensation awarded under a long-term incentive plan, the delay in vesting from the beginning of the performance period would generally be the same under the most common qualifying incentive-based compensation and long-term incentive plans. Under the proposed rule, the incentive-based compensation that would be required by the rule to be deferred would not be permitted to vest faster than on a pro rata annual basis beginning no earlier than the first anniversary of the end of the performance period. This requirement would apply to both deferred qualifying incentive-based compensation and deferred incentive-based compensation awarded under a long-term incentive plan. The Federal Banking Agencies have also observed that the minimum required deferral amounts and deferral periods that would be required under the proposed rule are generally consistent with industry practice at larger covered institutions that are currently subject to the 2010 Federal Banking Agency Guidance, although the Agencies recognize that some institutions would need to revise their individual incentive-based compensation programs and others were not subject to the 2010 Federal Banking Agency Guidance. In part because the 2010 Federal Banking Agency Guidance and compensation regulations imposed by international regulators 172 currently encourage banking institutions to increase the proportion of compensation that is deferred to reflect higher levels of seniority or responsibility, current practice for the largest international banking institutions reflects substantial levels of deferral for such individuals. 172 Most members of the FSB, for instance, have issued regulations, or encourage through guidance and supervisory practice, deferral standards that meet the minimums set forth in the FSB’s Implementation Standards. See 2015 FSB Compensation Progress Report (concluding ‘‘almost all FSB jurisdictions have now fully implemented the P&S for banks.’’). The FSB standards state that ‘‘a substantial portion of variable compensation, such as 40 to 60 percent, should be payable under deferral arrangements over a period of years and these proportions should increase significantly along with the level of seniority and/or responsibility. The deferral period should not be less than three years. See FSB Principles and Implementation Standards. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 Many of those individuals would be senior executive officers and significant risk-takers under the proposed rule. Under current practice, deferral typically ranges from 40 percent for less senior significant risk-takers to more than 60 percent for senior executives.173 The Agencies note that current practice for the largest international banking institutions reflects average deferral periods of at least three years.174 The deferral requirements of the proposed rule for senior executive officers and significant risk-takers at the largest covered institutions are also consistent with international standards on compensation. The European Union’s 2013 law on remuneration paid by financial institutions requires deferral for large firms, among other requirements.175 The PRA and the FCA initially adopted the European Union’s law and requires covered companies to defer 40 to 60 percent of ‘‘senior manager,’’ ‘‘risk manager,’’ and ‘‘material risk-taker’’ compensation. The PRA and FCA recently updated their implementing regulations to extend deferral periods to seven years for senior managers and up to five years for certain other persons.176 The proposed deferral requirements are also generally consistent with the FSB’s Principles for Sound Compensation Practices and their related implementation standards issued in 2009.177 Having standards that are generally consistent across jurisdictions would be important both to enable institutions subject to multiple regimes to fulfill the requirements of all applicable regimes, and to ensure that covered institutions in the United States 173 FSB member jurisdictions provided data for the purposes of the 2015 FSB Compensation Progress Report indicating that while the percentage of variable remuneration deferred varies significantly between institutions and across categories of staff, for the surveyed population of senior executives, the percentage of deferred incentive-based compensation averaged approximately 50 percent. See 2015 FSB Compensation Progress Report. 174 See Moody’s Report. 175 In June 2013, the European Union adopted CRD IV, which sets out requirements on compensation structures, policies, and practices that applies to all banks and investment firms subject to the CRD. CRD IV provides that at least 50 percent of total variable remuneration should consist of equity-linked interests and at least 40 percent of the variable component must be deferred over a period of three to five years. Directive 2013/ 36/EU of the European Parliament and of the Council of 26 June 2013 (effective January 1, 2014). 176 See UK Remuneration Rules. In the case of a material risk-taker who performs a PRA senior management function, the pro rata vesting requirement applies only from year three onwards (i.e., the required deferral period is seven years, with no vesting to take place until three years after award). 177 FSB Principles and Implementation Standards. PO 00000 Frm 00056 Fmt 4701 Sfmt 4702 would be on a level playing field compared to their non-U.S. peers in the global competition for talent. 7.1. The Agencies invite comment on the proposed requirements in sections ll.7(a)(1) and (a)(2). 7.2. Are minimum required deferral periods and percentages appropriate? If not, why not? Should Level 1 and Level 2 covered institutions be subject to different deferral requirements, as in the proposed rule, or should they be treated more similarly for this purpose and why? Should the minimum required deferral period be extended to, for example, five years or longer in certain cases and why? 7.3. Is a deferral requirement for senior executive officers and significant risk-takers at Level 1 and Level 2 covered institutions appropriate to promote the alignment of employees’ incentives with the risk undertaken by such covered persons? If not, why not? For example, comment is invited on whether deferral is generally an appropriate method for achieving incentive-based compensation arrangements that appropriately balance risk and reward for each type of senior executive officer and significant risktaker at these institutions or whether there are alternative or more effective ways to achieve such balance. 7.4. Commenters are also invited to address the possible impact that the required minimum deferral provisions for senior executive officers and significant risk-takers may have on larger covered institutions and whether any deferral requirements should apply to senior executive officers at Level 3 institutions. 7.5. A number of commenters to the 2011 Proposed Rule suggested that applying a prescriptive deferral requirement, together with other requirements under that proposal, would make it more difficult for covered institutions to attract and retain key employees in comparison to the ability of organizations not subject to such requirements to recruit and retain the same employees. What implications does the proposed rule have on ‘‘level playing fields’’ between covered institutions and non-covered institutions in setting forth minimum deferral requirements under the rule? 7.6. The Agencies invite comment on whether longer performance periods can provide risk balancing benefits similar to those provided by deferral, such that the shorter deferral periods for incentive-based compensation awarded under long-term incentive plans in the proposed rule would be appropriate. 7.7. Would the proposed distinction between the deferral requirements for E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules qualifying incentive-based compensation and incentive-based compensation awarded under a longterm incentive plan pose practical difficulties for covered institutions or increase compliance burdens? Why or why not? 7.8. Would the requirement in the proposed rule that amounts awarded under long-term incentive plans be deferred result in covered institutions offering fewer long-term incentive plans? If so, why and what other compensation plans will be used in place of long-term incentive plans and what negative or positive consequences might result? 7.9. Are there additional considerations, such as tax or accounting considerations, that may affect the ability of Level 1 or Level 2 covered institutions to comply with the proposed deferral requirement or that the Agencies should consider in connection with this provision in the final rule? Commenters on the 2011 Proposed Rule noted that employees of an investment adviser to a private fund hold partnership interests and that any incentive allocations paid to them are typically taxed at the time of allocation, regardless of whether these allocations have been distributed, and consequently, employees of an investment adviser to a private fund that would have been subject to the deferral requirement in the 2011 Proposed Rule would have been required to pay taxes relating to incentive allocations that they were required to defer. Should the determination of required deferral amounts under the proposed rule be adjusted in the context of investment advisers to private funds and, if so, how? Could the tax liabilities immediately payable on deferred amounts be paid from the compensation that is not deferred? 7.10. The Agencies invite comment on the circumstances under which acceleration of payment should be permitted. Should accelerated vesting be allowed in cases where employees are terminated without cause or cases where there is a change in control and the covered institution ceases to exist and why? Are there other situations for which acceleration should be allowed? If so, how can such situations be limited to those of necessity? 7.11. The Agencies received comment on the 2011 Proposed Rule that stated it was common practice for some private fund adviser personnel to receive payments in order to enable the recipients to make tax payments on unrealized income as they became due. Should this type of practice to satisfy tax liabilities, including tax liabilities VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 payable on unrealized amounts of incentive-based compensation, be permissible under the proposed rule, including, for example, as a permissible acceleration of vesting under the proposed rule? Why or why not? Is this a common industry practice? § ll.7(a)(3) Adjustments of Deferred Qualifying Incentive-Based Compensation and Deferred Long-Term Incentive Plan Compensation Amounts Under section ll.7(a)(3) of the proposed rule, during the deferral period, a Level 1 or Level 2 covered institution would not be permitted to increase a senior executive or significant risk-taker’s unvested deferred incentivebased compensation.178 In other words, any deferred incentive-based compensation, whether it was awarded as qualifying incentive-based compensation or under a long-term incentive plan, would be permitted to vest in an amount equal to or less than the amount awarded, but would not be permitted to increase during the deferral period.179 Deferred incentive-based compensation may be decreased, for example, under a forfeiture and downward adjustment review as would be required under section ll.7(b) of the proposed rule, discussed below. It may also be adjusted downward as a result of performance that falls short of agreed upon performance measure targets. As discussed in section 8(b), under some incentive-based compensation plans, covered persons can be awarded amounts in excess of their target amounts if the covered institution or covered person’s performance exceed performance targets. As explained in the discussion on section 8(b), this type of upside leverage in incentive-based compensation plans may encourage covered persons to take inappropriate risks. Therefore, the proposed rule would limit maximum payouts to between 125 and 150 percent of the preset target. In a similar vein, the Agencies are concerned that allowing Level 1 and Level 2 covered institutions to provide for additional increases in amounts that are awarded but deferred may encourage senior executive officers and significant risk-takers to take more risk during the deferral period and thus may not balance risk-taking incentives. This concern is especially acute when covered institutions require covered 178 This requirement is distinct from the prohibition in section 8(b) of the proposed rule, discussed below. 179 Accelerated vesting would be permitted in limited circumstances under sections ll.7(a)(1)(iii)(B) and ll.7(a)(2)(iii)(B), as described above. PO 00000 Frm 00057 Fmt 4701 Sfmt 4702 37725 persons to meet more aggressive goals than those established at the beginning of the performance period in order to ‘‘re-earn’’ already awarded, but deferred incentive-based compensation. Although increases in the amount awarded, as described above, would be prohibited by the proposed rule, increases in the value of deferred incentive-based compensation due solely to a change in share value, a change in interest rates, or the payment of reasonable interest or a reasonable rate of return according to terms set out at the award date would not be considered increases in the amount awarded for purposes of this restriction. Thus, a Level 1 or Level 2 covered institution would be permitted to award incentive-based compensation to a senior executive officer or significant risk-taker in the form of an equity or debt instrument, and, if that instrument increased in market value or included a provision to pay a reasonable rate of interest or other return that was set at the time of the award, the vesting of the full amount of that instrument would not be in violation of the proposed rule. For an example of how these requirements would work in practice, please see Appendix A of this SUPPLEMENTARY INFORMATION section. 7.12. The Agencies invite comment on the requirement in section ll.7(a)(3). § ll.7(a)(4) Composition of Deferred Qualifying Incentive-Based Compensation and Deferred Long-Term Incentive Plan Compensation for Level 1 and Level 2 Covered Institutions Section ll.7(a)(4) of the proposed rule would require that deferred qualifying incentive-based compensation or deferred incentivebased compensation awarded under a long-term incentive plan of a senior executive officer or significant risk-taker at a Level 1 or Level 2 covered institution meet certain composition requirements. Cash and Equity-Like Instruments Covered institutions award incentivebased compensation in a number of forms, including cash-based awards, equity-like instruments, and in a smaller number of cases, incentive-based compensation in the form of debt or debt-like instruments such as deferred cash. First, the proposed rule would require that, at Level 1 and Level 2 covered institutions 180 that issue equity 180 In the cases of the Board, FDIC and OCC, this requirement would not apply to a Level 1 and Level 2 covered institution that does not issue equity itself and is not an affiliate of an institution that issues equity. Credit unions and certain mutual E:\FR\FM\10JNP2.SGM Continued 10JNP2 37726 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 or are the affiliates of covered institutions that issue equity, deferred incentive-based compensation for senior executive officers and significant risktakers include substantial portions of both deferred cash and equity-like instruments throughout the deferral period. The Agencies recognize that the form of incentive-based compensation that a senior executive officer or significant risk-taker receives can have an impact on the incentives provided and thus their behavior. In particular, having incentive-based compensation in the form of equity-like instruments can align the interests of the senior executive officers and significant risktakers with the interests of the covered institution’s shareholders. Thus, the proposed rule would require that a senior executive officer’s or significant risk-taker’s deferred incentive-based compensation include a substantial portion of equity-like instruments. Similarly, having incentive-based compensation in the form of cash can align the interests of the senior executive officers and significant risktakers with the interests of other stakeholders in the covered institution.181 Thus, the proposed rule would require that a senior executive officer’s or significant risk-taker’s deferred incentive-based compensation include a substantial portion of cash. The value of equity-like instruments received by a covered person increases or decreases in value based on the value of the equity of the covered institution, which provides an implicit method of adjusting the underlying value of compensation as the share price of the covered institution changes as a result of better or worse operational performance. Deferred cash may increase in value over time pursuant to an interest rate, but its value generally does not vary based on the performance of the covered institution. These two forms of incentive-based compensation present a covered person with different incentives for performance, just as a covered institution itself faces different savings associations, mutual savings banks, and mutual holding companies do not issue equity and do not have a parent that issues equity. For those institutions, imposing this requirement would have little benefit, as no equity-like instruments would be based off of the equity of the covered institution or one of its parents. In the case of FHFA, this requirement would not apply to a Level 1 or Level 2 covered institution that does not issue equity or is not permitted by FHFA to use equity-like instruments as compensation for senior executive officers and significant risk-takers. 181 Generally, in the case of resolution or bankruptcy, deferred incentive-based compensation in the form of cash would be treated similarly to other unsecured debt. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 incentives when issuing debt or equitylike instruments.182 For purposes of this proposed rule, the Agencies consider incentive-based compensation paid in equity-like instruments to include any form of payment in which the final value of the award or payment is linked to the price of the covered institution’s equity, even if such compensation settles in the form of cash. Deferred cash can be structured to share many attributes of a debt instrument. For instance, while equitylike instruments have almost unlimited upside (as the value of the covered institution’s shares increase), deferred cash that is structured to resemble a debt instrument can be structured so as to offer limited upside and can be designed with other features that align more closely with the interests of the covered institution’s debtholders than its shareholders.183 182 Jensen and Meckling (1976) were the first to point out that the structure of compensation should reflect all of the stakeholders in the firm—both equity and debt holders, an idea further explored by Edmans and Liu (2013). Faulkender et al. (2012) argue that a compensation program that relies too heavily on stock-based compensation can lead to excessive risk taking, manipulation, and distract from long-term value creation. Empirical research has found that equity-based pay increases risk at financial firms Balanchandarn et al. 2010). See Jensen and Metcking, ‘‘Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure,’’ 3 Journal of Financial Economics 305 (July 1, 1976); Edmans and Liu, ‘‘Inside Debt,’’ 15 Review of Finance 75 (June 29, 2011); Faulkender, Kadyrzhanova, Prabhala, and Senbet, ‘‘Executive Compensation: An Overview of Research on Corporate Practices and Proposed Reforms,’’ 22 Journal of Applied Corporate Finance 107 (2010); and Balachandran, Kogut, and Harnal, ‘‘The Probability of Default, Excess Risk and Executive Compensation: A Study of Financial Service Firms from 1995 to 2008,’’ working paper (June 2010), available at https://www.insead.edu/facultyresearch/ areas/accounting/events/documents/excess_risk_ bank_revisedjune21bk.pdf. 183 There has been a recent surge in research on the use of compensation that has a payoff structure similar to debt, or ‘‘inside debt.’’ See, e.g., Wei and Yermack, ‘‘Investor Reactions to CEOs Inside Debt Incentives,’’ 24 Review of Financial Studies 3813 (2011) (finding that bond prices rise, equity prices fall, and the volatility of both bond and stock prices fall for firms where the CEO has sizable inside debt and arguing the results indicate that firms with higher inside debt have lower risk; Cassell, Huang, Sanchez, and Stuart, ‘‘Seeking Safety: The Relation between CEO Inside Debt Holding and the Riskiness of Firm Investment and Financial Policies,’’ 103 Journal of Financial Economics 518 (2012) (finding higher inside debt is associated with lower volatility of future firm stock returns, research and development expenditures, and financial leverage, and more diversification and higher asset liquidity and empirical research finding that debt holders recognize the benefits of firms including debt-like components in their compensation structure); Anantharaman, Divya, Fang, and Gong, ‘‘Inside Debt and the Design of Corporate Debt Contracts,’’ 60 Management Science 1260 (2013) (finding that higher inside debt is associated with a lower cost of debt and fewer debt covenants); Bennett, Guntay and Unal, ‘‘Inside Debt and Bank Default Risk and Performance During the Crisis,’’ FDIC Center for PO 00000 Frm 00058 Fmt 4701 Sfmt 4702 Where possible, it is important for the incentive-based compensation of senior executive officers and significant risktakers at Level 1 and Level 2 covered institutions to have some degree of balance between the amounts of deferred cash and equity-like instruments received. With the exception of the limitation of use of options discussed below, the Agencies propose to provide covered institutions with flexibility in meeting the general balancing requirement under section ll.7(a)(4)(i) and thus have not proposed specific percentages of deferred incentive-based compensation that must be paid in each form. Similar to the rest of section ll.7, the requirement in section ll.7(a)(4)(i) would apply to deferred incentive-based compensation of senior executive officers and significant risk-takers of Level 1 and Level 2 covered institutions. As discussed above, these covered persons are the ones most likely to have a material impact on the financial health and risk-taking of the covered institution. Importantly for this requirement, these covered persons are also the most likely to be able to influence the value of the covered institution’s equity and debt. 7.13. The Agencies invite comment on the composition requirement set out in section ll.7(a)(4)(i) of the proposed rule. Financial Research Working Paper No. 2012–3 (finding that banks that had higher inside debt before the recent financial crisis had lower default risk and higher performance during the crisis and that banks with higher inside debt had supervisory ratings that indicate that they had stronger capital positions, better management, stronger earnings, and being in a better position to withstand market shocks in the future); Srivastav, Abhishek, Armitage, and Hagendorff, ‘‘CEO Inside Debt Holdings and Risk-shifting: Evidence from Bank Payout Policies,’’ 47 Journal of Banking & Finance 41 (2014) (finding that banks with higher inside debt holdings have a more conservative dividend payout policy); Chen, Dou, and Wang, ‘‘Executive Inside Debt Holdings and Creditors’ Demand for Pricing and Non-Pricing Protections,’’ working paper (2010) (finding that higher inside debt is associated with lower interest rates and less restrictive debt covenants and that in empirical research, specifically on banks, similar patterns emerge). In addition, the Squam Lake Group has done significant work on the use of debt based structures. See, e.g., Squam Lake Group, ‘‘Aligning Incentives at Systemically Important Financial Institutions’’ (2013) available at https:// www.squamlakegroup.org/Squam%20Lake%20 Bonus%20Bonds%20Memo%20Mar%2019% 202013.pdf. In their paper ‘‘Enhancing Financial Stability in the Financial Services Industry: Contribution of Deferred Cash Compensation,’’ forthcoming in the Federal Reserve Bank of New York’s Economic Policy Review (available at https:// www.newyorkfed.org/research/epr/), Hamid Mehran and Joseph Tracy highlight three channels through which deferred cash compensation can help mitigate risk: Promoting conservatism, inducing internal monitoring, and creating a liquidity buffer. E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 7.14. In order to allow Level 1 and Level 2 covered institutions sufficient flexibility in designing their incentivebased compensation arrangements, the Agencies are not proposing a specific definition of ‘‘substantial’’ for the purposes of this section. Should the Agencies more precisely define the term ‘‘substantial’’ (for example, one-third or 40 percent) and if so, should the definition vary among covered institutions and why? Should the term ‘‘substantial’’ be interpreted differently for different types of senior executive officers or significant risk-takers and why? What other considerations should the Agencies factor into level of deferred cash and deferred equity required? Are there particular tax or accounting implications attached to use of particular forms of incentive-based compensation, such as those related to debt or equity? 7.15. The Agencies invite comment on whether the use of certain forms of incentive-based compensation in addition to, or as a replacement for, deferred cash or deferred equity-like instruments would strengthen the alignment between incentive-based compensation and prudent risk-taking. 7.16. The Agencies invite commenters’ views on whether the proposed rule should include a requirement that a certain portion of incentive-based compensation be structured with debt-like attributes. Do debt instruments (as opposed to equitylike instruments or deferred cash) meaningfully influence the behavior of senior executive officers and significant risk-takers? If so, how? How could the specific attributes of deferred cash be structured, if at all, to limit the amount of interest that can be paid? How should such an interest rate be determined, and how should such instruments be priced? Which attributes would most closely align use of a debt-like instrument with the interest of debt holders and promote risk-taking that is not likely to lead to material financial loss? Options Under section ll.7(a)(4)(ii), for senior executive officers and significant risk-takers at Level 1 and Level 2 covered institutions that receive incentive-based compensation in the form of options, the total amount of such options that may be used to meet the minimum deferral amount requirements is limited to, no more than 15 percent of the amount of total incentive-based compensation awarded for a given performance period. A Level 1 or Level 2 covered institution would be permitted to award incentive-based compensation to senior executive VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 officers and significant risk-takers in the form of options in excess of this limitation, and could defer such compensation, but the incentive-based compensation in the form of options in excess of the 15 percent limit would not be counted towards meeting the minimum deferral requirements for senior executive officers and significant risk-takers at these covered institutions. For example, a Level 1 covered institution might award a significant risk-taker $100,000 in incentive-based compensation at the end of a performance period: $80,000 in qualifying incentive-based compensation, of which $25,000 is in options, and $20,000 under a long-term incentive plan, all of which is delivered in cash. The Level 1 covered institution would be required to defer at least $40,000 of the qualifying incentivebased compensation and at least $10,000 of the amount awarded under the long-term incentive plan. Under the draft proposed rule, the amount that could be composed of options and count toward the overall deferral requirement would be limited to 15 percent of the total amount of incentive-based compensation awarded. In this example, the Level 1 covered institution could count $15,000 in options (15 percent of $100,000) toward the requirement to defer $40,000 of qualifying incentivebased compensation. For an example of how these requirements would work in the context of a more complete incentive-based compensation arrangement, please see Appendix A of this preamble. This requirement would thus limit the total amount of incentive-based compensation in the form of options that could satisfy the minimum deferral amounts in sections ll.7(a)(1)(i) and ll.7(a)(1)(ii). Any incentive-based compensation awarded in the form of options would, however, be required to be included in calculating the total amount of incentive-based compensation awarded in a given performance period for purposes of calculating the minimum deferral amounts at Level 1 and Level 2 covered institutions as laid out in sections ll.7(a)(1)(i) and ll.7(a)(2)(ii). Options can be a significant and important part of incentive-based compensation arrangements at many covered institutions. The Agencies are concerned, however, that overreliance on options as a form of incentive-based compensation could have negative effects on the financial health of a covered institution due to options’ emphasis on upside gains and possible PO 00000 Frm 00059 Fmt 4701 Sfmt 4702 37727 lack of responsiveness to downside risks.184 The risk dynamic for senior executive officers and significant risk-takers changes when options are awarded because options offer asymmetric payoffs for stock price performance. Options may generate very high payments to covered persons when the market price of a covered institution’s shares rises, representing a leveraged return relative to shareholders. Payment of incentive-based compensation in the form of options may therefore increase the incentives under some market conditions for covered persons to take inappropriate risks in order to increase the covered institution’s short-term share price, possibly without giving appropriate weight to long-term risks. Moreover, unlike restricted stock, options are limited in how much they decrease in value when the covered institution’s shares decrease in value.185 Thus, options may not be an effective tool for causing a covered person to adjust his or her behavior to manage downside risk. For senior executive officers and significant risk-takers, whose activities can materially impact the firm’s stock price, incentive-based 184 In theory, since the payoffs from holding stock options are positively related to volatility of stock returns, options create incentives for executives to increase the volatility of share prices by engaging in riskier activities. See, e.g., Guay, W.R., ‘‘The Sensitivity of CEO Weather to Equity Risk: An Analysis of the Magnitude and Determinants,’’ 53 Journal of Financial Economics 43 (1999); Cohen, Hall, and Viceira, ‘‘Do Executive Stock Options Encourage Risk Taking?’’ working paper (2000) available at https://www.people.hbs.edu/lviceira/ cohallvic3.pdf; Rajgopal and Shvelin, ‘‘Empirical Evidence on the Relation between Stock Option Compensation and Risk-Taking,’’ 33 Journal of Accounting and Economics 145 (2002); Coles, Daniel, and Naveen, ‘‘Managerial Incentives and Risk-Taking,’’ 79 Journal of Financial Economics 431 (2006); Chen, Steiner, and Whyte, ‘‘Does Stock Option-Based Executive Compensation Induce RiskTaking? An Analysis of the Banking Industry,’’ 30 Journal of Banking & Finance 916 (2006); Mehran, Hamid and Rosenberg, ‘‘The Effect of Employee Stock Options on Bank Investment Choice, Borrowing and Capital,’’ Federal Reserve Bank of New York Staff Reports No. 305 (2007) available at https://www.newyorkfed.org/medialibrary/media/ research/staff_reports/sr305.pdf. Beyond the typical measures of risk, the academic literature has found a relation between executive stock option holdings and risky behavior. See, e.g., Denis, Hanouna, and Sarin, ‘‘Is There a Dark Side to Incentive Compensation?’’ 12 Journal of Corporate Finance 467 (2006) (finding that there is a significant positive association between the likelihood of securities fraud allegations and the executive stock option incentives); Bergstresser and Phillippon, ‘‘CEO Incentives and Earnings Management,’’ 80 Journal of Financial Economics 511 (2006) (finding that the use of discretionary accruals to manipulate reported earnings was more pronounced at firms where CEO’s compensation was more closely tied to stock and option holdings). 185 This would be the case if the current market price for a share is less than or equal to the option’s strike price (i.e., the option is not ‘‘in the money’’). E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37728 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules compensation based on options may therefore create greater incentive to take inappropriate risk or provide inadequate disincentive to manage risk. For these reasons, the Agencies are proposing to limit to 15 percent the amount permitted to be used in meeting the minimum deferral requirements. In proposing to limit, but not prohibit, the use of options to fulfill the proposed rule’s deferral requirements, the Agencies have sought to conservatively apply better practice while still allowing for some flexibility in the design and operation of incentive-based compensation arrangements. The Agencies note that supervisory experience at large banking organizations and analysis of compensation disclosures, as well as the views of some commenters to the 2011 Proposed Rule, indicate that many institutions have recognized the risks of options as an incentive and have reduced their use of options in recent years. The proposed rule’s 15 percent limit on options is consistent with current industry practice, which is moving away from its historical reliance on options as part of incentive-based compensation. Since the financial crisis that began in 2007, institutions on their own initiative and those working with the Board have decreased the use of options in incentive-based compensation arrangements generally such that for most organizations options constitute no more than 15 percent of an institution’s total incentive-based compensation. Restricted stock unit awards have now emerged as the most common form of equity compensation and are more prevalent than stock options at all employee levels.186 Further, a sample of publicly available disclosures from large covered institutions shows minimal usage of stock options among CEOs and other named executive officers; out of a sample of 14 covered institutions reviewed by the Agencies, only two covered institutions awarded stock options as part of their incentive-based compensation in 2015. Only one of those two covered institutions awarded options in excess of 15 percent of total compensation, and the excess was small. Thus, the proposed rule’s limit on options has been set at a level that would, in the Agencies’ views, help mitigate concerns about the use of options in incentive-based compensation while still allowing flexibility for covered institutions to use 186 Bachelder, Joseph E., ‘‘What Has Happened To Stock Options,’’ New York Law Journal (September 19, 2014). VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 options in a manner that is consistent with the better practices that have developed following the recent financial crisis.187 7.17. The Agencies invite comment on the restrictions on the use of options in incentive-based compensation in the proposed rule. Should the percent limit be higher or lower and if so, why? Should options be permitted to be used to meet the deferral requirements of the rule? Why or why not? Does the use of options by covered institutions create, reduce, or have no effect on the institution’s risk of material financial loss? 7.18. Does the proposed 15 percent limit appropriately balance the benefits of using options (such as aligning the recipient’s interests with that of shareholders) and drawbacks of using options (such as their emphasis on upside gains)? Why or why not? Is the proposed 15 percent limit the appropriate limit, or should it be higher or lower? If it should be higher or lower, what should the limit be, and why? 7.19. Are there alternative means of addressing the concerns raised by options as a form of incentive-based compensation other than those proposed? § ll.7(b) Forfeiture and Downward Adjustment Section ll.7(b) of the proposed rule would require Level 1 and Level 2 covered institutions to place incentivebased compensation of senior executive officers and significant risk-takers at risk of forfeiture and downward adjustment and to subject incentive-based compensation to a forfeiture and downward adjustment review under a defined set of circumstances. As described below, a forfeiture and downward adjustment review would be required to identify senior executive officers or significant risk-takers responsible for the events or circumstances triggering the review. It would also be required to consider certain factors when determining the amount or portion of a senior executive officer’s or significant risk-taker’s incentive-based compensation that should be forfeited or adjusted downward. In general, the forfeiture and downward adjustment review requirements in section ll.7(b) would require a Level 1 or Level 2 covered 187 Rajgopal and Shvelin, ‘‘Empirical Evidence on the Relation between Stock Option Compensation and Risk-Taking,’’ 33 Journal of Accounting and Economics 145 (2002); Bettis, Bizjak, and Lemmon, ‘‘Exercise Behavior, Valuation, and the Incentive Effects of Employee Stock Options,’’ 76 Journal of Financial Economics 445; ISS Compensation FAQs. PO 00000 Frm 00060 Fmt 4701 Sfmt 4702 institution to consider reducing some or all of a senior executive officer’s or significant risk-taker’s incentive-based compensation when the covered institution becomes aware of inappropriate risk-taking or other aspects of behavior that could lead to material financial loss. The amount of incentive-based compensation that would be reduced would depend upon the severity of the event, the impact of the event on the covered institution, and the actions of the senior executive officer or significant risk-taker in the event. The covered institution could accomplish this reduction of incentivebased compensation by reducing the amount of unvested deferred incentivebased compensation (forfeiture), by reducing the amount of incentive-based compensation not yet awarded for a performance period that has begun (downward adjustment), or through a combination of both forfeiture and downward adjustment. The Agencies have found that the possibility of a reduction in incentive-based compensation in the circumstances identified in section ll.7(b)(2) of the rule is needed in order to properly align financial reward with risk-taking by senior executive officers and significant risk-takers at Level 1 and Level 2 covered institutions. The possibility of forfeiture and downward adjustment under the proposed rule would play an important role not only in better aligning incentive-based compensation payouts with long-run risk outcomes at the covered institution but also in reducing incentives for senior executive officers and significant risk-takers to take inappropriate risk that could lead to material financial loss at the covered institution. The proposed rule would also require covered institutions, through policies and procedures,188 to formalize the governance and review processes surrounding such decisionmaking, and to document the decisions made. While forfeiture and downward adjustment reviews would be required components of incentive-based compensation arrangements for senior executive officers and significant risktakers at Level 1 and Level 2 covered institutions under the proposed rule, and are one way for covered institutions to take into account information about performance that becomes known over time, such reviews would not alone be sufficient to appropriately balance risk and reward, as would be required under section ll.4(c)(1). Incentive-based compensation arrangements for those 188 See E:\FR\FM\10JNP2.SGM sections ll.11(b) and ll.11(c). 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 covered persons would also be required to comply with the specific requirements of sections ll.4(d), ll.7(a), ll.7(c) and ll.8. As discussed above, to achieve balance between risk and reward, covered institutions should examine incentivebased compensation arrangements as a whole, and consider including provisions for risk adjustments before the award is made, and for adjustments resulting from forfeiture and downward adjustment review during the deferral period. § ll.7(b)(1) Compensation at Risk Under the proposed rule, a Level 1 or Level 2 covered institution would be required to place at risk of forfeiture 100 percent of a senior executive officer’s or significant risk-taker’s deferred and unvested incentive-based compensation, including unvested deferred amounts awarded under long-term incentive plans. Additionally, a Level 1 or Level 2 covered institution would be required to place at risk of downward adjustment all of a senior executive officer’s or significant risk-taker’s incentive-based compensation that has not yet been awarded, but that could be awarded for a performance period that is underway and not yet completed. Forfeiture and downward adjustment give covered institutions an appropriate set of tools through which consequences may be imposed on individual risktakers when inappropriate risk-taking or misconduct, such as the events identified in section ll.7(b)(2), occur or are identified. They also help ensure that a sufficient amount of compensation is at risk. Certain risk management failures and misconduct can take years to manifest, and forfeiture and downward adjustment reviews provide covered institutions an opportunity to adjust the ultimate amount of incentive-based compensation that vests based on information about risk-taking or misconduct that comes to light after the performance period. A senior executive officer or significant risk-taker should not be rewarded for inappropriate risktaking or misconduct, regardless of when the covered institution learns of it. Some evidence of inappropriate risk taking, risk management failures and misconduct may not be immediately apparent to the covered institution. To provide a strong disincentive for senior executive officers and significant risktakers to engage in such conduct, which may lead to material financial loss to the covered institution, the Agencies are proposing to require that all unvested deferred incentive-based compensation VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 and all incentive-based compensation eligible to be awarded for the performance period in which the covered institution becomes aware of the conduct be available for forfeiture and downward adjustment under the forfeiture and downward adjustment review. A covered institution would be required to consider all incentive-based compensation available, in the form of both unvested deferred incentive-based compensation and yet-to-be awarded incentive-based compensation, when considering forfeiture or downward adjustments, even if the incentive-based compensation does not specifically relate to the performance in the period in which the relevant event occurred. For example, a significant risk-taker of a Level 1 covered institution might engage in misconduct in June 2025, but the Level 1 covered institution might not become aware of the misconduct until September 2028. The Level 1 covered institution would be required to consider downward adjustment of any amounts available under any of the significant risk-taker’s incentive-based compensation plans with performance periods that are still in progress as of September 2028 (for example, an annual plan with a performance period that runs from January 1, 2028, to December 31, 2028, or a long-term incentive plan with a performance period that runs from January 1, 2027, to December 31, 2030). The Level 1 covered institution would also be required to consider forfeiture of any amounts that are deferred, but not yet vested, as of September 2028 (for example, amounts that were awarded for a performance period that ran from January 1, 2026, to December 31, 2026, and that have been deferred and do not vest until December 31, 2030). For an additional example of how these requirements would work in practice, please see Appendix A of this SUPPLEMENTARY INFORMATION section. § ll.7(b)(2) Events Triggering Forfeiture and Downward Adjustment Review Section ll.7(b) of the proposed rule would require a Level 1 or Level 2 covered institution to conduct a forfeiture and downward adjustment review based on certain identified adverse outcomes. Under section ll.7(b), events 189 that would be required to trigger a 189 The underlying, or contractual, forfeiture language used by institutions need not be identical to the triggers enumerated in this section, provided the covered institution’s triggers capture the full set of outcomes outlined in section 7(b)(2) of the rule. For example, a trigger at a covered institution that read ‘‘if an employee improperly or with gross negligence fails to identify, raise, or assess, in a PO 00000 Frm 00061 Fmt 4701 Sfmt 4702 37729 forfeiture and downward adjustment review include: (1) Poor financial performance attributable to a significant deviation from the risk parameters set forth in the covered institution’s policies and procedures; (2) inappropriate risk-taking, regardless of the impact on financial performance; (3) material risk management or control failures; and (4) non-compliance with statutory, regulatory, or supervisory standards that results in: Enforcement or legal action against the covered institution brought by a Federal or state regulator or agency; or a requirement that the covered institution report a restatement of a financial statement to correct a material error. Covered institutions would be permitted to define additional triggers based on conduct or poor performance. Generally, in the Agencies’ supervisory experience as earlier described, the triggers are consistent with current practice at the largest financial institutions, although many covered institutions have triggers that are more granular in nature than those proposed and cover a wider set of adverse outcomes. The proposed enumerated adverse outcomes are a set of minimum standards. As discussed later in this SUPPLEMENTARY INFORMATION section, covered institutions would be required to provide for the independent monitoring of all events related to forfeiture and downward adjustment.190 When such monitoring, or other risk surveillance activity, reveals the occurrence of events triggering forfeiture and downward adjustment reviews, Level 1 and Level 2 covered institutions would be required to conduct those reviews in accordance with section ll.7(b). Covered institutions may choose to coordinate the monitoring for triggering events under section ll.9(c)(2) and the forfeiture and downward adjustment reviews with broader risk surveillance activities. Such coordinated reviews could take place on a schedule identified by the covered institution. Schedules may vary among covered institutions, but they should occur often enough to appropriately monitor risks and events related to forfeiture and downward adjustment. Larger covered institutions with more complex operations are likely to need to conduct more frequent timely manner and as reasonably expected, risks and/or concerns with respect to risks material to the institution or its business activities,’’ would be considered consistent with the minimum parameters set forth in the trigger identified in section 7(b)(2)(ii) of the rule. 190 See section ll.9(c)(2). E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37730 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules reviews to ensure effective risk management. Poor financial performance can indicate that inappropriate risk-taking has occurred at a covered institution. The Agencies recognize that not all inappropriate risk-taking does, in fact, lead to poor financial performance, but given the risks that are posed to the covered institutions by poorly designed incentive-based compensation programs and the statutory mandate of section 956, it is appropriate to prohibit incentive-based compensation arrangements that reward such inappropriate risk-taking. Therefore, if evidence of past inappropriate risktaking becomes known, the proposed rule would require a Level 1 or Level 2 covered institution to perform a forfeiture and downward adjustment review in order to assess whether the relevant senior executive officer’s or significant risk-taker’s incentive-based compensation should be affected by the inappropriate risk-taking. Similarly, material risk management or control failures may allow for inappropriate risk-taking that may lead to material financial loss at a covered institution. Because the role of senior executive officers and significant risktakers, including those in risk management and other control functions whose role is to identify, measure, monitor, and control risk, the material failure by covered persons to properly perform their responsibilities can be especially likely to put an institution at risk. Thus, if evidence of past material risk management or control failures becomes known, the proposed rule would require a Level 1 or Level 2 covered institution to perform a forfeiture and downward adjustment review, to assess whether a senior executive officer or significant risktaker’s incentive-based compensation should be affected by the risk management or control failure. Examples of risk management or control failures would include failing to properly document or report a transaction or failing to properly identify and control the risks that are associated with a transaction. In each case, the risk management or control failure, if material, could allow for inappropriate risk-taking at a covered institution that could lead to material financial loss. Finally, a covered institution’s noncompliance with statutory, regulatory, or supervisory standards may also reflect inappropriate risk-taking that may lead to material financial loss at a covered institution. The proposed rule would require a forfeiture and downward adjustment review whenever VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 any such non-compliance (1) results in an enforcement or legal action against the covered institution brought by a Federal or state regulator or agency; or (2) requires the covered institution to restate a financial statement to correct a material error. The Federal Banking Agencies have found that it is appropriate for a covered institution to conduct a forfeiture and downward adjustment review under these circumstances because in many cases a statutory, regulatory, or supervisory standard may have been put in place in order to prevent a covered person from taking an inappropriate risk. In addition, non-compliance with a statute, regulation, or supervisory standard may also give rise to inappropriate compliance risk for a covered institution. A forfeiture and downward adjustment review would allow the institution to assess whether this type of non-compliance should affect a senior executive officer or significant risktaker’s incentive-based compensation. § ll.7(b)(3) Senior Executive Officers and Significant Risk-Takers Affected by Forfeiture and Downward Adjustment A forfeiture and downward adjustment review would be required to consider forfeiture and downward adjustment of incentive-based compensation for a senior executive officer and significant risk-taker with direct responsibility or responsibility due to the senior executive officer or significant risk-taker’s role or position in the covered institution’s organizational structure, for the events that would trigger a forfeiture and downward adjustment review as described in section ll.7(b)(2). Covered institutions should consider not only senior executive officers or significant risk-takers who are directly responsible for an event that triggers a forfeiture or downward adjustment review, but also those senior executive officers or significant risk-takers whose roles and responsibilities include areas where failures or poor performance contributed to, or failed to prevent, a triggering event. This requirement would discourage senior executive officers and significant risk-takers who can influence outcomes from failing to report or prevent inappropriate risk. A covered institution conducting a forfeiture and downward adjustment review may also consider forfeiture for other covered persons at its discretion. § ll.7(b)(4) Determining Forfeiture and Downward Adjustment Amounts The proposed rule sets out factors that Level 1 and Level 2 covered institutions must consider, at a minimum, when PO 00000 Frm 00062 Fmt 4701 Sfmt 4702 making a determination to reduce incentive-based compensation as a result of a forfeiture or downward adjustment review. A Level 1 or Level 2 covered institution would be responsible for determining how much of a reduction in incentive-based compensation is warranted, consistent with the policies and procedures it establishes under § ll.11(b), and should be able to support its decisions that such an adjustment was appropriate if requested by its appropriate Federal regulator. In reducing the amount of incentive-based compensation, covered institutions may reduce the dollar amount of deferred cash or cash to be awarded, may lower the amount of equity-like instruments that have been deferred or were eligible to be awarded, or some combination thereof. A reduction in the value of equity-like instruments due to market fluctuations would not be considered a reduction for purposes of this review. The proposed minimum factors that would be required to be considered when determining the amount of incentive-based compensation to be reduced are: (1) The intent of the senior executive officer or significant risk-taker to operate outside the risk governance framework approved by the covered institution’s board of directors or to depart from the covered institution’s policies and procedures; (2) the senior executive officer’s or significant risktaker’s level of participation in, awareness of, and responsibility for, the events triggering the review; (3) any actions the senior executive officer or significant risk-taker took or could have taken to prevent the events triggering the review; (4) the financial and reputational impact of the events 191 triggering the review as set forth in section ll.7(b)(2) on the covered institution, the line or sub-line of business, and individuals involved, as applicable, including the magnitude of any financial loss and the cost of known or potential subsequent fines, settlements, and litigation; (5) the causes of the events triggering the review, including any decision-making 191 Reputational impact or harm related to the actions of covered individuals refers to a potential weakening of confidence in an institution as evidenced by negative reactions from customers, shareholders, bondholders and other creditors, consumer and community groups, the press, or the general public. Reputational impact is a factor currently considered by some institutions in their existing forfeiture policies. See, e.g., Wells Fargo & Company 2016 Proxy Statement, page 47, available at https://www08.wellsfargomedia.com/assets/pdf/ about/investor-relations/annual-reports/2016proxy-statement.pdf; and Citigroup 2016 Proxy Statement, page 74, available at https:// www.citigroup.com/citi/investor/quarterly/2016/ ar16cp.pdf?ieNocache=611. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules by other individuals; and (6) any other relevant information, including past behavior and risk outcomes linked to past behavior attributable to the senior executive officer or significant risktaker. The considerations identified constitute a minimum set of parameters that would be utilized for exercising the discretion permissible under the proposed rule while still holding senior executive officers and significant risktakers accountable for inappropriate risk-taking and other behavior that could encourage inappropriate risktaking that could lead to risk of material financial loss at covered institutions. For example, a covered institution might identify a pattern of misconduct stemming from activities begun three years before the review that ultimately leads to an enforcement action and reputational damage to the covered institution. A review of facts and circumstances, including consideration of the minimum review parameters set forth in the proposed rule, could reveal that one individual knowingly removed transaction identifiers in order to facilitate a trade or trades with a counterparty on whom regulators had applied Bank Secrecy Act or AntiMonetary Laundering sanctions. Several of the senior executive officer’s or significant risk-taker’s peers might have been aware of this pattern of behavior but did not report it to their managers. Under the proposed rule, the individual who knowingly removed the identifiers would, in most cases, be subject to a greater reduction in incentive-based compensation than those who were aware of but not participants in the misconduct. However, those peers that were aware of the misconduct, managers supervising the covered person directly involved in the misconduct, and control staff who should have detected but failed to detect the behavior would be considered for a reduction, depending on their role in the organization, and assuming the peers are now senior executive officers or significant risktakers. The Agencies do not intend for these proposed factors to be exhaustive and covered institutions should consider additional factors where appropriate. In addition, covered institutions generally should impact incentive-based compensation as a result of forfeiture and downward adjustment reviews to reflect the severity of the event that triggered the review and the level of an individual’s involvement. Covered institutions should be able to demonstrate to the appropriate Federal regulator that the impact on incentivebased compensation was appropriate VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 given the particular set of facts and circumstances. 7.20. The Agencies invite comment on the forfeiture and downward adjustment requirements of the proposed rule. 7.21. Should the rule limit the events that require a Level 1 or Level 2 covered institution to consider forfeiture and downward adjustment to adverse outcomes that occurred within a certain time period? If so, why and what would be an appropriate time period? For example, should the events triggering forfeiture and downward adjustment reviews be limited to those events that occurred within the previous seven years? 7.22. Should the rule limit forfeiture and downward adjustment reviews to reducing only the incentive-based compensation that is related to the performance period in which the triggering event(s) occurred? Why or why not? Is it appropriate to subject unvested or unawarded incentive-based compensation to the risk of forfeiture or downward adjustment, respectively, if the incentive-based compensation does not specifically relate to the performance in the period in which the relevant event occurred or manifested? Why or why not? 7.23. Should the rule place all unvested deferred incentive-based compensation, including amounts voluntarily deferred by Level 1 and Level 2 covered institutions or senior executive officers or significant risktakers, at risk of forfeiture? Should only that unvested deferred incentive-based compensation that is required to be deferred under section ll.7(a) be at risk of forfeiture? Why or why not? 7.24. Are the events triggering a review that are identified in section ll.7(b)(2) comprehensive and appropriate? If not, why not? Should the Agencies add ‘‘repeated supervisory actions’’ as a forfeiture or downward adjustment review trigger and why? Should the Agencies add ‘‘final enforcement or legal action’’ instead of the proposed ‘‘enforcement or legal action’’ and why? 7.25. Is the list of factors that a Level 1 or Level 2 covered institution must consider, at a minimum, in determining the amount of incentive-based compensation to be forfeited or downward adjusted by a covered institution appropriate? If not, why not? Are any of the factors proposed unnecessary? Should additional factors be included? 7.26. Are the proposed parameters for forfeiture and downward adjustment review sufficient to provide an appropriate governance framework for making forfeiture decisions while still PO 00000 Frm 00063 Fmt 4701 Sfmt 4702 37731 permitting adequate discretion for covered institutions to take into account specific facts and circumstances when making determinations related to a wide variety of possible outcomes? Why or why not? 7.27. Should the rule include a presumption of some amount of forfeiture for particularly severe adverse outcomes and why? If so, what should be the amount and what would those outcomes be? 7.28. What protections should covered institutions employ when making forfeiture and downward adjustment determinations? 7.29. In order to determine when forfeiture and downward adjustment should occur, should Level 1 and Level 2 covered institutions be required to establish a formal process that both looks for the occurrence of trigger events and fulfills the requirements of the forfeiture and downward adjustment reviews under the proposed rule? If not, why not? Should covered institutions be required as part of the forfeiture and downward adjustment review process to establish formal review committees including representatives of control functions and a specific timetable for such reviews? Should the answer to this question depend on the size of the institution considered? § ll.7(c) Clawback As used in the proposed rule, the term ‘‘clawback’’ means a mechanism by which a covered institution can recover vested incentive-based compensation from a covered person. The proposed rule would require Level 1 and Level 2 covered institutions to include clawback provisions in incentive-based compensation arrangements for senior executive officers and significant risktakers that, at a minimum, would allow for the recovery of up to 100 percent of vested incentive-based compensation from a current or former senior executive officer or significant risk-taker for seven years following the date on which such compensation vests. Under section ll.7(c) of the proposed rule, all vested incentive-based compensation for senior executive officers and significant risk-takers, whether it had been deferred before vesting or paid out immediately upon award, would be required to be subject to clawback for a period of no less than seven years following the date on which such incentive-based compensation vests. Clawback would be exercised under an identified set of circumstances. These circumstances include situations where a senior executive officer or significant risk-taker engaged in: (1) Misconduct that resulted in significant financial or E:\FR\FM\10JNP2.SGM 10JNP2 37732 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 reputational harm 192 to the covered institution; (2) fraud; or (3) intentional misrepresentation of information used to determine the senior executive officer’s or significant risk-taker’s incentive-based compensation.193 The clawback provisions would apply to all vested incentive-based compensation, whether that incentive-based compensation had been deferred or paid out immediately when awarded. If a Level 1 or Level 2 covered institution discovers that a senior executive officer or significant risk-taker was involved in one of the triggering circumstances during a past performance period, the institution would potentially be able to recover from that senior executive officer or significant risk-taker incentive-based compensation that was awarded for that performance period and has already vested. A covered institution could require clawback irrespective of whether the senior executive officer or significant risk-taker was currently employed by the covered institution. The proposed set of triggering circumstances would constitute a minimum set of outcomes for which covered institutions would be required to consider recovery of vested incentivebased compensation. Covered institutions would retain flexibility to include other circumstances or outcomes that would trigger additional use of such provisions. In addition, while the proposed rule would require the inclusion of clawback provisions in incentive-based compensation arrangements, the proposed rule would not require that Level 1 or Level 2 covered institutions exercise the clawback provision, and the proposed rule does not prescribe the process that covered institutions should use to recover vested incentive-based compensation. Facts, circumstances, and all relevant information should determine whether and to what extent it is reasonable for a Level 1 or Level 2 covered institution to seek recovery of any or all vested incentive-based compensation. The Agencies recognize that clawback provisions may provide another 192 As described in the above note 191, reputational impact or harm of an event related to the actions of covered individuals refers to a potential weakening of confidence in an institution as evidenced by negative reactions from customers, shareholders, bondholders and other creditors, consumer and community groups, the press, or the general public. 193 As with other provisions in this proposed rule, the clawback requirement would not apply to incentive-based compensation plans and arrangements in place at the time the proposed rule is final because those plans and arrangements would be grandfathered. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 effective tool for Level 1 and Level 2 covered institutions to deter inappropriate risk-taking because it lengthens the time horizons of incentive-based compensation.194 The Agencies are proposing that vested incentive-based compensation be subject to clawback for up to seven years. The Agencies are proposing seven years as the length of the review period because it is slightly longer than the length of the average business cycle in the United States and is close to the lower end of the range of average credit cycles.195 Also, the Agencies observe that seven years is consistent with some international standards.196 By proposing seven years as the length of the review period, the Agencies intend to encourage institutions to fairly compensate covered persons and incentivize appropriate risk-taking, while also recognizing that recovering amounts that have already been paid is more difficult than reducing compensation that has not yet been paid. The Agencies are concerned that a clawback period that is too short or one that is too long, or even infinite, could result in the covered person ignoring or discounting the effect of the clawback period and accordingly, could be less effective in balancing risk-taking. Additionally, a very long or even infinite clawback period may be difficult to implement. While the Agencies did not propose a clawback requirement in the 2011 Proposed Rule, mandatory clawback provisions are not a new concept. Commenters to the 2011 Proposed Rule advocated that the Agencies adopt measures to allow shareholders (and others) to recover incentive-based compensation already paid to covered persons. As discussed above, clawback provisions are now increasingly common at the largest financial institutions. The largest (and mostly 194 See, e.g., Faulkender, Kadyrzhanova, Prabhala, and Senbet, ‘‘Executive Compensation: An Overview of Research on Corporate Practices and Proposed Reforms,’’ 22 Journal of Applied Corporate Finance 107 (2010) (arguing that clawbacks guard against compensating executives for luck rather than long-term performance); Babenko, Bennett, Bizjak and Coles, ‘‘Clawback Provisions,’’ working paper (2015) available at https://wpcarey.asu.edu/sites/default/files/uploads/ department-finance/clawbackprovisions.pdf (finding that the use of clawback provisions are associated with lower institution risk); Chen, Greene, and Owers, ‘‘The Costs and Benefits of Clawback Provisions in CEO Compensation,’’ 4 Review of Corporate Finance Studies 108 (2015) (finding that the use of clawback provisions are associated with higher reporting quality). 195 See supra note 154. 196 See, e.g., PRA, ‘‘Policy Statement PS7/14: Clawback’’ (July 2014), available at https:// www.bankofengland.co.uk/pra/Documents/ publications/ps/2014/ps714.pdf. PO 00000 Frm 00064 Fmt 4701 Sfmt 4702 publicly traded) covered institutions are already subject to a number of overlapping clawback regimes as a result of statutory requirements.197 Over the past several years, many financial institutions have further refined such mechanisms.198 Most often, clawbacks allow banking institutions to recoup incentive-based compensation in cases of financial restatement, misconduct, or poor financial outcomes. A number of covered institutions have gone beyond these minimum parameters to include situations where poor risk management has led to financial or reputational damage to the firm.199 The Agencies were cognizant of these developments in proposing the clawback provision in section ll.7(c). The Agencies propose the three triggers referenced above for several reasons. First, a number of the specified triggers reflect better practice at covered institutions today.200 The factors triggering clawback are based on existing clawback requirements that appear in some covered institutions’ incentive-based compensation arrangements. Second, while many of the clawback regulatory regimes currently in place focus only on accounting restatements or material misstatements of financial results, the proposed triggers focus more broadly on risk-related outcomes that are more likely to contribute meaningfully to the balance of incentive-based compensation arrangements. Third, the proposed rule would extend coverage of 197 See, e.g., section 304 of the Sarbanes-Oxley Act of 2002, 15 U.S.C. 7243; section 111 of the Emergency Economic Stabilization Act of 2008, 12 U.S.C. 5221; section 210(s) of the Dodd-Frank Act, 12 U.S.C. 5390(s); section 954 of the Dodd-Frank Act, 15 U.S.C. 78j–4(b). 198 See, e.g., PricewaterhouseCoopers, ‘‘Executive Compensation: Clawbacks, 2014 Proxy Disclosure Study’’ (January 2015), available at https:// www.pwc.com/us/en/hr-management/publications/ assets/pwc-executive-compensation-clawbacks2014.pdf; Compensation Advisory Partners, ‘‘2014 Proxy Season: Changing Practices in Executive Compensation: Clawback, Hedging, and Pledging Policies’’ (December 17, 2014), available at https:// www.capartners.com/uploads/news/id204/ capartners.com-capflash-issue62.pdf. 199 See, e.g., JPMorgan Chase & Company 2015 Proxy Statement, page 56, available at https:// files.shareholder.com/downloads/ONE/1425504 805x0x820065/4c79f471-36d9-47d4-a0b3-7886 b0914c92/JPMC-2015-ProxyStatementl.pdf (where vested compensation is subject to clawback if, among other things, ‘‘the employee engaged in conduct detrimental to the Firm that causes material financial or reputational harm to the Firm’’). 200 See, e.g., notes 198 and 199. See also Dawn Kopecki, ‘‘JP Morgan’s Drew Forfeits 2 Years’ Pay as Managers Ousted,’’ Bloomberg Business (July 13, 2012); Dolia Estevez, ‘‘Pay Slash to Citigroup’s Top Mexican Executive Called ‘Humiliating,’ ’’ Forbes (March 13, 2014); Eyk Henning, ‘‘Deutsche Bank Cuts Co-CEOs’ Compensation,’’ Wall Street Journal (March 20, 2015). E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 clawback mechanisms to include additional senior executive officers or significant risk-takers whose inappropriate risk-taking may not result in an accounting restatement, but would inflict harm on the covered institution nonetheless. This provision would go beyond, but not conflict with, clawback provisions in other areas of law.201 For example, covered institutions that issue securities also may be subject to clawback requirements pursuant to statutes administered by the SEC: Æ Section 304 of the Sarbanes-Oxley Act of 2002 202 provides that if an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirements under the securities laws, the CEO and chief financial officer of the issuer shall reimburse the issuer for (i) any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the SEC (whichever first occurs) of the financial document embodying such financial reporting requirement and (ii) any profits realized from the sale of securities of the issuer during that 12month period. Æ Section 954 of the Dodd-Frank Act added Section 10D to the Securities Exchange Act of 1934.203 Specifically, Section 10D(a) of the Securities Exchange Act requires the SEC to adopt rules directing the national securities exchanges 204 and the national securities associations 205 to prohibit the listing of any security of an issuer that is not in 201 See, e.g., section 304 of the Sarbanes-Oxley Act of 2002, 15 U.S.C. 7243; section 111 of the Emergency Economic Stabilization Act of 2008, 12 U.S.C. 5221; section 210(s) of the Dodd-Frank Act, 12 U.S.C. 5390(s); section 954 of the Dodd-Frank Act, 15 U.S.C. 78j–4(b). 202 15 U.S.C. 7243. 203 15 U.S.C. 78a et seq. 204 A ‘‘national securities exchange’’ is an exchange registered as such under section 6 of the Exchange Act (15 U.S.C. 78f). There are currently 18 exchanges registered under Section 6(a) of the Exchange Act: BATS Exchange, BATS Y-Exchange, BOX Options Exchange, C2 Options Exchange, Chicago Board Options Exchange, Chicago Stock Exchange, EDGA Exchange, EDGX Exchange, International Securities Exchange (‘‘ISE’’), ISE Gemini, Miami International Securities Exchange, NASDAQ OMX BX, NASDAQ OMX PHLX, The NASDAQ Stock Market, National Stock Exchange, New York Stock Exchange (‘‘NYSE’’), NYSE Arca and NYSE MKT. 205 A ‘‘national securities association’’ is an association of brokers and dealers registered as such under Section 15A of the Exchange Act (15 U.S.C. 78o–3). The Financial Industry Regulatory Authority (‘‘FINRA’’) is the only association registered with the SEC under section 15A(a) of the Exchange Act, but FINRA does not list securities. VerDate Sep<11>2014 00:15 Jun 10, 2016 Jkt 238001 compliance with the requirements of Section 10D(b). Section 10D(b) requires the SEC to adopt rules directing the exchanges to establish listing standards to require each issuer to develop and implement a policy providing: (1) For the disclosure of the issuer’s policy on incentive-based compensation that is based on financial information required to be reported under the securities laws; and (2) that, in the event that the issuer is required to prepare an accounting restatement due to the issuer’s material noncompliance with any financial reporting requirement under the securities laws, the issuer will recover from any of the issuer’s current or former executive officers who received incentive-based compensation (including stock options awarded as compensation) during the three-year period preceding the date the issuer is required to prepare the accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement. The SEC has proposed rules to implement the requirements of Exchange Act Section 10D.206 7.30. The Agencies invite comment on the clawback requirements of the proposed rule. 7.31. Is a clawback requirement appropriate in achieving the goals of section 956? If not, why not? 7.32. Is the seven-year period appropriate? Why or why not? 7.33. Are there state contract or employment law requirements that would conflict with this proposed requirement? Are there challenges that would be posed by overlapping Federal clawback regimes? Why or why not? 7.34. Do the triggers discussed above effectively achieve the goals of section 956? Should the triggers be based on those contained in section 954 of the Dodd-Frank Act? 7.35. Should the Agencies provide additional guidance on the types of behavior that would constitute misconduct for purposes of section ll.7(c)(1)? 7.36. Should the rule include a presumption of some amount of clawback for particularly severe adverse outcomes? Why or why not? If so, what should be the amount and what would those outcomes be? § ll.8 Additional Prohibitions for Level 1 and Level 2 Covered Institutions Section ll.8 of the proposed rule would establish additional prohibitions 206 Listing Standards for Recovery of Erroneously Awarded Compensation, Release No. 33–9861 (July 1, 2015), 80 FR 41144 (July 14, 2015). PO 00000 Frm 00065 Fmt 4701 Sfmt 4702 37733 for Level 1 and Level 2 covered institutions to address practices that, in the view of the Agencies, could encourage inappropriate risks that could lead to material financial loss at covered institutions. The Agencies’ views are based in part on supervisory experiences in reviewing and supervising incentive-based compensation at some covered institutions, as described earlier in this Supplemental Information section. Under the proposed rule, an incentivebased compensation arrangement at a Level 1 or Level 2 covered institution would be considered to appropriately balance risk and reward, as required by section ll.4(c)(1) of the proposed rule, only if the covered institution complies with the prohibitions of section ll.8. § ll.8(a) Hedging Section ll.8(a) of the proposed rule would prohibit Level 1 and Level 2 covered institutions from purchasing hedging instruments or similar instruments on behalf of covered persons to hedge or offset any decrease in the value of the covered person’s incentive-based compensation. This prohibition would apply to all covered persons at a Level 1 or Level 2 covered institution, not just senior executive officers and significant risk-takers. Personal hedging strategies may undermine the effect of risk-balancing mechanisms such as deferral, downward adjustment and forfeiture, or may otherwise negatively affect the goals of these risk-balancing mechanisms and their overall efficacy in inhibiting inappropriate risk-taking.207 For example, a financial instrument, such as a derivative security that increases in value as the price of a covered institution’s equity decreases would offset the intended balancing effect of awarding incentive-based compensation in the form of equity, the value of which is linked to the performance of the covered institution. Similarly, a hedging arrangement with a third party, under which the third party would make direct or indirect payments to a covered person that are linked to or commensurate with the amounts by which a covered person’s incentive-based compensation is reduced by forfeiture, would protect the covered person against declines in the value of incentive-based compensation. 207 This prohibition would not limit a covered institutions ability to hedge its own exposure in deferred compensation obligations, which the Board, the OCC, and the FDIC continue to view as prudent practice. (see, e.g., Federal Reserve SR Letter 04–19 (Dec. 7, 2004); OCC Bulletin 2004–56 (Dec. 7, 2004); FDIC FIL–127–2004 (Dec. 7, 2004); OCC Interpretive Letter No. 878 (Dec. 22, 1999). E:\FR\FM\10JNP2.SGM 10JNP2 37734 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 In order for incentive-based compensation to provide the appropriate incentive effects, covered persons should not be shielded from exposure to the negative financial impact of taking inappropriate risks or other aspects of their performance at the covered institution. In the 2011 Proposed Rule, the Agencies stated that they were aware that covered persons who received incentive-based compensation in the form of equity might wish to use personal hedging strategies as a way to assure the value of deferred equity compensation.208 The Agencies expressed concern that such hedging during deferral periods could diminish the alignment between risk and financial rewards that deferral arrangements might otherwise achieve.209 After considering supervisory experiences in reviewing incentive-based compensation at some covered institutions and the purposes of section 956 and related provisions of the Dodd-Frank Act, the Agencies are proposing a prohibition on covered institutions purchasing hedging and similar instruments on behalf of a covered person as a practical approach to eliminate the possibility that hedging during deferral periods could diminish the alignment between risk and financial rewards that deferral arrangements might otherwise achieve. 8.1. The Agencies invite comment on whether this restriction on Level 1 and Level 2 covered institutions prohibiting the purchase of a hedging instrument or similar instrument on behalf of covered persons is appropriate to implement section 956 of the Dodd-Frank Act. 8.2. Are there additional requirements that should be imposed on covered institutions with respect to hedging of the exposure of covered persons under incentive-based compensation arrangements? 8.3. Should the proposed rule include a prohibition on the purchase of a hedging instrument or similar instrument on behalf of covered persons at Level 3 institutions? § ll.8(b) Maximum Incentive-Based Compensation Opportunity Section ll.8(b) of the proposed rule would limit the amount by which the actual incentive-based compensation awarded to a senior executive officer or significant risk-taker could exceed the target amounts for performance measure goals established at the beginning of the performance period. It is the 208 See 76 FR at 21183. Agencies note that one commenter to the 2011 Proposed Rule supported limits on hedging. 209 The VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 understanding of the Agencies that, under current practice, covered institutions generally establish performance measure goals for their covered persons at the beginning of, or early in, a performance period. At that time, under some incentive-based compensation plans, those covered institutions establish target amounts of incentive-based compensation that the covered persons can expect to be awarded if they meet the established performance measure goals. Some covered institutions also set out the additional amounts of incentive-based compensation, in excess of the target amounts, that covered persons can expect to be awarded if they or the covered institution exceed the performance measure goals. Incentivebased compensation plans commonly set out maximum awards of 150 to 200 percent of the pre-set target amounts.210 The proposed rule would prohibit a Level 1 or Level 2 covered institution from awarding incentive-based compensation to a senior executive officer in excess of 125 percent of the target amount for that incentive-based compensation. For a significant risktaker the limit would be 150 percent of the target amount for that incentivebased compensation. This limitation would apply on a plan-by-plan basis, and, therefore, would apply to long-term incentive plans separately from other incentive-based compensation plans. For example, a Level 1 covered institution might provide an incentivebased compensation plan for its senior executive officers that links the amount awarded to a senior executive officer to the covered institution’s four-year average return on assets (ROA). The plan could establish a target award amount of $100,000 and a target fouryear average ROA of 75 basis points. That is, if the covered institution’s fouryear average ROA was 75 basis points, a senior executive officer would receive $100,000. The plan could also provide that senior executive officers would earn nothing (zero percent of target) under the plan if ROA was less than 50 basis points; $60,000 (60 percent of target) if ROA was 65 basis points; and $125,000 (125 percent of target) if ROA was 100 basis points. Under the proposed rule, the plan would not be permitted to provide, for example, $130,000 (130 percent of target) if ROA was 100 basis points or $150,000 (150 210 See, e.g., Arthur Gallagher & Co., ‘‘Study of 2013 Short- and Long-Term Incentive Design Criterion Among Top 200 S&P 500 Companies’’ (December 5, 2014), available at https:// www.ajg.com/media/1420659/study-of-2013-shortand-long-term-incentive-design-criterion-amongtop-200.pdf. PO 00000 Frm 00066 Fmt 4701 Sfmt 4702 percent of target) if ROA was 110 basis points. The Agencies are proposing these limits, in part, because they are consistent with the current industry practice at large banking organizations. Moreover, high levels of upside leverage (e.g., 200 percent to 300 percent above the target amount) could lead to senior executive officers and significant risktakers taking inappropriate risks to maximize the opportunity to double or triple their incentive-based compensation. Recognizing the potential for inappropriate risk-taking with such high levels of leverage, the Federal Banking Agencies have worked with large banking organizations to reduce leverage levels to a range of 125 percent to 150 percent. Such a range continues to provide for flexibility in the design and operation of incentivebased compensation arrangements in covered institutions while it addresses the potential for inappropriate risktaking where leverage opportunities are large or uncapped. For a full example of how these requirements would work in practice, please see Appendix A of this Supplementary Information section. The proposed rule would set different maximums for senior executive officers and for significant risk-takers because senior executive officers and significant risk-takers have the potential to expose covered institutions to different types and levels of risk, and may be motivated by different types and amounts of incentive-based compensation. The Agencies intend the different limitations to reflect the differences between the risks posed by senior executive officers and significant risk-takers. The Agencies emphasize that the proposed limits on a covered employee’s maximum incentive-based compensation opportunity would not equate to a ceiling on overall incentivebased compensation. Such limits would represent only a constraint on the percentage by which incentive-based compensation could exceed the target amount, and is aimed at prohibiting the use of particular features of incentivebased compensation arrangements which can contribute to inappropriate risk-taking. 8.4. The Agencies invite comment on whether the proposed rule should establish different limitations for senior executive officers and significant risktakers, or whether the proposed rule should impose the same percentage limitation on senior executive officers and significant risk-takers. 8.5. The Agencies also seek comment on whether setting a limit on the amount that compensation can grow from the time the target is established E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules until an award occurs would achieve the goals of section 956. 8.6. The Agencies invite comment on the appropriateness of the limitation, i.e., 125 percent and 150 percent for senior executive officers and significant risk-takers, respectively. Should the limitations be set higher or lower and, if so, why? 8.7. Should the proposed rule apply this limitation on maximum incentivebased compensation opportunity to Level 3 institutions? mstockstill on DSK3G9T082PROD with PROPOSALS2 § ll.8(c) Relative Performance Measures Under section ll.8(c) of the proposed rule, a Level 1 or Level 2 covered institution would be prohibited from using incentive-based compensation performance measures based solely on industry peer performance comparisons. This prohibition would apply to incentivebased compensation arrangements for all covered persons at a Level 1 or Level 2 covered institution, not just senior executive officers and significant risktakers. As discussed above, covered institutions generally establish performance measures for covered persons at the beginning of, or early in, a performance period. For these types of plans, the performance measures (sometimes known as performance metrics) are the basis upon which a covered institution determines the related amounts of incentive-based compensation to be awarded to covered persons. These performance measures can be absolute, meaning they are based on the performance of the covered person or the covered institution without reference to the performance of other covered persons or covered institutions. In contrast, a relative performance measure is a performance measure that compares a covered institution’s performance to that of so called ‘‘peer institutions’’ or an industry average. The composition of peer groups is generally decided by the individual covered institution. An example of an absolute performance measure is total shareholder return (TSR). An example of a relative performance measure is the rank of the covered institution’s TSR among the TSRs of institutions in a preestablished peer group. The Agencies have observed that incentive-based compensation arrangements based solely on industry peer performance comparisons (a type of relative performance measure) can cause covered persons to take inappropriate risks that could lead to VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 material financial loss.211 For example, if a covered institution falls behind its industry peers, it may use performance measures—and set goals for those measures—that lead to inappropriate risk-taking by covered persons in order to perform better than its industry peers. Also, the performance of a covered institution can be strong relative to its peers, but poor on an absolute basis (e.g., every institution in the peer group is performing poorly, but the covered institution is the best of the group). Consequently, if incentive-based compensation arrangements were based only on relative performance measures, they would, in that circumstance, reward covered employees for performance that is poor on an absolute level but still better than that of the covered institution’s peer group. Similarly, in cases where only relative performance measures are used and performance is poor, performance-based vesting may still occur when peer performance is also poor. Using a combination of relative and absolute performance measures as part of the performance evaluation process can help maintain balance between financial rewards and potential risks in such situations. Additionally, covered persons do not know what level of performance is necessary to meet or exceed target peer group rankings, as rankings will become known only at the end of the performance period. As a result, covered employees may be strongly incentivized to achieve exceptional levels of performance by taking inappropriate risks to increase the likelihood that the covered institution will meet or exceed the peer group ranking in order to maximize their incentive-based compensation. Further, comparing an institution’s performance to a peer group can be misleading because the members of the peer group are likely to have different business models, product mixes, operations in different geographical locations, cost structures, or other attributes that make comparisons between institutions inexact. Relative performance measures, including industry peer performance measures, may be useful when used in combination with absolute performance measures. Thus, under the proposed rule, a covered institution would be permitted to use relative performance measures in combination with absolute performance measures, but not in 211 Gong, Li, and Shin, ‘‘Relative Performance Evaluation and Related Peer Groups in Executive Compensation Contracts,’’ 86 The Accounting Review 1007 (May 2011). PO 00000 Frm 00067 Fmt 4701 Sfmt 4702 37735 isolation. For instance, a covered institution would not be in compliance with the proposed rule if the performance of the CEO were assessed solely on the basis of total shareholder return relative to a peer group. However, if the performance of the CEO were assessed on the basis of institutionspecific performance measures, such as earnings per share and return on tangible common equity, along with the same relative TSR the covered institution would comply with section ll.8(c) of the proposed rule (assuming the CEO’s incentive-based compensation arrangement met the other requirements of the rule, such as an appropriate balance of risk and reward). 8.8. The Agencies invite comment on whether the restricting on the use of relative performance measures for covered persons at Level 1 and Level 2 covered institutions in section ll.8(d) of the proposed rule is appropriate in deterring behavior that could put the covered institution at risk of material financial loss. Should this restriction be limited to a specific group of covered persons and why? What are the relative performance measures being used in industry? 8.9. Should the proposed rule apply this restriction on the use of relative performance measures to Level 3 institutions? § ll.8(d) Volume-Driven IncentiveBased Compensation Section ll.8(d) of the proposed rule would prohibit Level 1 and Level 2 covered institutions from providing incentive-based compensation to a covered person that is based solely on transaction or revenue volume without regard to transaction quality or the compliance of the covered person with sound risk management. Under the proposed rule, transaction or revenue volume could be used as a factor in incentive-based compensation arrangements, but only in combination with other factors designed to cause covered persons to account for the risks of their activities. This prohibition would apply to incentive-based compensation arrangements for all covered persons at a Level 1 or Level 2 covered institution, not just senior executive officers and significant risktakers. Incentive-based compensation arrangements that do not account for the risks covered persons can take to achieve performance measures do not appropriately balance risk and reward, as section ll.4(c)(1) of the proposed rule would require. An arrangement that provides incentive-based compensation E:\FR\FM\10JNP2.SGM 10JNP2 37736 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 to a covered person based solely on transaction or revenue volume, without regard to other factors, would not adequately account for the risks to which the transaction in question could expose the covered institution. For instance, an incentive-based compensation arrangement that rewarded mortgage originators based solely on the volume of loans approved, without any subsequent adjustment for the quality of the loans originated (such as adjustments for early payment default or problems with representations and warranties) would not adequately balance risk and financial rewards. An incentive-based compensation arrangement with performance measures based solely on transaction or revenue volume could incentivize covered persons to generate as many transactions or as much revenue as possible without appropriate attention to resulting risks. Such arrangements were noted in MLRs and similar reports where compensation had been cited as a contributing factor to a financial institution’s failure during the recent financial crisis.212 In addition, many studies about the causes of the recent financial crisis discuss how volumedriven incentive-based compensation lead to inappropriate risk-taking and caused material financial loss to financial institutions.213 8.10. The Agencies invite comment on whether there are circumstances under which consideration of transaction or revenue volume as a sole performance measure goal, without consideration of risk, can be appropriate in incentivebased compensation arrangements for Level 1 or Level 2 covered institutions. 8.11. Should the proposed rule apply this restriction on the use of volumedriven incentive-based compensation arrangements to Level 3 institutions? 212 In accordance with section 38(k) of the FDIA, 12 U.S.C. 1831o(k), MLRs are conducted by the Inspectors General of the appropriate Federal banking agency following the failure of insured depository institutions. See, e.g., Office of Inspector General for the Department of Treasury, ‘‘Material Loss Review of Indymac Bank, FSB,’’ OIG–09–032 (February 26, 2009), available at https://www.treasury.gov/about/ organizational-structure/ig/Documents/ oig09032.pdf; Offices of Inspector General for the Federal Deposit Insurance Corporation and the Department of Treasury, ‘‘Evaluation of Federal Regulatory Oversight of Washington Mutual Bank,’’ EVAL–10–002 (April 9, 2010), available at https:// www.fdicig.gov/reports10/10-002EV.pdf. 213 See, e.g., Financial Crisis Inquiry Commission, ‘‘The Financial Crisis Inquiry Report’’ (January 2011), available at https://fcicstatic.law.stanford.edu/cdnlmedia/fcic-reports/ fciclfinallreportlfull.pdf. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 § ll.9 Risk Management and Controls Requirements for Level 1 and Level 2 Covered Institutions Prior to the financial crisis that began in 2007, institutions rarely involved risk management in either the design or monitoring of incentive-based compensation arrangements. Federal Banking Agency reviews of compensation practices have shown that one important development in the intervening years has been the increasing integration of control functions in compensation design and decision-making. For instance, control functions are increasingly relied on to ensure that risk is properly considered in incentive-based compensation programs. At the largest covered institutions, the role of the board of directors in oversight of compensation programs (including the oversight of supporting risk management processes) has also expanded. Section ll.9 of the proposed rule would establish additional risk management and controls requirements at Level 1 and Level 2 covered institutions. Without effective risk management and controls, larger covered institutions could establish incentive-based compensation arrangements that, in the view of the Agencies,214 could encourage inappropriate risks that could lead to material financial loss at covered institutions. Under the proposed rule, an incentive-based compensation arrangement at a Level 1 or Level 2 covered institution would be considered to be compatible with effective risk management and controls, as required by section ll.4(c)(2) of the proposed rule, only if the covered institution also complies with the requirements of section ll.9. In proposing section ll.9, the Agencies are also cognizant of comments received on the 2011 Proposed Rule.215 In order to facilitate 214 This view is based in part on supervisory experiences in reviewing and supervising incentivebased compensation at some covered institutions. 215 The 2011 Proposed Rule would have required incentive-based compensation arrangements to be compatible with effective risk management and controls. A number of commenters offered views on the proposed requirements, and some raised concerns. Some commenters emphasized the importance of sound risk management practices in the area of incentive-based compensation. However, a number of commenters also questioned whether the determination of an ‘‘appropriate’’ role for risk management personnel should be left to the discretion of individual institutions. In light of these comments, the proposed rule is designed to strike a reasonable balance between requiring an appropriate role for risk management and allowing institutions the ability to tailor their risk management practices to their business model. The proposed rule does not include prescriptive standards. Instead, it would allow Level 1 and Level PO 00000 Frm 00068 Fmt 4701 Sfmt 4702 consistent adoption of the practices that contribute to incentive-based compensation arrangements that appropriately balance risk and reward, the Agencies are proposing that the practices set forth in section ll.9 be required for all Level 1 and Level 2 covered institutions. Section ll.9(a) of the proposed rule would establish minimum requirements for a risk management framework at a Level 1 or Level 2 covered institution by requiring that such framework: (1) Be independent of any lines of business; (2) include an independent compliance program that provides for internal controls, testing, monitoring, and training with written policies and procedures consistent with section ll.11 of the proposed rule; and (3) be commensurate with the size and complexity of the covered institution’s operations. Generally, section ll.9(a) would require that Level 1 and Level 2 covered institutions have a systematic approach to designing and implementing their incentive-based compensation arrangements and incentive-based compensation programs supported by independent risk management frameworks with written policies and procedures, and developed systems. These frameworks would include processes and systems for identifying and reporting deficiencies; establishing managerial and employee responsibility; and ensuring the independence of control functions. To be effective, an independent risk management framework should have sufficient stature, authority, resources and access to the board of directors. Level 1 and Level 2 covered institutions would be required to develop, as part of their broader risk management framework, an independent compliance program for incentive-based compensation. The Federal Banking Agencies have found that an independent compliance program leads to more robust oversight of incentive-based compensation programs, helps to avoid undue influence by lines of business, and facilitates supervision. Agencies would expect such a compliance program to have formal policies and procedures to support compliance with the proposed rule and to help to ensure that risk is effectively taken into account in both design and decision-making processes related to incentive-based 2 covered institutions to retain flexibility to determine the specific role that risk management and control functions should play in incentivebased compensation processes, while still allowing for appropriate oversight of incentive-based compensation arrangements. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules compensation. The requirements for such policies and procedures are set forth in section ll.11 of the proposed rule. The requirements of the proposed rule would encourage Level 1 and Level 2 covered institutions to develop welltargeted internal controls that work within the covered institution’s broader risk management framework to support balanced risk-taking. Independent control functions should regularly monitor and test the covered institution’s incentive-based compensation program and its arrangements to validate their effectiveness. Training would generally include communication to employees of the covered institution’s compliance risk management standards and policies and procedures, and communication to managers on expectations regarding risk adjustment and documentation. The Agencies note that independent compliance programs consistent with these proposed requirements are already in place at a significant number of larger covered institutions, in part due to supervisory efforts such as the Board’s ongoing horizontal review of incentivebased compensation,216 Enhanced Prudential Standards from section 165 of the Dodd-Frank Act,217 and the OCC’s Heightened Standards.218 For example, control function employees monitor compliance with policies and procedures and help to ensure robust documentation of compensation decisions, including those relating to forfeiture and risk-adjustment processes. Institutions have also improved communication to managers and employees about how risk adjustment should work and have developed processes to review the application of related guidance in order to ensure better consideration of risk in compensation decisions. The Agencies are proposing to require similar compliance programs at covered institutions not subject to the supervisory efforts described above, as well as to reinforce the practices of covered institutions that already have such compliance programs in place. Section ll.9(b) of the proposed rule would require Level 1 and Level 2 covered institutions to provide individuals engaged in control functions with the authority to influence the risktaking of the business areas they monitor and to ensure covered persons engaged in control functions are compensated in accordance with the achievement of performance objectives 216 See 2011 FRB White Paper. 12 CFR part 252. 218 See 12 CFR part 30, appendix D. 217 See VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 linked to their control functions and independent of the performance of the business areas they oversee. These protections are intended to mitigate potential conflicts of interest that might undermine the role covered persons engaged in control functions play in supporting incentive-based compensation arrangements that appropriately balance risk and reward. Under sectionll.9(c) of the proposed rule, Level 1 and Level 2 covered institutions would be required to provide for independent monitoring of: (1) Incentive-based compensation plans to identify whether those plans appropriately balance risk and reward; (2) events relating to forfeiture and downward adjustment reviews and decisions related thereto; and (3) compliance of the incentive-based compensation program with the covered institution’s policies and procedures. To be considered independent under the proposed rule, the group or person at the covered institution responsible for monitoring the areas described above generally should have a reporting line to senior management or the board that is separate from the covered persons whom the group or person is responsible for monitoring. Some covered institutions may use internal audit to perform the independent monitoring that would be required under this section.219 The type of independent monitoring conducted to fulfill the requirements of section ll.9(c) generally should be appropriate to the size and complexity of the covered institution and its use of incentive-based compensation. For example, a Level 1 covered institution might be expected to use a different scope and type of data and analysis to monitor its incentive-based compensation program than a Level 2 covered institution. Likewise, a covered institution that offers incentive-based compensation to only a few employees may require a less formal monitoring process than a covered institution that offers many types of incentive-based compensation to many of its employees. Section ll.9(c)(1) of the proposed rule would require covered institutions to periodically review all incentivebased compensation plans to assess whether those plans provide incentives that appropriately balance risk and reward. Monitoring the incentives embedded in plans, rather than the individual arrangements that rely on those plans, provides an opportunity to identify incentives for imprudent risk219 At OCC-supervised institutions, the independent monitoring required under section ll.9(c) would be carried out by internal audit. PO 00000 Frm 00069 Fmt 4701 Sfmt 4702 37737 taking. It also reduces burden on covered institutions in a reasonable way in light of the proposed rule’s additional protections against excessive risk-taking which operate at the level of incentivebased compensation arrangements. Supervisory experience indicates that many covered institutions already periodically perform such a review, and the Agencies consider it a better practice. Level 1 and Level 2 covered institutions should have procedures for collecting information about the effects of their incentive-based compensation arrangements on employee risk-taking, and have systems and processes for using this information to adjust incentive-based compensation arrangements in order to eliminate or reduce unintended incentives for inappropriate risk-taking. Under Section ll.9(c)(2), covered institutions would be required to provide for the independent monitoring of all events related to forfeiture and downward adjustment. With regard to forfeiture and downward adjustment decisions, covered institutions would be expected to regularly monitor the events that could trigger a forfeiture and downward adjustment review. Many covered institutions also regularly conduct independent monitoring and testing activities, or broad-based risk reviews, that could reveal instances of inappropriate risk-taking. The policies and procedures established under section ll.11(b) would be expected to specify that covered institutions would evaluate whether inappropriate risktaking identified in the course of any independent monitoring and testing activities triggered a forfeiture and downward adjustment review. The frequency of reviews may vary depending on the size and complexity of, and the level of risks at, the covered institution, but they should occur often enough to reasonably monitor risks and events related to the forfeiture and downward adjustment triggers.220 When these reviews uncover events that trigger forfeiture and downward adjustment reviews, Level 1 and Level 2 covered institutions would be required to complete such a review, consistent with the requirements of section ll.7(b). They would also be required to monitor adherence to policies and procedures that support effective balancing of risk and rewards. Many covered institutions currently perform forfeiture reviews in the context of broader and more regular risk reviews to ensure that the forfeiture review process appropriately captures all risktaking activity. The Agencies view this 220 See E:\FR\FM\10JNP2.SGM section ll.7(b)(2). 10JNP2 37738 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 approach as better practice, as decisions about appropriate adjustment of compensation in such circumstances are only one desired outcome. For instance, identification of risk events generally should lead not only to consideration of compensation adjustments, but also to analysis of whether there are weaknesses in broader controls or risk management oversight that need to be addressed. In their supervisory experience, the Federal Banking Agencies have found that tying forfeiture reviews to broader risk reviews is a better practice. Section ll.9(c)(3) of the proposed rule would require covered institutions to provide for independent compliance monitoring of the institution’s incentive-based compensation program with policies and procedures. To be considered independent under the proposed rule, the group or person at the covered institution monitoring compliance should have a separate reporting line to senior management or to the board of directors from the business line or group being monitored, but may be conducted by groups within the covered institution. For example, internal audit could review whether award disbursement and vesting policies were adhered to and whether documentation of such decisions was sufficient to support independent review. Such independence will help ensure that the monitoring is unbiased and identifies appropriate issues. The Agencies have taken the position that Level 1 and Level 2 covered institutions should regularly review whether the design and implementation of their incentive-based compensation arrangements deliver appropriate risktaking incentives. Independent monitoring should enable covered institutions to correct deficiencies and make necessary improvements in a timely fashion based on the results of those reviews.221 9.1 Some Level 1 and Level 2 covered institutions are subject to separate risk management and controls requirements under other statutory or regulatory regimes. For example, OCC-supervised Level 1 and Level 2 covered institution are subject to the OCC’s Heightened 221 The 2010 Federal Banking Agency Guidance mentions several practices that can contribute to the effectiveness of such activity, including internal reviews and audits of compliance with policies and procedures, and monitoring of results relative to expectations. For instance, internal audit should assess the effectiveness of the compliance risk management program by performing regular independent reviews and evaluating whether internal controls, policies, and processes that limit incentive-based compensation risk are effective and appropriate for the covered institution’s activities and associated risks. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 Standards. Is it clear to commenters how the risk management and controls requirements under the proposed rule would interact, if at all, with requirements under other statutory or regulatory regimes? § ll.10 Governance Requirements for Level 1 and Level 2 Covered Institutions Section ll.10 of the proposed rule contains specific governance requirements that would apply to Level 1 and Level 2 covered institutions. Under the proposed rule, an incentivebased compensation arrangement at a Level 1 or Level 2 covered institution would be considered to be supported by effective governance, as required by section ll.4(c)(3) of the proposed rule, only if the covered institution also complies with the requirements of section ll.10. As discussed earlier in this Supplementary Information section, the supervisory experience of the Federal Banking Agencies at large consolidated financial institutions is that effective oversight by a covered institution’s board of directors, including review and approval by the board of the overall goals and purposes of the covered institution’s incentive-based compensation program, is essential to the attainment of incentive-based compensation arrangements that do not encourage inappropriate risks that could lead to material financial loss to the covered institution. Accordingly, section ll.10(a) of the proposed rule would require that a Level 1 or Level 2 covered institution establish a compensation committee, composed solely of directors who are not senior executive officers, to assist the board in carrying out its responsibilities related to incentivebased compensation.222 Having an independent compensation committee is consistent with the emphasis the Agencies place on the need for incentive-based compensation 222 As described above, under the Board’s and FDIC’s proposed rules, for a foreign banking organization, ‘‘board of directors’’ would mean the relevant oversight body for the institution’s U.S. branch, agency, or operations, consistent with the foreign banking organization’s overall corporate and management structure. The Board and FDIC will work with foreign banking organizations to determine the appropriate persons to carry out the required functions of a compensation committee under the proposed rule. Likewise, under the OCC’s proposed rule, for a Federal branch or agency of a foreign bank, ‘‘board of directors’’ would mean the relevant oversight body for the Federal branch or agency, consistent with its overall corporate and management structure. The OCC would work closely with Federal branches and agencies to determine the person or committee to undertake the responsibilities assigned to the oversight body. PO 00000 Frm 00070 Fmt 4701 Sfmt 4702 arrangements to be compatible with effective risk management and controls and supported by effective governance. In response to the 2011 Proposed Rule, some commenters expressed a view that an independent compensation committee composed solely of nonmanagement directors would have helped to avoid potential conflicts of interest and more appropriate consideration of management proposals, particularly proposed awards and payouts for senior executive officers. Section ll.10(b) of the proposed rule would require that compensation committees at Level 1 and Level 2 covered institutions obtain input and assessments from various parties. For example, the compensation committees would be required to obtain input on the effectiveness of risk measures and adjustments used to balance risk and reward in incentive-based compensation arrangements from the risk and audit committees of the covered institution’s board of directors, or groups performing similar functions, and from the covered institution’s risk management function. The proposed requirements would help protect covered institutions against inappropriate risk-taking that could lead to material financial loss by leveraging the expertise and experience of these parties. In their review of the incentive-based compensation practices of many of the largest covered institutions, the Federal Banking Agencies have noted that the compensation, risk, and audit committees of the boards of directors collaborate and seek advice from risk management and other control functions before making decisions. Many of these covered institutions have members of the compensation committee that are also members of the risk and audit committees. Some covered institutions rely on regular meetings between the compensation and risk committees, while others rely on more ad hoc communications. Human resources, risk management, finance, and audit committees work with compensation committees to ensure that compensation systems attain multiple objectives, including appropriate risk-taking.223 Section ll.10(b)(2) of the proposed rule would require the compensation committees to obtain from management, on an annual or more frequent basis, a written assessment of the covered institution’s incentive-based compensation program and related compliance and control processes. The 223 See generally 2011 FRB White Paper; FSB, ‘‘FSB 2015 Workshop on Compensation Practices’’ (April 14, 2015), available at https://www.fsb.org/ wp-content/uploads/Summary-of-the-April-2015FSB-workshop-on-compensation-practices.pdf. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules report should assess the extent to which the program and processes provide risktaking incentives that are consistent with the covered institution’s risk profile. Management would be required to develop the assessment with input from the covered institutions’ risk and audit committees, or groups performing similar functions, and from individuals in risk management and audit functions. In addition to the written assessment submitted by management, section ll.10(b)(3) of the proposed rule would require the compensation committee to obtain another written assessment on the same matter, submitted on an annual or more frequent basis, by the internal audit or risk management function of the covered institution. This written assessment would be developed independently of the covered institution’s management. The Agencies are proposing that the independent compensation committee of the board of directors to be the recipient of such input and written assessments. Developing incentive-based compensation arrangements that provide balanced risk-taking incentives and monitoring arrangements to ensure they achieve balance requires an understanding of the full spectrum of risks (including compliance risks) and potential risk outcomes associated with the activities of covered persons. For this reason, risk-management and other control functions generally should each have an appropriate role in the covered institution’s processes, not only for designing incentive-based compensation arrangements, but also for assessing their effectiveness in providing risktaking incentives that are consistent with the risk profile of the institution. The proposed rule sets forth two separate effectiveness assessments: (1) An assessment under the auspices of management, but reliant on risk management and audit functions, as well as the audit and risk committees of the board, and (2) an assessment conducted by the internal audit or risk management function of the covered institution, independent of management. In support of the first requirement, a covered institution’s management has a full understanding of both the entirety of the covered institution’s activities and a detailed understanding of its incentive-based compensation program, including both the performance that the covered institution intends to reward and the risks to which covered persons can expose the covered institution. An understanding of the full compensation program (including the effectiveness of risk measures across various lines of VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 business, the measurement of actual risk outcomes, and the analysis of risktaking and risk outcomes relative to incentive-based compensation payments) requires a large degree of technical expertise. It also requires an understanding of the wider strategic and risk management frameworks in place at the covered institution (including the various objectives that compensation programs seek to balance, such as recruiting and retention goals and prudent risk management). While the board of directors at a covered institution is ultimately responsible for the balance of incentive-based compensation arrangements, and for an incentive-based compensation program that incentivizes behaviors consistent with the long-term health of the organization, the board should generally hold senior management accountable for effectively executing the covered institution’s incentive-based compensation program, and for modifying it when weaknesses are identified. In addition, some Level 1 and Level 2 covered institutions use automated systems to monitor the effectiveness of incentive-based compensation arrangements in balancing risk-taking incentives, especially systems that support capture of relevant data in databases that support monitoring and analysis. Management plays a role in all of these activities and is well-positioned to oversee an analysis that considers such a wide variety of inputs. In order to ensure that considerations of risktaking are included in such an exercise, an active role for independent control functions is critical in such a review as well as input from the risk and audit committees of the board of directors, or groups performing similar functions. Periodic presentations by the chief risk officer or other risk management staff to the board of directors can help complement the annual effectiveness review. In addition, the proposed rule includes a requirement that internal audit or risk management submit a written assessment of the effectiveness of a Level 1 or Level 2 covered institution’s incentive-based compensation program and related control processes in providing risktaking incentives that are consistent with the risk profile of the covered institution. Regular internal reviews and audits of compliance with policies and procedures are important to helping implement the incentive-based compensation system as intended by those employees involved in incentivebased compensation decision-making. Internal audit and risk management are PO 00000 Frm 00071 Fmt 4701 Sfmt 4702 37739 well-positioned to provide an independent perspective on a covered institution’s incentive-based compensation program and related control processes. The Federal Banking Agencies have observed that compensation committees benefit from an independent analysis of the effectiveness of their covered institutions’ incentive-based compensation programs.224 The proposed requirement takes into consideration comments received on the policies and procedures standards embodied in the 2011 Proposed Rule that would have required the covered financial institution’s board of directors, or a committee thereof, to receive data and analysis from management and other sources sufficient to allow the board, or committee thereof, to assess whether the overall design and performance of the institution’s incentive-based compensation arrangements were consistent with section 956. Many commenters on the 2011 Proposed Rule expressed concern that the proposed requirements in the 2011 Proposed Rule would have inappropriately expanded the traditional ‘‘oversight’’ role of the board and would have required the board to exercise judgment in areas that traditionally have been—and, in the view of some commenters, are best left to—the expertise and prerogative of management. Commenters suggested that the proposed requirement instead place responsibility on management to conduct a formal assessment of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes. The Agencies agree that management should be responsible for conducting such an assessment and section ll.10(b)(2) of the proposed rule would thus place this responsibility on management, while requiring input from risk and audit committees, or groups performing similar functions, and from the covered institutions’ risk management and audit functions. Under the proposed rule, the board’s primary focus would be oversight of incentivebased compensation program and arrangements, while management would be expected to implement a program consistent with the vision of the board. 10.1. The Agencies invite comment on this provision generally and whether the written assessments required under sections ll.10(b)(2) and ll.10(b)(3) 224 For example, the 2010 Federal Banking Agency Guidance notes that a banking organization’s risk-management processes and internal controls should reinforce and support the development and maintenance of balanced incentive compensation arrangements. E:\FR\FM\10JNP2.SGM 10JNP2 37740 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules of the proposed rule should be provided to the compensation committee on an annual basis or at more or less frequent intervals? 10.2. Are both reports required under § ll.10(b)(2) and (3) necessary to aid the compensation committee in carrying out its responsibilities under the proposed rule? Would one or the other be more helpful? Why or why not? mstockstill on DSK3G9T082PROD with PROPOSALS2 § ll.11 Policies and Procedures Requirements for Level 1 and Level 2 Covered Institutions Section ll.11 of the proposed rule would require Level 1 and Level 2 covered institutions to develop and implement certain minimum policies and procedures relating to their incentive-based compensation programs. Requiring covered institutions to develop and follow policies and procedures related to incentive-based compensation would help both covered institutions and regulators identify the incentive-based compensation risks to which covered institutions are exposed, and how these risks are managed so as not to incentivize inappropriate risk-taking by covered persons that could lead to material financial loss to the covered institution. The Agencies are not proposing to require specific policies and procedures of Level 3 covered institutions because these institutions are generally less complex and the impact to the financial system by risks taken at these covered institutions is not as significant as risks taken by covered persons at the larger, more complex covered institutions. In addition, by not requiring additional policies and procedures, Agencies intend to reduce burden on smaller covered institutions. In contrast, the larger Level 1 and Level 2 covered institutions generally will have more complex organizations that tend to conduct a wide range of business activities and therefore will need robust policies and procedures as part of their compliance programs.225 Therefore, under section ll.11 of the proposed rule, Level 3 covered institutions would not be subject to any specific requirements in this area, while Level 1 and Level 2 covered institutions would be required to develop and implement specific policies and procedures for their incentive-based compensation programs. Section ll.11 of the proposed rule would identify certain areas that the policies and procedures of Level 1 and 225 See Federal Reserve SR Letter 08–08, ‘‘Compliance Risk Management Programs and Oversight at Large Banking Organizations with Complex Compliance Profiles’’ (October 16, 2008). VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 Level 2 covered institutions would, at a minimum, have to address. The list is not exhaustive. Instead, it is meant to indicate the policies and procedures that would, at a minimum, be necessary to carry out the requirements in other sections of the proposed rule. The development and implementation of the policies and procedures under section ll.11 of the proposed rule would help to ensure and monitor compliance with the requirements set forth in section 956 and the other requirements in the proposed rule because the policies and procedures would set clear expectations for covered persons and allow the Agencies to better understand how a covered institution’s incentive-based compensation program operates. Section ll.11(a) of the proposed rule would contain the general requirement that the policies and procedures be consistent with the prohibitions and requirements under the proposed rule. Other parts of section ll.11 of the proposed rule would help to ensure and monitor compliance with specific portions of the proposed rule. Under section ll.11(b) of the proposed rule, a Level 1 or Level 2 covered institution would have to develop and implement policies and procedures that specify the substantive and procedural criteria for the application of forfeiture and clawback, including the process for determining the amount of incentive-based compensation to be clawed back. These policies and procedures would provide covered persons with notice of the circumstances that would lead to forfeiture and clawback at their covered institutions, including any circumstances identified by the covered institution in addition to those required under the proposed rule. They would also help ensure consistent application of forfeiture and clawback by establishing a common set of expectations. Policies and procedures should make clear the triggers that will result in consideration of forfeiture, downward adjustment, and clawback; should indicate what individuals or committees are responsible for identifying, escalating and resolving these issues in such cases; should ensure that control functions contribute relevant information and participate in any decisions; and should set out a clear process for determining responsibility for the events triggering the forfeiture and downward adjustment review including provisions requiring appropriate input from covered employees under consideration for forfeiture or clawback. PO 00000 Frm 00072 Fmt 4701 Sfmt 4702 The proposed rule also would require that Level 1 and Level 2 covered institutions’ policies and procedures require the maintenance of documentation of final forfeiture, downward adjustment, and clawback decisions under section ll.11(c) of the proposed rule. Documentation would allow control functions and the Agencies to evaluate compliance with the requirements of section ll.7 of the proposed rule. The Agencies are proposing this requirement because they have found that it is critical that forfeiture and downward adjustment reviews at covered institutions be supported by effective governance to ensure consistency, fairness and robustness of all related decisionmaking. Section ll.11(d) of the proposed rule would include a requirement for policies and procedures of Level 1 and Level 2 covered institutions that would specify the substantive and procedural criteria for acceleration of payments of deferred incentive-based compensation to a covered person consistent with sections ll.7(a)(1)(iii)(B) and ll .7(a)(2)(iii)(B) of the proposed rule. Under section ll.7 of the proposed rule, acceleration of vesting of incentive-based compensation that is required to be deferred under such section would only be permitted in the case of death or disability. A Level 1 or Level 2 covered institution would have to have policies and procedures that describe how disability would be evaluated for purposes of determining whether to accelerate payments of deferred incentive-based compensation. Section ll.11(e) would require Level 1 and Level 2 covered institutions to have policies and procedures that identify and describe the role of any employees, committees, or groups authorized to make incentive-based compensation decisions, including when discretion is authorized. A Level 1 or Level 2 covered institution’s policies and procedures would also have to describe how discretion is expected to be exercised in order to appropriately balance risk and reward and how the incentive-based compensation arrangements will be monitored under sections ll.11(f) and (h) of the proposed rule, respectively. Related to the requirements regarding disclosure under sections ll.4(f) and ll.5 of the proposed rule, under section ll.11(g), a Level 1 or Level 2 covered institution would need to have policies and procedures that require the covered institution to maintain documentation of the establishment, implementation, modification, and monitoring of incentive-based E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 compensation arrangements sufficient to support the covered institution’s decisions. Section ll.11(i) would require the policies and procedures to specify the substantive and procedural requirements of the independent compliance program, consistent with section ll.9(a)(2). And section ll .11(j) would require policies and procedures that address the appropriate roles for risk management, risk oversight, and other control function personnel in the covered institution’s processes for (1) designing incentivebased compensation arrangements and determining awards, deferral amounts, deferral periods, forfeiture, downward adjustment, clawback, and vesting, and (2) assessing the effectiveness of incentive-based compensation arrangements in restraining inappropriate risk-taking. The Agencies anticipate that some Level 1 and Level 2 covered institutions that have international operations might choose to adopt enterprise-wide incentive-based compensation policies and procedures. The Agencies recognize that such policies and procedures, when utilized by various subsidiary institutions, may need to be further modified to reflect local regulation and the requirements of home country regulators in the case of international institutions and tailored to a certain extent by line of business, legal entity, or business model. 11.1. The Agencies invite general comment on the proposed policies and procedures requirements for Level 1 and Level 2 covered institutions under section ll.11 of the proposed rule. § ll.12 Indirect Actions Section ll.12 of the proposed rule would prohibit a covered institution from doing indirectly what it cannot do directly under the proposed rule. Section ll.12 would apply all of the proposed rule’s requirements and prohibitions to actions taken by covered institutions indirectly or through or by any other person. Section ll.12 is substantially the same as section ll.7 of the 2011 Proposed Rule. The Agencies did not receive any comments on section ll.7 of the 2011 Proposed Rule. By subjecting such indirect actions by covered institutions to all of the proposed rule’s requirements and prohibitions, section ll.12 would implement the directive in section 956(b) to adopt rules that prohibit any type of incentive-based payment arrangement, or any feature of any such arrangement, that the Agencies determine encourages inappropriate risks by covered institutions (1) by VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 providing excessive compensation, fees, or benefits or (2) that could lead to material financial loss. The Agencies are concerned that a covered institution may take indirect actions in order to avoid application of the proposed rule’s requirements and prohibitions. For example, a covered institution could attempt to make substantial numbers of its covered persons independent contractors for the purpose of avoiding application of the proposed rule’s requirements and prohibitions. A covered institution could also attempt to make substantial numbers of its covered persons employees of another entity for the purpose of avoiding application of the proposed rule’s requirements and prohibitions. If left unchecked, such indirect actions could encourage inappropriate risk-taking by providing covered persons with excessive compensation or could lead to material financial loss at a covered institution. The Agencies, however, do not intend to disrupt indirect actions, including independent contractor or employment relationships, not undertaken for the purpose of avoiding application of the proposed rule’s requirements and prohibitions. Thus, the Agencies would apply the proposed rule regardless of how covered institutions classify their actions, while also recognizing that covered institutions may legitimately engage in activities that are outside the scope of section 956 and the proposed rule.226 NCUA’s proposed rule also would clarify that covered credit unions may not use CUSOs to avoid the requirements of the proposed rule, such as by using CUSOs to maintain noncompliant incentive-based compensation arrangements on behalf of senior executive officers or significant risk-takers of Federally insured credit unions. 12.1. Commenters are invited to address all aspects of section ll.12, including any examples of other indirect actions that the Agencies should consider. § ll.13 Enforcement By its terms, section 956 applies to any depository institution and any depository institution holding company (as those terms are defined in section 3 of the FDIA), any broker-dealer registered under section 15 of the Securities Exchange Act, any credit union, any investment adviser (as that term is defined in the Investment 226 The Agencies note, however, that section 956 of the Dodd-Frank Act does not, and the proposed rule would not, limit the authority of the Agencies under other provisions of applicable law and regulations. PO 00000 Frm 00073 Fmt 4701 Sfmt 4702 37741 Advisers Act of 1940), the Federal National Mortgage Association, and the Federal Home Loan Mortgage Corporation. Section 956 also applies to any other financial institution that the appropriate Federal regulators jointly by rule determine should be treated as a covered financial institution for purposes of section 956. Section 956(d) also specifically sets forth the enforcement mechanism for rules adopted under that section. The statute provides that section 956 and the implementing rules shall be enforced under section 505 of the Gramm-LeachBliley Act and that a violation of section 956 or the regulations under section 956 will be treated as a violation of subtitle A of Title V of the Gramm-Leach-Bliley Act. Section 505 of the Gramm-LeachBliley Act provides for enforcement under section 1818 of title 12, by the appropriate Federal banking agency, as defined in section 1813(q) of title 12,227 in the case of national banks, Federal branches and Federal agencies of foreign banks, and any subsidiaries of such entities (except brokers, dealers, persons providing insurance, investment companies, and investment advisers); member banks of the Federal Reserve System (other than national banks), branches and agencies of foreign banks (other than Federal branches, Federal agencies, and insured State branches of foreign banks), commercial lending companies owned or controlled by foreign banks, organizations operating under section 25 or 25A of the Federal Reserve Act [12 U.S.C. 601 et seq., 611 et seq.], and bank holding companies and their nonbank subsidiaries or affiliates (except brokers, dealers, persons providing insurance, investment companies, and investment advisers); as well as banks insured by the FDIC (other than members of the Federal Reserve System), insured State branches of foreign banks, and any subsidiaries of such entities (except brokers, dealers, persons providing insurance, investment companies, and investment advisers); and savings associations the deposits of which are insured by the FDIC, and any subsidiaries of such savings associations (except brokers, dealers, persons providing insurance, investment companies, and investment advisers). The Gramm-Leach-Bliley Act also provides for enforcement under the following: (1) Federal Credit Union Act 227 For purposes of section 1813(q), the appropriate Federal banking agency for institutions listed in paragraphs (A) and (D) is the OCC; for institutions listed in paragraphs (B), the Board; and for institutions listed in paragraph (C), the FDIC. 12 U.S.C. 1813(q). E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37742 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules [12 U.S.C. 1751 et seq.], by the Board of the NCUA with respect to any federally insured credit union, and any subsidiaries of such an entity; (2) the Securities Exchange Act of 1934 [15 U.S.C. 78a et seq.], by the SEC with respect to any broker or dealer; (3) the Investment Company Act of 1940 [15 U.S.C. 80a–1 et seq.], by the SEC with respect to investment companies; (4) the Investment Advisers Act of 1940 [15 U.S.C. 80b–1 et seq.], by the SEC with respect to investment advisers registered with the Commission under such Act; (5) State insurance law, in the case of any person engaged in providing insurance, by the applicable State insurance authority of the State in which the person is domiciled, subject to section 6701 of the Gramm-LeachBliley Act; (6) the Federal Trade Commission Act [15 U.S.C. 41 et seq.], by the Federal Trade Commission for any other financial institution or other person that is not subject to the jurisdiction of any agency or authority listed above; and (7) subtitle E of the Consumer Financial Protection Act of 2010 [12 U.S.C. 5561 et seq.], by the Bureau of Consumer Financial Protection, in the case of any financial institution and other covered person or service provider that is subject to the jurisdiction of the Bureau. The proposed rule includes these enforcement provisions as provided in section 956. FHFA’s enforcement authority for the proposed rule derives from its authorizing statute, the Safety and Soundness Act. FHFA is not one of the ‘‘Federal functional regulators’’ listed in section 505 of the Gramm-Leach-Bliley Act. Additionally, the applicability of Title V of the Gramm-Leach-Bliley Act to Fannie Mae and Freddie Mac is limited by their conditional exclusion from that Title’s definition of ‘‘financial institution.’’ But there is no evidence that Congress intended to exclude FHFA, or Fannie Mae and Freddie Mac, from enforcement of the proposed rule. To the contrary, Congress specifically included Fannie Mae and Freddie Mac as covered financial institutions and FHFA as an ‘‘appropriate federal regulator’’ in section 956, and FHFA requires no additional enforcement authority. The Safety and Soundness Act provides FHFA with enforcement authority for all laws and regulations that apply to its regulated entities. 13.1. The Agencies invite comment on all aspects of section ll.13. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 § ll.14 NCUA and FHFA Covered Institutions in Conservatorship, Receivership, or Liquidation The NCUA’s and FHFA’s proposed rules each include a section ll.14 that would address those instances when a covered institution is placed in conservatorship, receivership, or liquidation, including limited-life regulated entities, under their respective authorizing statutes, the Federal Credit Union Act or the Safety and Soundness Act.228 If a covered institution is placed in conservatorship, receivership, or liquidation, the conservator, receiver, or liquidating agent, respectively, and not the covered institution’s board or management, has ultimate authority over all compensation arrangements, including any incentive-based compensation for covered persons. When determining or approving any incentive-based compensation plans for covered persons at such a covered institution, the conservator, receiver, or liquidating agent will implement the purposes of the Dodd-Frank Act by prohibiting excessive incentive-based compensation and incentive-based compensation that encourages inappropriate risk-taking. Institutions placed in conservatorship, receivership, or liquidation may be subject to different needs and circumstances with respect to attracting and retaining talent than other types of covered institutions. In order to attract and retain qualified individuals at a covered institution in conservatorship, for example, the conservator may determine that while a significant portion of a covered person’s incentive-based compensation should be deferred, due to the uncertain future of the covered institution in conservatorship, the deferral period would be shorter than that set forth in the deferral provisions of the proposed rule. In another example, where a conservator assumes the roles and responsibilities of the covered institution’s board and its committees, the conservator may determine that it is not necessary for the board of the covered institution, if any remains in conservatorship, to approve a material adjustment to a senior executive officer’s incentive-based compensation arrangement as described by the governance section of the proposed rule. Certain provisions of the proposed rule, such as the deferral and governance provisions, may not be 228 The FDIC’s proposed rule would not apply to institutions for which the FDIC is appointed receiver under the FDIA or Title II of the DoddFrank Act, as appropriate, as those statutes govern such cases. PO 00000 Frm 00074 Fmt 4701 Sfmt 4702 appropriate for institutions in conservatorship, receivership, or liquidation, and the incentive-based compensation structure that best meets their needs while implementing the purposes of the Dodd-Frank Act is appropriately left to the conservator, receiver, or liquidating agent, respectively. Under the applicable section ll.14 of the proposed rule, if a covered institution is placed in conservatorship, receivership, or liquidation under the Safety and Soundness Act, for FHFA’s proposed rule, or the Federal Credit Union Act, for the NCUA’s proposed rule, the respective conservator, receiver, or liquidating agent would have the responsibility to fulfill the requirements and purposes of 12 U.S.C. 5641. The conservator, receiver, or liquidating agent also has the discretion to determine transition terms should the covered institution cease to be in conservatorship, receivership, or liquidation. 14.1. Commenters are invited to address all aspects of section ll.14 of the proposed rule. SEC Amendment to Exchange Act Rule 17a–4 The SEC is proposing an amendment to Exchange Act Rule 17a–4(e) (17 CFR 240.17a–4(e)) to require that brokerdealers maintain the records required by § ll.4(f), and for Level 1 and Level 2 broker-dealers, §§ ll.5 and ll.11, in accordance with the recordkeeping requirements of Exchange Act Rule 17a– 4. Exchange Rule 17a–4 establishes the general formatting and storage requirements for records that brokerdealers are required to keep. For the sake of consistency with other brokerdealer records, the SEC believes that broker-dealers should also keep the records required by § ll.4(f), and for Level 1 and Level 2 broker-dealers, §§ l l.5 and ll.11, in accordance with these requirements. New paragraph (e)(10) of Exchange Act Rule 17a–4 would require Level 1, Level 2, and Level 3 broker-dealers to maintain and preserve in an easily accessible place the records required by § ll.4(f), and for Level 1 and Level 2 broker-dealers, the records required by §§ ll.5 and ll.11. Paragraph (f) of Exchange Act Rule 17a–4 provides that the records a broker-dealer is required to maintain and preserve under Exchange Act Rule 17a–3 (17 CFR 240.17a–3) and Exchange Act Rule 17a–4 may be immediately produced or reproduced on micrographic media or by means of electronic storage media. Paragraph (j) of Exchange Act Rule 17a–4 requires a broker-dealer, which would include a E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules broker-dealer that is a Level 1, Level 2, or Level 3 covered institution pursuant to the proposed rules, to furnish promptly to a representative of the SEC legible, true, complete, and current copies of those records of the brokerdealer that are required to be preserved under Exchange Act Rule 17a–4, or any other records of the broker-dealer subject to examination under section 17(b) of the Securities Exchange Act of 1934 that are requested by the representative.229 SEC Amendment to Investment Advisers Act Rule 204–2 mstockstill on DSK3G9T082PROD with PROPOSALS2 The SEC is proposing an amendment to rule 204–2 under the Investment Advisers Act (17 CFR 275.204–2) to require that investment advisers registered or required to be registered under section 203 of the Investment Advisers Act (15 U.S.C. 80b–3) maintain the records required by § ll.4(f) and, for those investment advisers that are Level 1 or Level 2 covered institutions, §§ ll.5 and ll.11, in accordance with the recordkeeping requirements of rule 204–2. New paragraph (a)(19) of rule 204–2 would require investment advisers subject to rule 204–2 that are Level 1, Level 2, or Level 3 covered institutions to make and keep true, accurate, and current the records required by, and for the period specified in, § ll.4(f) and, for those investment advisers that are Level 1 or Level 2 covered institutions, the records required by, and for the periods specified in, §§ ll.5 and ll.11. Rule 204–2 establishes the general recordkeeping requirements for investment advisers registered or required to be registered under section 203 of the Investment Advisers Act. For the sake of consistency with other investment adviser records, the SEC is proposing that this rule require such investment advisers that are covered institutions to keep the records required by § ll.4(f) and those that are Level 1 or Level 2 covered institutions to keep the records required by §§ ll.5 and ll.11 in accordance with the requirements of rule 204–2. 229 For a discussion generally of Exchange Act Rule 17a–4, see Recordkeeping and Reporting Requirements for Security-Based Swap Dealers, Major Security-Based Swap Participants, and Broker-Dealers; Capital Rule for Certain SecurityBased Swap Dealers, Release No. 34–71958 (Apr. 17, 2014), 79 FR 25194 (May 2, 2014). VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 III. Appendix to the Supplementary Information: Example Incentive-Based Compensation Arrangement and Forfeiture and Downward Adjustment Review For an incentive-based compensation arrangement to meet the requirements of the proposed rule, particularly the requirement that such an arrangement appropriately balance risk and reward, covered institutions would need to look holistically at the entire incentive-based arrangement. Below, for purposes of illustration only, the Agencies outline an example of a hypothetical incentivebased compensation arrangement that would meet the requirements of the proposed rule and an example of how a forfeiture and downward adjustment review might be conducted. These illustrations do not cover every aspect of the proposed rule. They are provided as an aid to understanding the proposed rule and would not carry the force and effect of law or regulation, if issued as a companion to a final rule. Reviewing these illustrations does not substitute for a review of the proposed rule. This example assumes that the final rule was published as proposed and all incentive-based compensation programs and arrangements were required to comply on or before January 1, 2020. Ms. Ledger: Senior Executive Officer at Level 2 Covered Institution Ms. Ledger is the chief financial officer at a bank holding company, henceforth ‘‘ABC,’’ which has $200 billion in average total consolidated assets. Under the definitions of the proposed rule Ms. Ledger would be a senior executive officer and ABC would be a Level 2 covered institution.230 Ms. Ledger is provided incentivebased compensation under three separate incentive-based compensation plans. The first plan, the ‘‘Annual Executive Plan,’’ is applicable to all senior executive officers at ABC, and requires assessment over the course of one calendar year. The second plan, the ‘‘Annual Firm-Wide Plan,’’ is applicable to all employees at ABC, and is also based on a one-year performance period that coincides with the calendar year. The third plan, ‘‘Ms. Ledger’s LTIP,’’ is applicable only to Ms. Ledger, and requires assessment of performance over a three-year performance period that begins on January 1 of year 1 and ends on December 31 of year 3. These three plans together comprise Ms. Ledger’s incentive-based compensation arrangement. 230 See the definitions of ‘‘senior executive officer’’ and ‘‘Level 2 covered institution’’ in section ll.2 of the proposed rule. PO 00000 Frm 00075 Fmt 4701 Sfmt 4702 37743 The proposed rule would impose certain requirements on Ms. Ledger’s incentive-based compensation arrangement. Section ll.4(a)(1) of the proposed rule would require that Ms. Ledger’s entire incentive-based compensation arrangement, and each feature of that arrangement, not provide excessive compensation. ABC would be required to consider the six factors listed in section ll.4(b) of the proposed rule, as well as any other factors that ABC finds relevant, in evaluating whether Ms. Ledger’s incentive-based compensation arrangement provides excessive compensation before approving Ms. Ledger’s incentive-based compensation arrangement. Balance Under section ll.4(c)(1) of the proposed rule, the entire arrangement would be required to appropriately balance risk and reward. ABC would be expected to consider the risks that Ms. Ledger’s activities pose to the institution, and the performance that Ms. Ledger’s incentive-based compensation arrangement rewards. ABC might consider both the type and target level of any associated performance measures; how all performance measures would work together under the three plans; the form of incentive-based compensation; the recourse ABC has to reduce incentivebased compensation once awarded (through forfeiture) 231 including under the conditions outlined in section ll .7 of the proposed rule; the ability ABC has to use clawback of incentive-based compensation once vested, including under the conditions outlined in section ll.7 of the proposed rule; and any overlapping performance periods of the various incentive-based compensation plans, which apply to Ms. Ledger. Under section ll.4(d) of the proposed rule, Ms. Ledger’s incentivebased compensation arrangement would be required to include both financial and non-financial measures of performance. These measures would need to include considerations of risktaking that are relevant to Ms. Ledger’s role within ABC and to the type of business in which Ms. Ledger is engaged. They also would need to be appropriately weighted to reflect risktaking. The arrangement would be required to allow non-financial 231 This requirement for balance under section ll.4(c)(1) would not, however require forfeiture, or any specific forfeiture measure, for any particular covered person. As discussed below, sections ll.7 and ll.8 contain specific requirements applicable to senior executive officers at Level 1 and Level 2 covered institutions. E:\FR\FM\10JNP2.SGM 10JNP2 37744 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules measures of performance to override financial measures of performance when appropriate in determining Ms. Ledger’s incentive-based compensation. Any amounts to be awarded under Ms. Ledger’s arrangement would be subject to adjustment to reflect ABC’s actual losses, inappropriate risks Ms. Ledger took or was accountable for others taking, compliance deficiencies Ms. Ledger was accountable for, or other measures or aspects of Ms. Ledger’s and ABC’s financial and non-financial performance. For example, the Annual Firm-Wide Plan might use a forwardlooking internal profit measure that takes into account stressed conditions as a proxy for liquidity risk that Ms. Ledger’s activities pose to ABC and thus mitigates against incentives to take imprudent liquidity risk. It might also include limits on liquidity risk, the repeated breach of which would result in non-compliance with a key nonfinancial performance objective. In practice, each incentive-based compensation plan will include various measures of performance, and under the proposed rule, each plan would be required to include both financial and non-financial measures. The Annual Firm-Wide Plan may be largely based on the change in value of ABC’s equity over the performance year, but that cannot be the only basis for incentive-based compensation awarded under that plan. Non-financial measures of Ms. Ledger’s risk-taking activity would have to be taken into account in determining the incentive-based compensation awarded under that plan, and those non-financial measures would need to be appropriately weighted so that they could override financial measures. Even if ABC’s equity performed very well over the performance year, if Ms. Ledger was found to have violated risk performance measures, Ms. Ledger should not be awarded the full target of incentive-based compensation from the plan. Because Ms. Ledger is a senior executive officer at a Level 2 covered institution, Ms. Ledger’s incentive-based compensation arrangement would not be considered to appropriately balance risk and reward unless it was structured to be consistent with the requirements set forth in sections ll.7 and ll.8 of the proposed rule. The incentive-based compensation awarded to Ms. Ledger would not be permitted to be based solely on relative performance measures 232 or be based solely on transaction revenue or volume.233 The Annual Executive Plan may include a measure of ABC’s TSR relative to its peer group, but that plan would comply with the proposed rule only if other absolute measures of ABC’s or Ms. Ledger’s performance were also included (e.g., achievement of a threeyear average return on risk adjusted capital). Similarly, a plan that applied to significant risk-takers who were engaged in trading might include transaction volume as one of the financial performance measures, but that plan would comply with the proposed rule only if it also included other factors, such as measurement of transaction quality or the significant risk-taker’s compliance with the institution’s riskmanagement policies. Award of Incentive-Based Compensation for Performance Periods Ending December 31, 2024 Ms. Ledger’s incentive-based compensation is awarded on January 31, 2025. The Annual Executive Plan and the Annual Firm-Wide Plan are awarded on this date for the performance period starting on January 1, 2024 and ending on December 31, 2024. Ms. Ledger’s LTIP will be awarded on this date for the performance period starting on January 1, 2022 and ending on December 31, 2024. This example assumes ABC’s share price on December 31, 2024 (the end of the performance period) is $50. Ms. Ledger’s target incentive-based compensation award amount under the Annual Executive plan is $60,000 and 1,000 shares of ABC.234 Under the Annual Firm-Wide Plan, Ms. Ledger’s target incentive-based compensation award amount is $30,000. Finally, under Ms. Ledger’s LTIP, her target incentiveTarget award mstockstill on DSK3G9T082PROD with PROPOSALS2 Incentive-based compensation Cash ($) Annual Executive Plan .................................. Annual Firm-Wide Plan ................................. Ms. Ledger’s LTIP ......................................... 232 See 233 See 60,000 30,000 40,000 section ll.8(c) of the proposed rule. section ll.8(d) of the proposed rule. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 Equity (#) Value of equity ($) 1,000 ................ 2,000 50,000 ................ 100,000 Maximum award Total value ($) 110,000 30,000 140,000 Equity (#) Value of equity ($) 1,250 ................ 2,500 62,500 ................ 125,000 Cash ($) 75,000 37,500 50,000 234 That is, if Ms. Ledger meets all of the performance measure targets set out under that plan, she will be awarded both $60,000 in cash and 1,000 shares of ABC stock. PO 00000 Frm 00076 based compensation award amount is $40,000 and 2,000 shares of ABC. To be consistent with the proposed rule, the maximum incentive-based compensation amounts that ABC would be allowed to award to Ms. Ledger are 125 percent of the target amount, which would amount to: $75,000 and 1,250 shares under the Annual Executive Plan; $37,500 under the Annual FirmWide Plan; and $50,000 and 2,500 shares under Ms. Ledger’s LTIP. If Ms. Ledger were implicated in a forfeiture and downward adjustment review during the performance period, ABC would be expected to consider whether and by what amount to reduce the amounts awarded to Ms. Ledger. As part of that review, ABC would be expected to consider all of the amounts that could be awarded to Ms. Ledger under the Annual Executive Plan, Annual Firm-Wide Plan, and Ms. Ledger’s LTIP for downward adjustment before any incentive-based compensation were awarded to Ms. Ledger.235 Regardless of whether a downward forfeiture and downward adjustment review occurred, ABC would be expected to evaluate Ms. Ledger’s performance, including Ms. Ledger’s risk-taking activities, at or near the end of the performance period (December 31, 2024). ABC would be required to use non-financial measures of performance, and particularly measures of risk-taking, to determine Ms. Ledger’s incentivebased compensation award, possibly decreasing the amount Ms. Ledger would be awarded if only financial measures were taken into account.236 Based on performance and taking into account Ms. Ledger’s risk-taking behavior, ABC decides to award Ms. Ledger: $30,000 and 1,000 shares under the Annual Executive Plan; $35,000 under the Annual Firm-Wide Plan; and $40,000 and 2,000 shares under Ms. Ledger’s LTIP. Valuing the ABC equity at the time of award, the total value of Ms. Ledger’s award under the Annual Executive Plan is $80,000, under the Annual Firm-Wide Plan is $35,000, and under Ms. Ledger’s LTIP is $140,000. Fmt 4701 Sfmt 4702 Actual award Total value ($) Cash 1 ($) 137,500 37,500 175,000 235 See 236 See E:\FR\FM\10JNP2.SGM 30,000 35,000 40,000 Equity 2 (#) Value of equity ($) 1,000 ................ 2,000 50,000 ................ 100,000 Total value ($) 80,000 35,000 140,000 section ll.7(b) of the proposed rule. section ll.4(d)(2) of the proposed rule. 10JNP2 37745 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules Target award Incentive-based compensation Cash ($) Total Incentive-Based Compensation .... Value of equity ($) Equity (#) 130,000 3,000 150,000 Maximum award Total value ($) Cash ($) 280,000 162,500 Equity (#) Actual award Value of equity ($) 3,750 Total value ($) 87,500 Cash 1 350,000 105,000 ($) Equity 2 (#) 3,000 Value of equity ($) 150,000 Total value ($) 255,000 1 The amount of actual cash award ABC chose to award. 2 The amount of actual equity award ABC chose to award. To calculate the minimum required deferred amounts, ABC would have to aggregate the amounts awarded under both the Annual Executive Plan ($80,000) and the Annual Firm-Wide Plan ($35,000), because each has the same performance period, which is less than three years, to determine the total amount of qualifying incentive-based compensation awarded ($115,000).237 At least 50 percent of that qualifying incentive-based compensation would be Total award Incentive-based compensation equity.239 ABC would also have the flexibility to defer amounts awarded from either the Annual Executive Plan or the Annual Firm-Wide Plan. In this example, ABC chooses to defer $27,500 of cash and 650 shares from Ms. Ledger’s award from the Annual Executive Plan, which has a total value of $60,000 at the time of the award, for three years and none of the award under the Annual Firm-Wide Plan.240 required to be deferred for at least three years.238 Thus, ABC would be required to defer cash and equity with an aggregate value of at least $57,500 from qualifying incentive-based compensation. ABC would have the flexibility to defer the amounts awarded in cash or in equity, as long as the total deferred incentive-based compensation was composed of both substantial amounts of deferred cash and substantial amounts of deferred Equity (#) Cash ($) Value of equity ($) Minimum required deferred Total value ($) Actual deferred Total value ($) Deferral rate (%) Total value ($) Cash 2 ($) Equity 3 (#) Value of equity ($) Total value ($) Annual Executive Plan ...................................................... Annual Firm-Wide Plan ..................................................... Qualified Incentive-Based Compensation ......................... Ms. Ledger’s LTIP ............................................................. 30,000 35,000 65,000 40,000 1,000 ................ 1,000 2,000 50,000 ................ 50,000 100,000 80,000 35,000 115,000 140,000 ................ ................ 115,000 140,000 ................ ................ 50 50 ................ ................ 57,500 70,000 27,500 ................ 27,500 35,000 650 ................ 650 700 32,500 ................ 32,500 35,000 60,000 ................ 60,000 70,000 Total Incentive-Based Compensation ........................ 105,000 3,000 150,000 255,000 255,000 50 127,500 62,500 1,350 67,500 130,000 1 The aggregate amount from both the Annual Executive Plan and Annual Firm-Wide Plan. 2 The amount of actual cash award ABC chose to defer. 3 The amount of actual equity award ABC chose to defer. mstockstill on DSK3G9T082PROD with PROPOSALS2 Vesting Schedule ABC would have the flexibility to determine the schedule by which this deferred incentive-based compensation would be eligible for vesting, as long as the cumulative total of the deferred incentive-based compensation that has been made eligible for vesting by any given year is not greater than the cumulative total that would have been eligible for vesting had the covered institution made equal amounts eligible for vesting each year.241 With deferred qualifying incentive-based compensation valued at $60,000 and three-year vesting, no more than $20,000 would be allowed to be eligible to vest on December 31, 2025, and no more than $40,000 would be eligible to vest on or before December 31, 2026. At least $20,000 would need to be eligible to vest on December 31, 2027, to be consistent with the proposed rule. In this example, ABC decides to make none of the deferred award from the Annual Executive Plan eligible for section ll.7(a)(1) of the proposed rule. sections ll.7(a)(1)(i)(C) and ll .7(a)(1)(ii)(B) of the proposed rule. 239 See section ll.7(a)(4)(i) of the proposed rule. 240 Ms. Ledger’s entire award under the Annual Firm-Wide Plan, $35,000, and remaining award under the Annual Executive Plan, $2,500 and 350 shares, could vest immediately. 237 See 238 See VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 vesting on December 31, 2025; to make $13,750 and 325 shares (total value of cash and equity $30,000) eligible for vesting on December 31, 2026; and to make $13,750 and 325 shares (total value of cash and equity $30,000) eligible for vesting on December 31, 2027. Ms. Ledger’s LTIP has a performance period of three years, so Ms. Ledger’s LTIP would meet the definition of a ‘‘long-term incentive-plan’’ under the proposed rule.242 At least 50 percent of Ms. Ledger’s LTIP amount ($140,000) would be required to be deferred for at least one year.243 Thus, ABC would be required to defer cash and equity with an aggregate value of at least $70,000 from Ms. Ledger’s LTIP, which would be eligible for vesting on December 31, 2025. ABC would have flexibility to defer the amounts awarded in cash or in equity, as long as the total deferred incentive-based compensation were composed of both substantial amounts of deferred cash and substantial amounts of deferred equity.244 If ABC 241 See section ll.7(a)(1)(iii) of the proposed chooses to defer amounts awarded from Ms. Ledger’s LTIP for longer than one year, ABC would have flexibility to determine the schedule on which it would be eligible for vesting, as long as the cumulative total of the deferred incentive-based compensation that has been made eligible for vesting by any given year is not greater than the cumulative total that would have been eligible for vesting had the covered institution made equal amounts eligible for vesting in one year.245 In this example, ABC chooses to defer $35,000 of cash and 700 shares of the award from Ms. Ledger’s LTIP, which has a total value of $70,000 at the time of the award, for one year.246 The nondeferred amount ($35,000 and 700 shares) could vest at the time of the award on January 31, 2025. In summary, Ms. Ledger would receive $42,500 and 1,650 shares (a total value of $125,000) immediately after December 31, 2024.247 A total of $35,000 and 700 shares (total value $70,000) would be eligible to vest on 245 See section ll.7(a)(2)(iii) of the proposed rule. rule. 242 See the definition of ‘‘long-term incentive plan’’ in section ll.2 of the proposed rule. 243 See sections ll.7(a)(2)(i)(C) and ll .7(a)(2)(ii)(B) of the proposed rule. 244 See section ll.7(a)(4)(i) of the proposed rule. 246 Ms. Ledger’s remaining award under Ms. Ledger’s LTIP would vest immediately. 247 This amount would represent $2,500 and 350 shares awarded under the Annual Executive Plan, $35,000 awarded under the Annual Firm-Wide Plan and $5,000 and 1,300 shares awarded under Ms. Ledger’s LTIP. PO 00000 Frm 00077 Fmt 4701 Sfmt 4702 E:\FR\FM\10JNP2.SGM 10JNP2 37746 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules December 31, 2025. A total of $13,750 and 325 shares (total value $30,000) would be eligible to vest on December 31, 2026. Finally, a total of $13,750 and 325 shares (total value $30,000) would again be eligible to vest on December 31, 2027. Immediate amounts payable Incentive-based compensation Equity (#) Cash ($) Total amounts deferred Value of equity ($) Total value ($) Cash ($) Equity (#) Value of equity ($) Total value ($) Annual Executive Plan ..... Annual Firm-Wide Plan .... Ms. Ledger’s LTIP ............ $2,500 35,000 5,000 350 .................... 1,300 $17,500 .................... 65,000 $20,000 35,000 70,000 $27,500 .................... 35,000 650 .................... 700 $32,500 .................... 35,000 $60,000 .................... 70,000 Total Incentive-Based Compensation ....... 42,500 1,650 82,500 125,000 62,500 1,350 67,500 130,000 VESTING SCHEDULE 12/31/2025 12/31/2026 Incentive-based compensation Cash ($) Equity (#) Value of equity ($) Annual Executive Plan .................................. Ms. Ledger’s LTIP ......................................... Amount Eligible for Vesting .......................... Remaining Unvested Amount ....................... ................ $35,000 ................ ................ ................ 700 ................ ................ ................ $35,000 ................ ................ Use of Options in Deferred IncentiveBased Compensation If, under the total award amount outlined above, ABC chooses to award Ms. Ledger incentive-based compensation partially in the form of options, and chooses to defer the vesting of those options, no more than $38,250 worth of those options (the equivalent of 15 percent of the aggregate incentivebased compensation awarded to Ms. Ledger) would be eligible to be treated as deferred incentive-based compensation.248 As an example, ABC may award Ms. Ledger options that have a value at the end of the performance period of $10 and deferred vesting. ABC may choose to award Ms. Ledger incentive-based compensation with a total value of $255,000 in the following forms: $30,000 in cash, 640 shares of 12/31/2027 Equity (#) Total value ($) $13,750 ................ ................ ................ Total value ($) Cash ($) Equity (#) Value of equity ($) Total value ($) 325 ................ ................ ................ $16,250 ................ ................ ................ $30,000 ................ 30,000 30,000 $13,750 ................ ................ ................ 325 ................ ................ ................ $16,250 ................ ................ ................ $30,000 ................ 30,000 0 Cash ($) ................ $70,000 70,000 60,000 Value of equity ($) equity (valued at $32,000), and 1,800 options (valued at $18,000) under the Annual Executive Plan; $35,000 cash under the Annual Firm-Wide Plan; and $40,000 cash, 1,600 shares of equity (valued at $80,000), and 2,000 options (valued at $20,000) under Ms. Ledger’s LTIP. Of that award, ABC may defer: $27,500 in cash, 290 shares (valued at $14,500), and 1,800 options (valued at $18,000) under the Annual Executive Plan (total value of deferred $60,000); none of the award from the Annual Firm-Wide Plan; and $35,000 in cash, 300 shares (valued at $15,000) and 2,000 options (valued at $20,000) under Ms. Ledger’s LTIP (total value of deferred $70,000). The total value of options being counted as deferred incentivebased compensation would be $38,000, which would be 14.9 percent of the total incentive-based compensation awarded ($255,000). Assuming the vesting schedule is consistent with the proposed rule, Ms. Ledger’s incentivebased compensation arrangement would be consistent with the proposed rule, because: (1) The value of Ms. Ledger’s deferred incentive-based compensation under the Annual Executive Plan (which comprises all of Ms. Ledger’s deferred qualifying incentive-based compensation) is more than 50 percent of the value of Ms. Ledger’s total qualifying incentive-based compensation award ($115,000) and (2) the value of Ms. Ledger’s deferred incentive-based compensation under Ms. Ledger’s LTIP is 50 percent the value of Ms. Ledger’s incentive-based compensation awarded under a longterm incentive plan ($140,000). ALTERNATIVE SCENARIO 1: DEFERRED OPTIONS CONSISTENT WITH THE PROPOSED RULE Total award amounts Incentive-based compensation Equity (#) Cash ($) Value of equity ($) Options (#) Value of options ($) Total value ($) mstockstill on DSK3G9T082PROD with PROPOSALS2 Annual Executive Plan ............................. Annual Firm-Wide Plan ............................ Ms. Ledger’s LTIP .................................... $30,000 35,000 40,000 640 ........................ 1,600 $32,000 ........................ 80,000 1,800 ........................ 2,000 $18,000 ........................ 20,000 $80,000 35,000 140,000 Total .................................................. 105,000 2,240 112,000 3,800 38,000 255,000 ........................ ........................ ........................ 20,000 35,000 70,000 Amounts immediately payable Annual Executive Plan ............................. Annual Firm-Wide Plan ............................ Ms. Ledger’s LTIP .................................... 248 See $2,500 35,000 5,000 350 ........................ 1,300 $17,500 ........................ 65,000 ........................ ........................ ........................ section ll.7(a)(4)(ii). VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 PO 00000 Frm 00078 Fmt 4701 Sfmt 4702 E:\FR\FM\10JNP2.SGM 10JNP2 37747 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules ALTERNATIVE SCENARIO 1: DEFERRED OPTIONS CONSISTENT WITH THE PROPOSED RULE—Continued Total award amounts Incentive-based compensation Cash ($) Total .................................................. Value of equity ($) Equity (#) 42,500 1,650 82,500 Options (#) Value of options ($) Total value ($) ........................ ........................ 125,000 Total deferred amounts Annual Executive Plan ............................. Annual Firm-Wide Plan ............................ Ms. Ledger’s LTIP .................................... $27,500 ........................ 35,000 290 ........................ 300 $14,500 ........................ 15,000 1,800 ........................ 2,000 $18,000 ........................ 20,000 $60,000 ........................ 70,000 Total .................................................. 62,500 590 29,500 3,800 38,000 130,000 following forms: $30,000 In cash, 500 shares of equity (valued at $25,000), and 2,500 options (valued at $25,000) under 38,250 the Annual Executive Plan; $35,000 cash under the Annual Firm-Wide Plan; and $40,000 cash, 1,600 shares of equity 57,500 (valued at $80,000), and 2,000 options (valued at $20,000) under Ms. Ledger’s LTIP. Of that award, if ABC defers the following amounts, the arrangement 70,000 would not be consistent with the proposed rule: $27,500 in cash, 150 In contrast, if ABC chooses to award shares (valued at $7,500), and 2,500 Ms. Ledger more options than in the options (valued at $25,000) under the example above, Ms. Ledger’s incentiveAnnual Executive Plan (total value of based compensation arrangement may deferred $60,000); none of the award no longer be consistent with the from the Annual Firm-Wide Plan; and proposed rule. As a second alternative $35,000 in cash, 300 shares (valued at scenario, ABC may choose to award Ms. $15,000) and 2,000 options (valued at Ledger incentive-based compensation $20,000) under Ms. Ledger’s LTIP (total with a total value of $255,000 in the value of deferred $70,000). The total Aggregate Incentive-Based Compensation Awarded ........ Option Value at 15% Threshold Maximum ............................... Minimum Qualifying IncentiveBased Compensation—Deferral at 50% ......................... Minimum Incentive-Based Compensation Required under a Long-Term Incentive Plan—Deferral at 50% .......... $255,000 value of options would be $45,000, which would be 17.6 percent of the total incentive-based compensation awarded ($255,000). Thus, 675 of those options, or $6,750 worth, would not qualify to meet the minimum deferral requirements of the proposed rule. Combining qualifying incentive-based compensation and incentive-based compensation awarded under a longterm incentive plan, Ms. Ledger’s total minimum required deferral amount would be $127,500, and yet incentivebased compensation worth only $123,250 would be eligible to meet the minimum deferral requirements. ABC could alter the proportions of incentivebased compensation awarded and deferred in order to comply with the proposed rule. ALTERNATIVE SCENARIO 2: DEFERRED OPTIONS INCONSISTENT WITH THE PROPOSED RULE Total award amounts Incentive-based compensation Equity (#) Cash ($) Value of equity ($) Options (#) Value of options ($) Total value ($) Annual Executive Plan ............................. Annual Firm-Wide Plan ............................ Ms. Ledger’s LTIP .................................... $30,000 35,000 40,000 500 ........................ 1,600 $25,000 ........................ 80,000 2,500 ........................ 2,000 $25,000 ........................ 20,000 $80,000 35,000 140,000 Total .................................................. 105,000 2,100 105,000 4,500 45,000 255,000 Amounts immediately payable Annual Executive Plan ............................. Annual Firm-Wide Plan ............................ Ms. Ledger’s LTIP .................................... $2,500 35,000 5,000 350 ........................ 1,300 $17,500 ........................ 65,000 ........................ ........................ ........................ ........................ ........................ ........................ $20,000 35,000 70,000 Total .................................................. 42,500 1,650 82,500 ........................ ........................ 125,000 mstockstill on DSK3G9T082PROD with PROPOSALS2 Total deferred amounts Annual Executive Plan ............................. Annual Firm-Wide Plan ............................ Ms. Ledger’s LTIP .................................... $27,500 ........................ 35,000 150 ........................ 300 $7,500 ........................ 15,000 2,500 ........................ 2,000 $25,000 ........................ 20,000 $60,000 ........................ 70,000 Total .................................................. 62,500 450 22,500 4,500 45,000 130,000 VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 PO 00000 Frm 00079 Fmt 4701 Sfmt 4702 E:\FR\FM\10JNP2.SGM 10JNP2 37748 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules increase in the amount of deferred incentive-based compensation for the purposes of the proposed rule.251 ABC would be required to include 38,250 6,750 or clawback provisions in Ms. Ledger’s 675 options incentive-based compensation Incentive-Based Compensation arrangement that, at a minimum, Eligible to Meet the Minimum allowed for clawback for seven years Deferral Requirements .......... 123,250 following the date on which Ms. Ledger’s incentive-based compensation Other Requirements Specific to Ms. vested.252 These provisions would Ledger’s Incentive-Based Compensation permit ABC to recover up to 100 percent Arrangement of any vested incentive-based compensation if ABC determined that Under the proposed rule, ABC would Ms. Ledger engaged in certain not be allowed to accelerate the vesting of Ms. Ledger’s deferred incentive-based misconduct, fraud or intentional compensation, except in the case of Ms. misrepresentation of information, as described in section ll.7(c) of the Ledger’s death or disability, as determined by ABC pursuant to sections proposed rule. Thus, if in the year 2030, ABC determined that Ms. Ledger ll.7(a)(1)(iii)(B) and engaged in fraud in the year 2024, the ll.7(a)(2)(iii)(B). Before vesting, ABC may determine to entirety of the $42,500 and 1,650 shares of equity that vested immediately after reduce the amount of deferred 2024, and as well as any part of her incentive-based compensation that Ms. deferred incentive-based compensation Ledger receives pursuant to a forfeiture and downward adjustment review.249 If ($62,500 and 1,350 shares of equity) that actually had vested by 2030, could be Ms. Ledger, or an employee Ms. Ledger subject to clawback by ABC. Facts and managed, had been responsible for an circumstances would determine event triggering the proposed rule’s whether the ABC would actually seek to requirements for forfeiture and claw back amounts, as well as the downward adjustment review, ABC would be expected to consider all of the specific amount ABC would seek to recover from Ms. Ledger’s alreadyunvested deferred amounts from the Annual Executive Plan and Ms. Ledger’s vested incentive-based compensation. Finally, in order for Ms. Ledger’s LTIP for forfeiture before any incentiveincentive-based compensation based compensation vested even if the arrangement to appropriately balance event occurred outside of the relevant risk and reward, ABC would not be performance period for the awards permitted to purchase a hedging discussed in the example (i.e., January instrument or similar instrument on Ms. 1, 2022 to December 31, 2024).250 ABC Ledger’s behalf that would offset any may also rely on other performance decrease in the value of Ms. Ledger’s adjustments during the deferral period deferred incentive-based to appropriately balance Ms. Ledger’s compensation.253 incentive-based compensation arrangement. In this case ABC would Risk Management and Controls and take into account information about Ms. Governance Ledger’s and ABC’s performance that Sections ll.4(c)(2) and ll.4(c)(3) becomes better known during the deferral period to potentially reduce the of the proposed rule would require that Ms. Ledger’s incentive-based amount of deferred incentive-based compensation arrangement be compensation that vests. ABC would compatible with effective risk not be allowed to increase the amount management and controls and be of deferred incentive-based supported by effective governance. compensation that vests. In the case of For Ms. Ledger’s arrangement to be the deferred equity awarded to Ms. compatible with effective risk Ledger, the number of shares or options management and controls, ABC’s risk awarded to Ms. Ledger and eligible for management framework and controls vesting on each anniversary of the end would be required to comply with the of the performance period is the specific provisions of section ll.9 of maximum number of shares or options the proposed rule. ABC would have to that may vest on that date. An increase maintain a risk management framework in the total value of those shares or for its incentive-based compensation options would not be considered an program that is independent of any lines of business, includes an independent 249 See ‘‘Mr. Ticker: Forfeiture and downward mstockstill on DSK3G9T082PROD with PROPOSALS2 Aggregate Incentive-Based Compensation Awarded ........ Option Value at 15% Threshold Maximum ............................... Non-Qualifying Options ............ $255,000 adjustment review’’ discussion below for more details about the requirements for a forfeiture and downward adjustment review. 250 See section ll.7(b) of the proposed rule. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 section ll.7(a)(3) of the proposed rule. section ll.7(c) of the proposed rule. 253 See section ll.8(a) of the proposed rule. 251 See 252 See PO 00000 Frm 00080 Fmt 4701 Sfmt 4702 compliance program, and is commensurate with the size and complexity of ABC’s operations.254 ABC would have to provide individuals engaged in control functions with the authority to influence the risk-taking of the business areas they monitor and ensure that covered persons engaged in control functions are compensated in accordance with the achievement of performance objectives linked to their job functions, independent of the performance of those business areas.255 In addition, ABC would have to provide for independent monitoring of events related to forfeiture and downward adjustment reviews and decisions of forfeiture and downward adjustment reviews.256 For Ms. Ledger’s arrangement to be consistent with the effective governance requirement in the proposed rule, the board of directors of ABC would be required to establish a compensation committee composed solely of directors who are not senior executive officers. The board of directors, or a committee thereof, would be required to approve Ms. Ledger’s incentive-based compensation arrangements, including the amounts of all awards and payouts under those arrangements.257 In this example, the board of directors or a committee thereof (such as the compensation committee) would be required to approve the total award of $105,000 and 3,000 shares in 2024. Each time deferred amounts are scheduled to vest (in this example, in December 31, 2025, December 31, 2026, and December 31, 2027), the board of directors or a committee thereof would also be required to approve the amounts that vest.258 Additionally, the compensation committee would be required to receive input from the risk and audit committees of the ABC’s board of directors on the effectiveness of risk measures and adjustments used to balance risk and reward in incentivebased compensation arrangements.259 Finally, the compensation committee would be required to obtain at least annually two written assessments, one prepared by ABC’s management with input from the risk and audit committees of the board of directors and a separate assessment written from ABC’s risk management or internal audit function developed independently of ABC’s senior management. Both section ll.9(a) of the proposed rule. section ll.9(b) of the proposed rule. 256 See section ll.9(c) of the proposed rule. 257 See section ll.4(e) of the proposed rule. 258 See sections ll.4(e)(2) and ll.4(e)(3) of the proposed rule. 259 See section ll.10(b)(1) of the proposed rule. 254 See 255 See E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules assessments would focus on the effectiveness of ABC’s incentive-based compensation program and related compliance and control processes in providing appropriate risk-taking incentives.260 Recordkeeping In order to comply with the recordkeeping requirements in the proposed rule, ABC would be required to document Ms. Ledger’s incentivebased compensation arrangement.261 ABC would be required to maintain copies of the Annual Executive Plan, the Annual Firm-Wide Plan, and Ms. Ledger’s LTIP, along with all plans that are part of ABC’s incentive-based compensation program. ABC also would be required to include Ms. Ledger on the list of senior executive officers and significant risk-takers, including the legal entity for which she works, her job function, her line of business, and her position in the organizational hierarchy.262 Finally, ABC would be required to document Ms. Ledger’s entire incentive-based compensation arrangement, including information on percentage deferred and form of payment and any forfeiture and downward adjustment or clawback reviews and decisions that pertain to her.263 Mr. Ticker: Forfeiture and Downward Adjustment Review mstockstill on DSK3G9T082PROD with PROPOSALS2 Under section ll.7(b) of the proposed rule, ABC would be required to put certain portions of a senior executive officer’s or significant risktaker’s incentive-based compensation at risk of forfeiture and downward adjustment upon certain triggering events.264 In this example, Mr. Ticker is a significant risk-taker who is the senior manager of a trader and a trading desk that engaged in inappropriate risktaking in calendar year 2021, which was discovered on March 1, 2024.265 The activity of the trader, and several other members of the same trading desk, resulted in an enforcement proceeding against ABC and the imposition of a significant fine. Mr. Ticker is provided incentivebased compensation under two separate incentive-based compensation plans. 260 See sections ll.10(b)(2) and ll.10(b)(3) of the proposed rule. 261 See sections ll.4(f) and ll.5(a) of the proposed rule. 262 See section ll.5(a) of the proposed rule. 263 See section ll.5(a) of the proposed rule. 264 See section ll.7(b) of the proposed rule. 265 If Mr. Ticker’s inappropriate risk-taking during 2021 were instead discovered in another year, ABC could subject all deferred amounts not yet vested in that year to forfeiture. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 37749 The first plan, the ‘‘Annual Firm-Wide Plan,’’ is applicable to all employees at ABC, and is based on a one-year performance period that coincides with the calendar year. The second plan, ‘‘Mr. Ticker’s LTIP,’’ is applicable to all traders at Mr. Ticker’s level, and requires assessment of performance over a three-year performance period that begins on January 1, 2022 (year 1) and ends on December 31, 2024 (year 3). These two plans together comprise Mr. Ticker’s incentive-based compensation arrangement. The proposed rule would require ABC to conduct a forfeiture and downward adjustment review both because the trades resulted from inappropriate risktaking and because they failed to comply with a statutory, regulatory, or supervisory standard in a manner that resulted in an enforcement or legal action against ABC.266 In addition, the possibility exists that a material risk management and control failure as described in section ll.7(b)(2)(iii) of the proposed rule has occurred, which would widen the group of covered employees whose incentive-based compensation would be considered for possible forfeiture and downward adjustment. Under the proposed rule, covered institutions would be required to consider forfeiture and downward adjustment for a covered person with direct responsibility for the adverse outcome (in this case, the trader, if designated as a significant risk-taker), as well as responsibility due to the covered person’s role or position in the covered institution’s organizational structure (in this case, Mr. Ticker for his possible lack of oversight of the trader when such activities were conducted).267 In this example, ABC determines that as the senior manager of the trader, Mr. Ticker is responsible for inappropriate oversight of the trader and that Mr. Ticker facilitated the inappropriate risktaking the trader engaged in. Under the proposed rule, ABC would have to consider all of Mr. Ticker’s unvested deferred incentive-based compensation, including unvested deferred amounts awarded under Mr. Ticker’s LTIP, when determining the appropriate impact on Mr. Ticker’s incentive-based compensation.268 In addition, all of Mr. Ticker’s incentive-based compensation amounts not yet awarded for the current performance period, including amounts to be awarded under Mr. Ticker’s LTIP, would have to be considered for possible downward adjustment.269 The amount by which Mr. Ticker’s incentive-based compensation would be reduced could be part or all of the relevant tranches which have not yet vested or have not yet been awarded. For example, if Mr. Ticker’s lack of oversight were determined to be only a contributing factor that led to the adverse outcome (e.g., Mr. Ticker identified and elevated the breach of related risk limits but made no effort to follow up in order to ensure that such activity immediately ceased), ABC might be comfortable reducing only a portion of the incentive-based compensation to be awarded under Mr. Ticker’s LTIP in 2024. To determine the amount or portion of Mr. Ticker’s incentive-based compensation that should be forfeited or adjusted downward under the proposed rule, ABC would be required to consider, at a minimum, the six factors listed in section ll.7(b)(4) of the proposed rule.270 The cumulative impact of these factors, when appropriately weighed in the final decision-making process, might lead to lesser or greater impact on Mr. Ticker’s incentive-based compensation. For instance, if it were found that Mr. Ticker had repeatedly failed to manage traders or others who report to him, ABC might decide that a reduction of 100 percent of Mr. Ticker’s incentive-based compensation at risk would be appropriate.271 On the other hand, if it were determined that Mr. Ticker took immediate and meaningful actions to prevent the adverse outcome from occurring and immediately escalated and addressed the inappropriate behavior, the impact on Mr. Ticker’s incentive-based compensation could be less than 100 percent, or nothing. It is possible that some or all of Mr. Ticker’s incentive-based compensation may be forfeited before it vests, which could result in amounts vesting faster than pro rata. In this case, ABC decides to defer $30,000 of Mr. Ticker’s incentive-based compensation for three years so that $10,000 is eligible for vesting in 2022, $10,000 is eligible for vesting in 2023, and $10,000 is eligible for vesting in 2024. This schedule would meet the proposed rule’s pro rata vesting requirement. No adverse information about Mr. Ticker’s performance comes to light in 2022 or 2023 and so $10,000 vests in each of those years. However, Mr. Ticker’s sections ll.7(b)(2)(ii) and ll .7(b)(2)(iv)(A) of the proposed rule. 267 See section ll.7(b)(3) of the proposed rule. 268 See section ll.7(b)(1)(i) of the proposed rule. rule. 266 See PO 00000 Frm 00081 Fmt 4701 Sfmt 4702 269 See section ll.7(b)(1)(ii) of the proposed section ll.7(b)(4) of the proposed rule. sections ll.7(b)(4)(ii) and (iii) of the proposed rule. 270 See 271 See E:\FR\FM\10JNP2.SGM 10JNP2 37750 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules inappropriate risk-taking during 2021 is discovered in 2024, causing ABC to forfeit the remaining $10,000. Therefore, the amounts that vest in this case are $10,000 in 2022, $10,000 in 2023, and $0 in 2024. While the vesting is faster than pro rata due to the forfeiture, the incentive-based compensation arrangement would still be consistent with the proposed rule since the original vesting schedule would have been in compliance. ABC would be required to document the rationale for its decision and to keep timely and accurate records that detail the individuals considered for compensation adjustments, the factors weighed in reaching a final decision and how those factors were considered during the decision-making process.272 IV. Request for Comments The Agencies are interested in receiving comments on all aspects of the proposed rule. V. Regulatory Analysis mstockstill on DSK3G9T082PROD with PROPOSALS2 A. Regulatory Flexibility Act OCC: Pursuant to section 605(b) of the Regulatory Flexibility Act, 5 U.S.C. 605(b) (‘‘RFA’’), the initial regulatory flexibility analysis otherwise required under section 603 of the RFA is not required if the agency certifies that the proposed rule will not, if promulgated, have a significant economic impact on a substantial number of small entities (defined for purposes of the RFA to include banks and Federal branches and agencies with assets less than or equal to $550 million) and publishes its certification and a short, explanatory statement in the Federal Register along with its proposed rule. As discussed in the SUPPLEMENTARY INFORMATION section above, section 956 of the Dodd-Frank Act does not apply to institutions with assets of less than $1 billion. As a result, the proposed rule will not, if promulgated, apply to any OCC-supervised small entities. For this reason, the proposed rule will not, if promulgated, have a significant economic impact on a substantial number of OCC-supervised small entities. Therefore, the OCC certifies that the proposed rule will not, if promulgated, have a significant economic impact on a substantial number of small entities. Board: The Board has considered the potential impact of the proposed rule on small banking organizations in accordance with the RFA (5 U.S.C. 603(b)). As discussed in the SUPPLEMENTARY INFORMATION above, 272 See section ll.5(a)(3) of the proposed rule. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 section 956 of the Dodd-Frank Act (codified at 12 U.S.C. 5641) requires that the Agencies prohibit any incentivebased payment arrangement, or any feature of any such arrangement, at a covered financial institution that the Agencies determine encourages inappropriate risks by a financial institution by providing excessive compensation or that could lead to material financial loss. In addition, under the Dodd-Frank Act a covered financial institution also must disclose to its appropriate Federal regulator the structure of its incentive-based compensation arrangements. The Board and the other Agencies have issued the proposed rule in response to these requirements of the Dodd-Frank Act. The proposed rule would apply to ‘‘covered institutions’’ as defined in the proposed rule. Covered institutions as so defined include specifically listed types of institutions, as well as other institutions added by the Agencies acting jointly by rule. In every case, however, covered institutions must have at least $1 billion in total consolidated assets pursuant to section 956(f). Thus the proposed rule is not expected to apply to any small banking organizations (defined as banking organizations with $550 million or less in total assets). See 13 CFR 121.201. The proposed rule would implement section 956(a) of the Dodd-Frank act by requiring a covered institution to create annually and maintain for a period of at least seven years records that document the structure of all its incentive-based compensation arrangements and demonstrate compliance with the proposed rule. A covered institution must disclose the records to the Board upon request. At a minimum, the records must include copies of all incentive-based compensation plans, a record of who is subject to each plan, and a description of how the incentivebased compensation program is compatible with effective risk management and controls. Covered institutions with at least $50 billion in consolidated assets, and their subsidiaries with at least $1 billion in total consolidated assets, would be subject to additional, more specific requirements, including that such covered institutions create annually and maintain for a period of at least seven years records that document: (1) The covered institution’s senior executive officers and significant risk-takers, listed by legal entity, job function, organizational hierarchy, and line of business; (2) the incentive-based compensation arrangements for senior executive officers and significant risktakers, including information on PO 00000 Frm 00082 Fmt 4701 Sfmt 4702 percentage of incentive-based compensation deferred and form of award; (3) any forfeiture and downward adjustment or clawback reviews and decisions for senior executive officers and significant risk-takers; and (4) any material changes to the covered institution’s incentive-based compensation arrangements and policies. These larger covered institutions must provide these records in such form and with such frequency as requested by the Board, and they must be maintained in a manner that allows for an independent audit of incentive-based compensation arrangements, policies, and procedures. As described above, the volume and detail of information required to be created and maintained by a covered institution is tiered; covered institutions with less than $50 billion in total consolidated assets are subject to less rigorous and detailed informational requirements than larger covered institutions. As such, the Board expects that the volume and detail of information created and maintained by a covered institution with greater than $50 billion in consolidated assets, that may use incentive-based arrangements to a significant degree, would be substantially greater than that created and maintained by a smaller institution. The proposed rule would implement section 956(b) of the Dodd-Frank Act by prohibiting a covered institution from having incentive-based compensation arrangements that may encourage inappropriate risks (i) by providing excessive compensation or (ii) that could lead to material financial loss. The proposed rule would establish standards for determining whether an incentive-based compensation arrangement violates these prohibitions. These standards would include deferral, forfeiture, downward adjustment, clawback, and other requirements for certain covered persons at covered institutions with total consolidated assets of more than $50 billion, and their subsidiaries with at least $1 billion in assets, as well as specific prohibitions on incentive-based compensation arrangements at these institutions. Consistent with section 956(c), the standards adopted under section 956 are comparable to the compensation-related safety and soundness standards applicable to insured depository institutions under section 39 of the FDIA. The proposed rule also would supplement existing guidance adopted by the Board and the other Federal Banking Agencies regarding incentivebased compensation (i.e., the 2010 Federal Banking Agency Guidance, as E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules defined in the SUPPLEMENTARY INFORMATION above). The proposed rule also would require all covered institutions to have incentive-based compensation arrangements that are compatible with effective risk management and controls and supported by effective governance. In addition, the board of directors, or a committee thereof, of a covered institution to conduct oversight of the covered institution’s incentive-based compensation program and to approve incentive-based compensation arrangements and material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers. For covered institutions with greater than $50 billion in total consolidated assets, and their subsidiaries with at least $1 billion in total consolidated assets, the proposed rule includes additional specific requirements for risk management and controls, governance and policies and procedures. Thus, like the deferral, forfeiture, downward adjustment, clawback and other requirements referred to above, risk management, governance, and policies and procedures requirements are tiered based on the size of the covered institution, with smaller institutions only subject to general risk management, controls, and governance requirements and larger institutions subject to more detailed requirements, including policies and procedures requirements. Therefore, the requirements of the proposed rule in these areas would be expected to be less extensive for covered institutions with less than $50 billion in total consolidated assets than for larger covered institutions. As noted above, because the proposed rule applies to institutions that have at least $1 billion in total consolidated assets, if adopted in final form it is not expected to apply to any small banking organizations for purposes of the RFA. In light of the foregoing, the Board does not believe that the proposed rule, if adopted in final form, would have a significant economic impact on a substantial number of small entities supervised by the Board. The Board specifically seeks comment on whether the proposed rule would impose undue burdens on, or have unintended consequences for, small institutions and whether there are ways such potential burdens or consequences could be addressed in a manner consistent with section 956 of the Dodd-Frank Act. FDIC: In accordance with the RFA, 5 U.S.C. 601–612 (‘‘RFA’’), an agency must provide an initial regulatory flexibility analysis with a proposed rule VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 or to certify that the rule will not have a significant economic impact on a substantial number of small entities (defined for purposes of the RFA to include banking entities with total assets of $550 million or less). As described in the Scope and Initial Applicability section of the SUPPLEMENTARY INFORMATION above, the proposed rule would establish general requirements applicable to the incentive-based compensation arrangements of all institutions defined as covered institutions under the proposed rule (i.e., covered institutions with average total consolidated assets of $1 billion or more that offers incentivebased compensation to covered persons). As of December 31, 2015, a total of 353 FDIC-supervised institutions had total assets of $1 billion or more and would be subject to the proposed rule. As of December 31, 2015, there were 3,947 FDIC-supervised depository institutions. Of those depository institutions, 3,262 had total assets of $550 million or less. All FDICsupervised depository institutions that fall under the $550 million asset threshold, by definition, would not be subject to the proposed rule, regardless of their incentive-based compensation practices. Therefore, the FDIC certifies that the notice of proposed rulemaking would not have a significant economic impact on a substantial number of small FDICsupervised institutions. FHFA: FHFA believes that the proposed rule will not have a significant economic impact on a substantial number of small entities, since none of FHFA’s regulated entities come within the meaning of small entities as defined in the RFA (see 5 U.S.C. 601(6)), and the proposed rule will not substantially affect any business that its regulated entities might conduct with such small entities. NCUA: The RFA requires NCUA to prepare an analysis to describe any significant economic impact a regulation may have on a substantial number of small entities.273 For purposes of this analysis, NCUA considers small credit unions to be those having under $100 million in assets.274 Section 956 of the Dodd Frank Act and the NCUA’s proposed rule apply only to credit unions with $1 billion or more in assets. Accordingly, NCUA certifies that the proposed rule would not have a significant economic impact on a substantial number of small entities since the credit unions subject 273 5 U.S.C. 603(a). FR 57512 (September 24, 2015). 274 80 PO 00000 Frm 00083 Fmt 4701 Sfmt 4702 37751 to NCUA’s proposed rule are not small entities for RFA purposes. SEC: Pursuant to 5 U.S.C. 605(b), the SEC hereby certifies that the proposed rules would not, if adopted, have a significant economic impact on a substantial number of small entities. The SEC notes that the proposed rules would not apply to broker-dealers or investment advisers with less than $1 billion in total consolidated assets. Therefore, the SEC believes that all broker-dealers and investment advisers that are likely to be covered institutions under the proposed rules would not be small entities. The SEC encourages written comments regarding this certification. The SEC solicits comment as to whether the proposed rules could have an effect on small entities that has not been considered. The SEC requests that commenters describe the nature of any impact on small entities and provide empirical data to support the extent of such impact. B. Paperwork Reduction Act Certain provisions of the proposed rule contain ‘‘collection of information’’ requirements within the meaning of the Paperwork Reduction Act (PRA) of 1995.275 In accordance with the requirements of the PRA, the Agencies may not conduct or sponsor, and a respondent is not required to respond to, an information collection unless it displays a currently valid Office of Management and Budget (OMB) control number. The information collection requirements contained in this joint notice of proposed rulemaking have been submitted by the OCC, FDIC, NCUA, and SEC to OMB for review and approval under section 3506 of the PRA and section 1320.11 of OMB’s implementing regulations (5 CFR part 1320). The Board reviewed the proposed rule under the authority delegated to the Board by OMB. FHFA has found that, with respect to any regulated entity as defined in section 1303(20) of the Safety and Soundness Act (12 U.S.C. 4502(20)), the proposed rule does not contain any collection of information that requires the approval of the OMB under the PRA. The recordkeeping requirements are found in sections ll.4(f), ll.5, and ll.11. Comments are invited on: (a) Whether the collections of information are necessary for the proper performance of the Agencies’ functions, including whether the information has practical utility; (b) The accuracy of the estimates of the burden of the information 275 44 E:\FR\FM\10JNP2.SGM U.S.C. 3501–3521. 10JNP2 37752 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 collections, including the validity of the methodology and assumptions used; (c) Ways to enhance the quality, utility, and clarity of the information to be collected; (d) Ways to minimize the burden of the information collections on respondents, including through the use of automated collection techniques or other forms of information technology; and (e) Estimates of capital or start up costs and costs of operation, maintenance, and purchase of services to provide information. All comments will become a matter of public record. Comments on aspects of this notice that may affect reporting, recordkeeping, or disclosure requirements and burden estimates should be sent to the addresses listed in the ADDRESSES section. A copy of the comments may also be submitted to the OMB desk officer for the Agencies by mail to U.S. Office of Management and Budget, 725 17th Street NW., #10235, Washington, DC 20503, by facsimile to (202) 395–5806, or by email to oira_ submission@omb.eop.gov, Attention, Commission and Federal Banking Agency Desk Officer. Proposed Information Collection Title of Information Collection: Recordkeeping Requirements Associated with Incentive-Based Compensation Arrangements. Frequency of Response: Annual. Affected Public: Businesses or other for-profit. Respondents: OCC: National banks, Federal savings associations, and Federal branches or agencies of a foreign bank with average total consolidated assets greater than or equal to $1 billion and their subsidiaries. Board: State member banks, bank holding companies, savings and loan holding companies, Edge and Agreement corporations, state-licensed uninsured branches or agencies of a foreign bank, and foreign banking organization with average total consolidated assets greater than or equal to $1 billion and their subsidiaries. FDIC: State nonmember banks, state savings associations, and state insured branches of a foreign bank, and certain subsidiaries thereof, with average total consolidated assets greater than or equal to $1 billion. NCUA: Credit unions with average total consolidated assets greater than or equal to $1 billion. SEC: Brokers or dealers registered under section 15 of the Securities Exchange Act of 1934 and investment advisers as such term is defined in VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 section 202(a)(11) of the Investment Advisers Act of 1940, in each case, with average total consolidated assets greater than or equal to $1 billion. Abstract: Section 956(e) of the DoddFrank Act requires that the Agencies prohibit incentive-based payment arrangements at a covered financial institution that encourage inappropriate risks by a financial institution by providing excessive compensation or that could lead to material financial loss. Under the Dodd-Frank Act, a covered financial institution also must disclose to its appropriate Federal regulator the structure of its incentivebased compensation arrangements sufficient to determine whether the structure provides ‘‘excessive compensation, fees, or benefits’’ or ‘‘could lead to material financial loss’’ to the institution. The Dodd-Frank Act does not require a covered financial institution to disclose compensation of individuals as part of this requirement. Section ll.4(f) would require all covered institutions to create annually and maintain for a period of at least seven years records that document the structure of all its incentive-based compensation arrangements and demonstrate compliance with this part. A covered institution must disclose the records to the Agency upon request. At a minimum, the records must include copies of all incentive-based compensation plans, a record of who is subject to each plan, and a description of how the incentive-based compensation program is compatible with effective risk management and controls. Section ll.5 would require a Level 1 or Level 2 covered institution to create annually and maintain for a period of at least seven years records that document: (1) The covered institution’s senior executive officers and significant risktakers, listed by legal entity, job function, organizational hierarchy, and line of business; (2) the incentive-based compensation arrangements for senior executive officers and significant risktakers, including information on percentage of incentive-based compensation deferred and form of award; (3) any forfeiture and downward adjustment or clawback reviews and decisions for senior executive officers and significant risk-takers; and (4) any material changes to the covered institution’s incentive-based compensation arrangements and policies. A Level 1 or Level 2 covered institution must create and maintain records in a manner that allows for an independent audit of incentive-based compensation arrangements, policies, and procedures, including, those PO 00000 Frm 00084 Fmt 4701 Sfmt 4702 required under § ll.11. A Level 1 or Level 2 covered institution must provide the records described above to the Agency in such form and with such frequency as requested by Agency. Section ll.11 would require a Level 1 or Level 2 covered institution to develop and implement policies and procedures for its incentive-based compensation program that, at a minimum (1) are consistent with the prohibitions and requirements of this part; (2) specify the substantive and procedural criteria for the application of forfeiture and clawback, including the process for determining the amount of incentive-based compensation to be clawed back; (3) require that the covered institution maintain documentation of final forfeiture, downward adjustment, and clawback decisions; (4) specify the substantive and procedural criteria for the acceleration of payments of deferred incentive-based compensation to a covered person, consistent with section ll.7(a)(1)(iii)(B) and section ll.7(a)(2)(iii)(B)); (5) identify and describe the role of any employees, committees, or groups authorized to make incentive-based compensation decisions, including when discretion is authorized; (6) describe how discretion is expected to be exercised to appropriately balance risk and reward; (7) require that the covered institution maintain documentation of the establishment, implementation, modification, and monitoring of incentive-based compensation arrangements, sufficient to support the covered institution’s decisions; (8) describe how incentive-based compensation arrangements will be monitored; (9) specify the substantive and procedural requirements of the independent compliance program consistent with section 9(a)(2); and (10) ensure appropriate roles for risk management, risk oversight, and other control function personnel in the covered institution’s processes for designing incentive-based compensation arrangements and determining awards, deferral amounts, deferral periods, forfeiture, downward adjustment, clawback, and vesting; and assessing the effectiveness of incentive-based compensation arrangements in restraining inappropriate risk-taking. Collection of Information Is Mandatory The collection of information will be mandatory for any covered institution subject to the proposed rules. Confidentiality The information collected pursuant to the collection of information will be E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules kept confidential, subject to the provisions of applicable law. Estimated Paperwork Burden In determining the method for estimating the paperwork burden the Board, OCC and FDIC made the assumption that covered institution subsidiaries of a covered institution subject to the Board’s, OCC’s or FDIC’s proposed rule, respectively, would act in concert with one another to take advantage of efficiencies that may exist. The Board, OCC and FDIC invite comment on whether it is reasonable to assume that covered institutions that are affiliated entities would act jointly or whether they would act independently to implement programs tailored to each entity. Estimated Average Hours per Response Recordkeeping Burden § ll.4(f)–20 hours (Initial setup 40 hours). §§ ll.5 and ll.11 (Level 1 and Level 2)–20 hours (Initial setup 40 hours). OCC Number of respondents: 229 (Level 1– 18, Level 2–17, and Level 3–194). Total estimated annual burden: 15,840 hours (10,560 hours for initial setup and 5,280 hours for ongoing compliance). Board Number of respondents: 829 (Level 1– 15, Level 2–51, and Level 3–763). Total estimated annual burden: 53,700 hours (35,800 hours for initial setup and 17,900 hours for ongoing compliance). FDIC Number of respondents: 353 (Level 1– 0, Level 2–13, and Level 3–340). Total estimated annual burden: 21,960 hours (14,640 hours for initial setup and 7,320 hours for ongoing compliance). mstockstill on DSK3G9T082PROD with PROPOSALS2 NCUA Number of respondents: 258 (Level 1– 0, Level 2–1, and Level 3–257). Total estimated annual burden: 15,540 hours (10,360 hours for initial setup and 5,180 hours for ongoing compliance). SEC Number of respondents: 806 (Level 1– 58, Level 2–36, and Level 3–712). Total estimated annual burden: 54,000 hours (36,000 hours for initial setup and 18,000 hours for ongoing compliance) Amendments to Exchange Act Rule 17a–4 and Investment Advisers Act Rule VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 204–2: The proposed amendments to Exchange Act Rule 17a–4 and Investment Advisers Act Rule 204–2 contain ‘‘collection of information requirements’’ within the meaning of the PRA. The SEC has submitted the collections of information to OMB for review in accordance with 44 U.S.C. 3507 and 5 CFR 1320.11. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a currently valid OMB control number. OMB has assigned control number 3235–0279 to Exchange Act Rule 17a–4 and control number 3235– 0278 to Investment Advisers Act Rule 204–2. The titles of these collections of information are ‘‘Rule 17a–4; Records to be Preserved by Certain Exchange Members, Brokers and Dealers’’ and ‘‘Rule 204–2 under the Investment Advisers Act of 1940.’’ The collections of information required by the proposed amendments to Exchange Act Rule 17a– 4 and Investment Advisers Act Rule 204–2 will be necessary for any brokerdealer or investment adviser (registered or required to be registered under section 203 of the Investment Advisers Act (15 U.S.C. 80b–3)) (‘‘covered investment advisers’’), as applicable, that is a covered institution subject to the proposed rules. A. Summary of Collection of Information The SEC is proposing amendments to Exchange Act Rule 17a–4(e) (17 CFR 240.17a–4(e)) and Investment Advisers Act Rule 204–2 (17 CFR 275.204–2) to require that broker-dealers and covered investment advisers that are covered institutions maintain the records required by § ll.4(f), and for brokerdealers or covered investment advisers that are Level 1 or Level 2 covered institutions, §§ ll.5 and ll.11, in accordance with the recordkeeping requirements of Exchange Act Rule 17a– 4 or Investment Advisers Act Rule 204– 2, as applicable. B. Proposed Use of Information The collections of information are necessary for, and will be used by, the SEC to determine compliance with the proposed rules and section 956 of the Dodd-Frank Act. Exchange Act Rule 17a–4 requires a broker-dealer to preserve records if the broker-dealer makes or receives the type of record and establishes the general formatting and storage requirements for records that broker-dealers are required to keep. Investment Advisers Act Rule 204–2 establishes general recordkeeping requirements for covered investment advisers. For the sake of consistency PO 00000 Frm 00085 Fmt 4701 Sfmt 4702 37753 with other broker-dealer or covered investment adviser records, the SEC believes that broker-dealers and covered investment advisers that are covered institutions should also keep the records required by § ll.4(f), and for brokerdealers or covered investment advisers that are Level 1 or Level 2 covered institutions, §§ ll.5 and ll.11, in accordance with these requirements. C. Respondents The collections of information will apply to any broker-dealer or covered investment adviser that is a covered institution under the proposed rules. The SEC estimates that 131 brokerdealers and approximately 669 investment advisers will be covered institutions under the proposed rules. The SEC further estimates that of those 131 broker-dealers, 49 will be Level 1 or Level 2 covered institutions, and 82 will be Level 3 covered institutions and that of those 669 investment advisers, approximately 18 will be Level 1 covered institutions, approximately 21 will be Level 2 covered institutions, and approximately 630 will be Level 3 covered institutions.276 D. Total Annual Reporting and Recordkeeping Burden The collection of information would add three types of records to be maintained and preserved by brokerdealers and covered investment advisers: The records required by § ll .4(f), and for broker-dealers or covered investment advisers that are Level 1 or Level 2 covered institutions, the records required by § ll.5 and the policies and procedures required by § ll.11. 1. Exchange Act Rule 17a–4 In recent proposed amendments to Exchange Act Rule 17a–4, the SEC estimated that proposed amendments adding three types of records to be preserved by broker-dealers pursuant to Exchange Act Rule 17a–4(b) would impose an initial burden of 39 hours per broker-dealer and an ongoing annual burden of 18 hours and $360 per brokerdealer.277 The SEC believes that those 276 For a discussion of how the SEC arrived at these estimates, see the SEC Economic Analysis at Section V.I. 277 Recordkeeping and Reporting Requirements for Security-Based Swap Dealers, Major SecurityBased Swap Participants, and Broker-Dealers; Capital Rule for Certain Security-Based Swap Dealers, Release No. 34–71958 (Apr. 17, 2014), 79 FR 25194, 25267 (May 2, 2014). The burden hours estimated by the SEC for amending Exchange Act Rule 17a–4(b) include burdens attributable to ensuring adequate physical space and computer hardware and software storage for the records and promptly producing them when requested. These burdens may include, as necessary, acquiring E:\FR\FM\10JNP2.SGM Continued 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37754 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules estimates provide a reasonable estimate for the burden imposed by the collection of information because the collection of information would add three types of records to be preserved by broker-dealers pursuant to Exchange Act Rule 17a–4(e). The records required to be preserved under Exchange Act Rule 17a–4(e) are subject to the similar formatting and storage requirements as the records required to be preserved under Exchange Act Rule 17a–4(b). For example, paragraph (f) of Exchange Act Rule 17a–4 provides that the records a broker-dealer is required to maintain and preserve under Exchange Act Rule 17a–4, including those under paragraph (b) and (e), may be immediately produced or reproduced on micrographic media or by means of electronic storage media. Similarly, paragraph (j) of Exchange Act Rule 17a– 4 requires a broker-dealer to furnish promptly to a representative of the SEC legible, true, complete, and current copies of those records of the brokerdealer that are required to be preserved under Exchange Act Rule 17a–4, including those under paragraph (b) and (e). The SEC notes, however, that paragraph (b) of Exchange Act Rule 17a– 4 includes a three-year minimum retention period while paragraph (e) does not include any retention period. Thus, to the extent that a portion of the SEC’s previously estimated burdens with respect to the amendments to Exchange Act Rule 17a–4(b) represent the burden of complying with the minimum retention period, using those same burden estimates with respect to the collection of information may represent a slight overestimate because the collection of information does not include a minimum retention period. The SEC believes, however, that the previously estimated burdens with respect to the amendments to Exchange Act Rule 17a–4(b) represent a reasonable estimate of the burdens of the collection of information given the other similarities between Exchange Act Rule 17a–4(b) and Exchange Act Rule 17a–4(e) discussed above. Moreover, the burden to create, and the retention period for, the records required by § ll.4(f), and for Level 1 and Level 2 broker-dealers, the records required by § ll.5 and the policies and procedures required by § ll.11, is accounted for in the PRA estimates for the proposed rules. Consequently, the burdens imposed by the collection of additional physical space, computer hardware, and software storage and establishing and maintaining additional systems for computer software and hardware storage. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 information are to ensure adequate physical space and computer hardware and software storage for the records and promptly produce them when requested.278 Therefore, the SEC estimates that each of the three types of records required to be preserved pursuant to the collection of information will each impose an initial burden of 13 hours 279 per respondent and an ongoing annual burden of 6 hours 280 and $120 281 per respondent. This is the result of dividing the SEC’s previously estimated burdens with respect to the amendments to Exchange Act Rule 17a– 4(b) by three to produce a per-record burden estimate. The SEC estimates that requiring broker-dealers to maintain the records required by § ll.4(f) in accordance with Exchange Act Rule 17a–4 will impose an initial burden of 13 hours per respondent and a total ongoing annual burden of 6 hours and $120 per respondent. The total burden for all respondents will be 1,703 hours initially (13 hours × 131 Level 1, Level 2, and Level 3 broker-dealers) and 786 hours annually (6 hours × 131 Level 1, Level 2, and Level 3 broker-dealers) with an annual cost of $15,720 ($120 × 131 Level 1, Level 2, and Level 3 brokerdealers). The SEC estimates that requiring Level 1 and Level 2 broker-dealers to maintain the records required by § ll.5 in accordance with Exchange Act Rule 17a–4 will impose an initial burden of 13 hours per respondent and a total ongoing annual burden of 6 hours and $120 per respondent. The total burden for all Level 1 and Level 2 broker-dealers will be 637 hours initially (13 hours × 49 Level 1 and 278 As discussed above, paragraph (j) of Exchange Act Rule 17a–4 requires a broker-dealer to furnish promptly to a representative of the SEC legible, true, complete, and current copies of those records of the broker-dealer that are required to be preserved under Exchange Act Rule 17a–4. Thus, the SEC estimates that this promptness requirement will be part of the incremental burden of the collection of information. 279 13 hours is the result of dividing the SEC’s previously estimated burdens with respect to the amendments to Exchange Act Rule 17a–4(b) (39 hours) by three to produce a per-record burden estimate. 39 hours/3 types of records = 13 hours per record. These internal hours likely will be performed by a senior database administrator. 280 6 hours is the result of dividing the SEC’s previously estimated burdens with respect to the amendments to Exchange Act Rule 17a–4(b) (18 hours) by three to produce a per-record burden estimate. 18 hours/3 types of records = 6 hours per record. These internal hours likely will be performed by a compliance clerk. 281 $120 is the result of dividing the SEC’s previously estimated cost with respect to the amendments to Exchange Act Rule 17a–4(b) ($360) by three to produce a per-record cost estimate. $360 hours/3 types of records = $120 per record. PO 00000 Frm 00086 Fmt 4701 Sfmt 4702 Level 2 broker-dealers) and 294 hours annually (6 hours × 49 Level 1 and Level 2 broker-dealers) with an annual cost of $5,880 ($120 × 49 Level 1 and Level 2 broker-dealers). The SEC estimates that requiring Level 1 and Level 2 broker-dealers to maintain the policies and procedures required by § ll.11 in accordance with Exchange Act Rule 17a–4 will impose an initial burden of 13 hours per respondent and a total ongoing annual burden of 6 hours and $120 per respondent. The total burden for all Level 1 and Level 2 broker-dealers will be 637 hours initially (13 hours × 49 Level 1 and Level 2 broker-dealers) and 294 hours annually (6 hours × 49 Level 1 and Level 2 broker-dealers) with an annual cost of $5,880 ($120 × 49 Level 1 and Level 2 broker-dealers). In the Supporting Statement accompanying the most recent extension of Exchange Act Rule 17a–4’s collection of information, the SEC estimated that each registered brokerdealer spends 254 hours annually to ensure it is in compliance with Rule 17a–4 and produce records promptly when required, and $5,000 each year on physical space and computer hardware and software to store the requisite documents and information.282 Thus, for Level 3 broker-dealers, as a result of the collection of information, the total annual burden to ensure compliance with Rule 17a–4 and produce records promptly when required will be 260 hours 283 and $5,120 284 per Level 3 broker-dealer, or 21,320 hours and $419,840 per all 82 Level 3 brokerdealers. For Level 1 and Level 2 brokerdealers, as a result of the collection of information, the total annual burden to ensure compliance with Rule 17a–4 and produce records promptly when required will be 272 hours 285 and $5,360 286 per Level 1 and Level 2 282 See Supporting Statement for the Paperwork Reduction Act Information Collection Submission for Rule 17a–4, Collection of Information for Exchange Act Rule 17a–4 (OMB Control No. 3235– 0279), Office of information and Regulatory Affairs, Office of Management and Budget, available at https://www.reginfo.gov/public/doPRAMain. 283 254 hours + 6 hour annual burden of maintaining the records required by § ll.4(f) in accordance with Exchange Act Rule 17a–4. 284 $5,000 + $ 120 annual cost of maintaining the records required by § ll.4(f) in accordance with Exchange Act Rule 17a–4. 285 254 hours + 6 hour annual burden of maintaining the records required by § ll.4(f) in accordance with Exchange Act Rule 17a–4 + 6 hour annual burden of maintaining the records required by § ll.5 in accordance with Exchange Act Rule 17a–4 + 6 hour annual burden of maintaining the policies and procedures required by § ll.11 in accordance with Exchange Act Rule 17a–4. 286 $5,000 + $120 annual cost of maintaining the records required by § ll.4(f) in accordance with Exchange Act Rule 17a–4 + $120 annual cost of E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules broker-dealer, or 13,328 hours and $262,640 per all 49 Level 1 and Level 2 broker-dealers. 37755 $262,640 per all 49 Level 1 and Level 2 broker-dealers. SUMMARY OF COLLECTION OF INFORMATION BURDENS PER RECORD TYPE Initial hourly burden estimate per respondent (all respondents) Nature of information collection burden Annual hourly burden estimate per respondent (all respondents) Annual cost estimate per respondent (all respondents) § ll.4(f) Recordkeeping for Level 1, Level 2, and Level 3 Broker-Dealers .......... § ll.5 Recordkeeping for Level 1 and Level 2 Broker-Dealers ............................. § ll.11 Policies and Procedures for Level 1 and Level 2 Broker-Dealers ............ 13 (1,703) 13 (637) 13 (637) 6 (786) 6 (294) 6 (294) $120 ($15,720) 120 (5,880) 120 (5,880) Totals .................................................................................................................. 39 (2,977) 18 (1,374) 360 (27,480) SUMMARY OF COLLECTION OF INFORMATION BURDENS PER RESPONDENT TYPE Initial hourly burden estimate per respondent (all respondents) Nature of information collection burden Level 1 and Level 2 Broker-Dealers (49 total) .......................................................... Level 3 Broker-Dealers (82 total) .............................................................................. Annual hourly burden estimate per respondent (all respondents) 39 (1,911) 13 (1,066) 18 (882) 6 (492) Annual cost estimate per respondent (all respondents) $360 ($17,640) 120 (9,840) SUMMARY OF COLLECTION OF INFORMATION BURDENS PER RESPONDENT TYPE INCLUDING ESTIMATE OF ANNUAL COMPLIANCE WITH RULE 17a–4 Annual hourly burden estimate per respondent (all respondents) Nature of information collection burden Level 1 and Level 2 Broker-Dealers (49 total) ............................................................................................ Level 3 Broker-Dealers (82 total) ................................................................................................................ mstockstill on DSK3G9T082PROD with PROPOSALS2 As discussed above, the SEC estimates an increase of $120 for Level 3 brokerdealers and $360 for Level 1 and Level 2 broker-dealers to the $5,000 spent each year by a broker-dealer on physical space and computer hardware and software to store the requisite documents and information as a result of the collection of information. The SEC estimates that respondents will not otherwise seek outside assistance in completing the collection of information or experience any other external costs in connection with the collection of information. maintaining the records required by § ll.5 in accordance with Exchange Act Rule 17a–4 + $120 annual cost of maintaining the policies and procedures required by § ll.11 in accordance with Exchange Act Rule 17a–4. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 2. Investment Advisers Act Rule 204–2 The currently-approved total annual burden estimate for rule 204–2 is 1,986,152 hours. This burden estimate was based on estimates that 10,946 advisers were subject to the rule, and each of these advisers spends an average of 181.45 hours preparing and preserving records in accordance with the rule. Based on updated data as of January 4, 2016, there are 11,956 registered investment advisers.287 This increase in the number of registered investment advisers increases the total burden hours of current rule 204–2 from 287 Based on data from the Commission’s Investment Adviser Registration Depository (‘‘IARD’’) as of January 4, 2016. PO 00000 Frm 00087 Fmt 4701 Sfmt 4702 272 (13,328) 260 (21,320) Annual cost estimate per respondent (all respondents) $5,360 ($262,640) 5,120 (419,840) 1,986,152 to 2,169,417, an increase of 183,265 hours.288 The proposed amendment to rule 204–2 would require covered investment advisers that are Level 1, Level 2, or Level 3 covered institutions to make and keep true, accurate, and current the records required by, and for the period specified in, § ll.4(f) and, for those covered investment advisers that are Level 1 or Level 2 covered institutions, the records required by, and for the periods specified in, §§ ll.5 and ll.11. 288 This estimate is based on the following calculations: (11,956 ¥ 10,946) × 181.45 = 183,265; 183,265 + 1,986,152 = 2,169,417. E:\FR\FM\10JNP2.SGM 10JNP2 37756 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules Based on SEC staff experience, the SEC estimates that the proposed amendment to rule 204–2 would increase each registered investment adviser’s average annual collection burden under rule 204–2 by 2 hours 289 for each of the three types of records required to be preserved pursuant to the collection of information.290 Therefore, for a covered investment adviser that is a Level 1 covered institution, the increase in its average annual collection burden would be from 181.45 hours to 187.45 hours,291 and would thus increase the annual aggregate burden for rule 204–2 by 108 hours,292 from 2,169,417 hours to 2,169,525 hours.293 As monetized, the estimated burden for each such investment adviser’s average annual burden under rule 204–2 would increase by approximately $450,294 which would increase the estimated monetized aggregate annual burden for rule 204–2 by $8,100, from $162,706,275 to $162,714,375.295 For a covered investment adviser that is a Level 2 covered institution, the increase in its average annual collection burden would be from 181.45 hours to 185.45 hours,296 and would thus increase the annual aggregate burden for rule 204–2 mstockstill on DSK3G9T082PROD with PROPOSALS2 289 The burden hours estimated by the SEC for amending Investment Advisers Act Rule 204–2 assumes that the covered investment adviser already has systems in place to comply with the general requirements of Investment Advisers Rule 204–2. Accordingly, the 2 burden hours estimated by the SEC for each type of record required to be preserved pursuant to these proposed rules is attributable solely to the burden associated with maintaining such record. 290 The records required by § ll.4(f), and for covered investment advisers that are Level 1 or Level 2 covered institutions, the records required by § ll.5 and the policies and procedures required by § ll.11. 291 This estimate is based on the following calculation: 181.45 existing hours + 6 new hours = 187.45 hours. 292 This estimate is based on the following calculation: 18 (Level 1 covered institution) advisers × 6 hours = 108 hours. 293 This estimate is based on the following calculation: 2,169,417 hours + 108 hours = 2,169,525 hours. 294 This estimate is based on the following calculation: 6 hours × $75 (hourly rate for an administrative assistant) = $450. The hourly wage used is from SIFMA’s Management & Professional Earnings in the Securities Industry 2013, modified to account for an 1800-hour work-year and inflation and multiplied by 5.35 to account for bonuses, firm size, employee benefits, and overhead. 295 This estimate is based on the following calculations: 2,169,417 hours × $75 = $162,706,275. 2,169,525 hours × $75 = $162,714,375. $162,714,375 ¥ $162,706,275 = $8,100. 296 This estimate is based on the following calculation: 181.45 existing hours + 4 new hours = 185.45 hours. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 by 84 hours,297 from 2,169,525 hours 298 to 2,169,609 hours.299 As monetized, the estimated burden for each such investment adviser’s average annual burden under rule 204–2 would increase by approximately $300,300 which would increase the estimated monetized aggregate annual burden for rule 204–2 by $6,300, from $162,714,375 301 to $162,720,675.302 For a covered investment adviser that is a Level 3 covered institution, the increase in its average annual collection burden would be from 181.45 hours to 183.45 hours,303 and would thus increase the annual aggregate burden for rule 204–2 by 1,260 hours,304 from 2,169,609 hours 305 to 2,170,869 hours.306 As monetized, the estimated burden for each such investment adviser’s average annual burden under rule 204–2 would increase by approximately $150,307 which would increase the estimated monetized aggregate annual burden for rule 204–2 by $94,500, from 297 This estimate is based on the following calculation: 21 (Level 2 covered institution) advisers x 4 hours = 84 hours. 298 This estimate includes the increase in the annual aggregate burden for covered investment advisers that are Level 1 covered institutions. 299 This estimate is based on the following calculation: 2,169,525 hours + 84 hours = 2,169,609 hours. 300 This estimate is based on the following calculation: 4 hours × $75 (hourly rate for an administrative assistant) = $300. The hourly wage used is from SIFMA’s Management & Professional Earnings in the Securities Industry 2013, modified to account for an 1800-hour work-year and inflation and multiplied by 5.35 to account for bonuses, firm size, employee benefits, and overhead. 301 This estimate includes the monetized increase in the annual aggregate burden for covered investment advisers that are Level 1 covered institutions. 302 This estimate is based on the following calculations: 2,169,525 hours × $75 = $162,714,375. 2,169,609 hours × $75 = $162,720,675. $162,720,675 ¥ $162,714,375 = $6,300. 303 This estimate is based on the following calculation: 181.45 existing hours + 2 new hours = 183.45 hours. 304 This estimate is based on the following calculation: 630 (Level 3 covered institution) advisers × 2 hours = 1,260 hours. 305 This estimate includes the increase in the annual aggregate burden for covered investment advisers that are Level 1 or Level 2 covered institutions. 306 This estimate is based on the following calculation: 2,169,609 hours + 1,260 hours = 2,170,869 hours. 307 This estimate is based on the following calculation: 2 hours × $75 (hourly rate for an administrative assistant) = $150. The hourly wage used is from SIFMA’s Management & Professional Earnings in the Securities Industry 2013, modified to account for an 1800-hour work-year and inflation and multiplied by 5.35 to account for bonuses, firm size, employee benefits, and overhead. PO 00000 Frm 00088 Fmt 4701 Sfmt 4702 $162,720,675 308 to $162,815,175.309 The SEC estimates that the proposed amendment does not result in any additional external costs associated with this collection of information for rule 204–2. E. Collection of Information Is Mandatory The collections of information will be mandatory for any broker-dealer or covered investment adviser that is a covered institution subject to the proposed rules. F. Confidentiality The information collected pursuant to the collections of information will be kept confidential, subject to the provisions of applicable law. G. Retention Period of Recordkeeping Requirements The collections of information will not impose any retention period with respect to recordkeeping requirements. The retention period for the records required by § ll.4(f) and the records required by § ll.5 is accounted for in the PRA estimates for the proposed rules. H. Request for Comment Pursuant to 44 U.S.C. 3505(c)(2)(B), the SEC solicits comment to: 1. Evaluate whether the proposed collections are necessary for the proper performance of its functions, including whether the information shall have practical utility; 2. Evaluate the accuracy of its estimate of the burden of the proposed collections of information; 3. Determine whether there are ways to enhance the quality, utility, and clarity of the information to be collected; and 4. Evaluate whether there are ways to minimize the burden of collections of information on those who are to respond, including through the use of automated collection techniques or other forms of information technology. Persons submitting comments on the collection of information requirements should direct them to the Office of Management and Budget, Attention: Desk Officer for the Securities and Exchange Commission, Office of Information and Regulatory Affairs, Washington, DC 20503, and should also 308 This estimate includes the monetized increase in the annual aggregate burden for covered investment advisers that are Level 1 or Level 2 covered institutions. 309 This estimate is based on the following calculations: 2,169,609 hours × $75 = $162,720,675. 2,170,869 hours × $75 = $162,815,175. $162,815,175 ¥ $162,706,275 = $94,500. E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules send a copy of their comments to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549–1090, with reference to File No. S7–07–16. Requests for materials submitted to OMB by the SEC with regard to this collection of information should be in writing, with reference to File No. S7– 07–16, and be submitted to the Securities and Exchange Commission, Office of FOIA Services, 100 F Street NE., Washington, DC 20549. As OMB is required to make a decision concerning the collections of information between 30 and 60 days after publication of this proposal, a comment to OMB is best assured of having its full effect if OMB receives it within 30 days of publication. mstockstill on DSK3G9T082PROD with PROPOSALS2 C. The Treasury and General Government Appropriations Act, 1999— Assessment of Federal Regulations and Policies on Families NCUA and the FDIC have determined that this proposed rulemaking would not affect family well-being within the meaning of Section 654 of the Treasury and General Government Appropriations Act of 1999.310 D. Riegle Community Development and Regulatory Improvement Act of 1994 The Riegle Community Development and Regulatory Improvement Act of 1994 (‘‘RCDRIA’’) requires that each Federal Banking Agency, in determining the effective date and administrative compliance requirements for new regulations that impose additional reporting, disclosure, or other requirements on insured depository institutions, consider, consistent with principles of safety and soundness and the public interest, any administrative burdens that such regulations would place on depository institutions, including small depository institutions, and customers of depository institutions, as well as the benefits of such regulations. In addition, new regulations that impose additional reporting, disclosures, or other new requirements on insured depository institutions generally must take effect on the first day of a calendar quarter that begins on or after the date on which the regulations are published in final form. The Federal Banking Agencies note that comment on these matters has been solicited in the discussions of section ll.1 and ll.3 in Part II of the Supplementary Information, as well as other sections of the preamble, and that the requirements of RCDRIA will be 310 Public Law 105–277, 112 Stat. 2681 (1998). VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 considered as part of the overall rulemaking process. In addition, the Federal Banking Agencies also invite any other comments that further will inform the Federal Banking Agencies’ consideration of RCDRIA. E. Solicitation of Comments on Use of Plain Language Section 722 of the Gramm-LeachBliley Act 311 requires the Federal Banking Agencies to use plain language in all proposed and final rules published after January 1, 2000. The Federal Banking Agencies invite comments on how to make these proposed rules easier to understand. For example: • Have the agencies organized the material to suit your needs? If not, how could this material be better organized? • Are the requirements in the proposed rules clearly stated? If not, how could the proposed rules be more clearly stated? • Do the proposed rules contain language or jargon that is not clear? If so, which language requires clarification? • Would a different format (grouping and order of sections, use of headings, paragraphing) make the proposed rules easier to understand? If so, what changes to the format would make the proposed rules easier to understand? • What else could the Agencies do to make the regulation easier to understand? F. OCC Unfunded Mandates Reform Act of 1995 Determination The OCC has analyzed the proposed rule under the factors set forth in section 202 of the Unfunded Mandates Reform Act of 1995 (‘‘UMRA’’) (2 U.S.C. 1532). Under this analysis, the OCC considered whether the proposed rule includes Federal mandates that may result in the expenditure by State, local, and tribal governments, in the aggregate, or by the private sector, of $100 million or more in any one year (adjusted annually for inflation). For the following reasons, the OCC finds that the proposed rule does not trigger the $100 million UMRA threshold. First, the mandates in the proposed rule do not apply to State, local, and tribal governments. Second, the overall estimate of the maximum one-year cost of the proposed rule to the private sector is approximately $50 million. For this reason, and for the other reasons cited above, the OCC has determined that this proposed rule will not result in expenditures by State, local, and tribal 311 Public Law 106–102, section 722, 113 Stat. 1338 1471 (1999). PO 00000 Frm 00089 Fmt 4701 Sfmt 4702 37757 governments, or the private sector, of $100 million or more in any one year. Accordingly, this proposed rule is not subject to section 202 of the UMRA. G. Differences Between the Federal Home Loan Banks and the Enterprises Section 1313(f) of the Safety and Soundness Act requires the Director of FHFA, when promulgating regulations relating to the Federal Home Loan Banks, to consider the differences between the Federal Home Loan Banks and the Enterprises (Fannie Mae and Freddie Mac) as they relate to: The Federal Home Loan Banks’ cooperative ownership structure; the mission of providing liquidity to members; the affordable housing and community development mission; their capital structure; and their joint and several liability on consolidated obligations (12 U.S.C. 4513(f)). The Director also may consider any other differences that are deemed appropriate. In preparing this proposed rule, the Director considered the differences between the Federal Home Loan Banks and the Enterprises as they relate to the above factors, and determined that the rule is appropriate. FHFA requests comments regarding whether differences related to those factors should result in any revisions to the proposed rule. H. NCUA Executive Order 13132 Determination Executive Order 13132 encourages independent regulatory agencies to consider the impact of their actions on state and local interests. In adherence to fundamental federalism principles, NCUA, an independent regulatory agency,312 voluntarily complies with the Executive Order. As required by statute, the proposed rule, if adopted, will apply to federally insured, state-chartered credit unions. These institutions are already subject to numerous provisions of NCUA’s rules, based on the agency’s role as the insurer of member share accounts and the significant interest NCUA has in the safety and soundness of their operations. Because the statute specifies that this rule must apply to state-chartered credit unions, NCUA has determined that the proposed rule does not constitute a policy that has federalism implications for purposes of the Executive Order. I. SEC Economic Analysis A. Introduction As discussed above, section 956 of the Dodd-Frank Act requires the SEC, jointly with other appropriate Federal regulators, to prescribe regulations or 312 44 E:\FR\FM\10JNP2.SGM U.S.C. 3502(5). 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37758 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules guidelines to require covered institutions to disclose information about their incentive-based compensation arrangements sufficient for the Agencies to determine whether their compensation structure provides an executive officer, employee, director or principal shareholder with excessive compensation, fees or benefits or could lead to material financial loss to the firm. Section 956 also requires the Agencies to jointly prescribe regulations or guidelines that prohibit any type of incentive-based compensation arrangements, or any feature of these arrangements, that the Agencies determine encourages inappropriate risks by covered institutions by providing excessive compensation to officers, employees, directors, or principal shareholders (‘‘covered persons’’) or that could lead to material financial loss to the covered institution. While section 956 requires rulemaking to address a number of types of financial institutions, the rule being proposed by the SEC would apply to broker-dealers registered with the SEC under section 15 of the Securities Exchange Act (‘‘broker-dealers’’ or ‘‘BDs’’) and investment advisers, as defined in section 202(a)(11) of the Investment Advisers Act of 1940 (‘‘investment advisers’’ or ‘‘IAs’’). In connection with its rulemakings, the SEC considers the likely economic effects of the rules. This section provides the SEC’s economic analysis of the main likely effects of the proposed rule on broker-dealers and investment advisers that would be covered under the proposed rule. For purposes of this analysis, the SEC addresses the potential economic effects for covered BDs and IAs resulting from the statutory mandate and from the SEC’s exercise of discretion together, recognizing that it is often difficult to separate the economic effects arising from these two sources. The SEC also has considered the potential costs and benefits of reasonable alternative means of implementing the mandate. Where practicable, the SEC has attempted to quantify the effects of the proposed rule; however, in certain cases noted below, the SEC is unable to provide a reasonable estimate because the SEC lacks the necessary data. In particular, because the SEC’s regulation of individuals’ compensation has historically been centered on disclosures by reporting companies, the SEC lacks information and data regarding the present incentive-based compensation practices of brokerdealers and investment advisers if those entities are not themselves reporting companies under the Exchange Act. In VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 addition, in proposing these rules jointly for public comment, the Agencies have relied in part on the supervisory experience of the Federal Banking Agencies.313 Accordingly, for the purposes of evaluating the economic impact of the proposed rule, the SEC has considered outside analyses and other studies regarding the effects of incentive-based compensation that are not directly related to broker-dealers or investment advisers. In addition, the SEC is requesting that commenters provide data that will permit the SEC to perform a more direct analysis of the economic impact on broker-dealers and investment advisers that the proposed rules would have if adopted. The SEC requests comment on all aspects of the economic effects, including the costs and benefits of the proposed rule and possible alternatives to the proposed rule. The SEC appreciates comments that include data or qualitative information that would enable it to quantify the costs and benefits associated with the proposed rule and alternatives to the proposed rule. B. Broad Economic Considerations Economic theory suggests that even compensation practices that are optimal from the perspective of one set of stakeholders may not be optimal from the perspective of others. As discussed below, pay packages that are optimal from the point of view of certain shareholders may not be optimal from the point of view of taxpayers and other stakeholders. In particular, as discussed above, under certain facts and circumstances, even pay packages that are optimal from the point of view of shareholders may induce an excessive amount of risktaking that could create potentially negative externalities for taxpayers. For example, also as discussed above, some have argued that during financial crises the losses of certain financial institutions have resulted in taxpayer assistance.314 To the extent that the 313 See, e.g., OCC, Board, FDIC, and Office of Thrift Supervision, ‘‘Guidance on Sound Incentive Compensation Policies’’ (‘‘2010 Federal Banking Agency Guidance’’), 75 FR 36395 (June 25, 2010), available at: https://www.federalreserve.gov/ newsevents/press/bcreg/20100621a.htm. As discussed above, the Federal Banking Agencies have found that any incentive-based compensation arrangement at a covered institution will encourage inappropriate risks if it does not sufficiently expose the risk-takers to the consequences of their risk decisions over time, and that in order to do this, it is necessary that meaningful portions of incentive-based compensation be deferred and placed at risk of reduction or recovery. This economic analysis relies in part on these Agencies’ supervisory experience described above. 314 See Gorton, G., 2012. Misunderstanding Financial Crises: Why We Don’t See Them Coming, PO 00000 Frm 00090 Fmt 4701 Sfmt 4702 proposed rule would curtail pay convexity 315 by imposing restrictions of certain amounts, components, and features of incentive-based compensation, the proposed rule may have potential benefits by lowering the likelihood of an outcome that may induce negative externalities. The extent of these potential benefits would depend on specific facts and circumstances at the firm level and individual level, including whether the size, centrality, and business complexity of the firm and the position of the individual materially affect the level of risk, including risks that could lead to negative externalities. While academic literature does not provide clear evidence that broker-dealers and investment advisers have produced negative externalities for taxpayers,316 the proposed rule may address scenarios where such externalities could nonetheless arise because the incentivebased compensation arrangements at a broker-dealer or investment adviser generate differences in risk preferences between managers 317 and taxpayers. From an economic standpoint, when the risk preferences of managers (agents) differ from the risk preferences of stakeholders (principals) of a firm, risktaking may be considered inappropriate from the point of view of a particular stakeholder.318 While the economic Oxford University Press; French et al., 2010. Excerpts from The Squam Lake Report: Fixing the Financial System. Journal of Applied Corporate Finance 22, 8–21. 315 Pay convexity describes the shape of the payoff curve as a result of compensation arrangements. More convex payoff curves provide higher rewards for taking on risk. 316 In the academic literature, some studies relate to a broad spectrum of firms in different industries, while other studies related to firms, primarily banks, in the financial services sector. The SEC is not aware of studies that focus on broker-dealers and investment advisers. While certain findings in the financial services sector may apply also to broker-dealers and investment advisers, any generalization is subject to a number of limitations. For example, BDs and IAs differ from other financial services firms with respect to business models, nature of the risks posed by the institutions, and the nature and identity of the persons affected by those risks. 317 The SEC’s economic analysis uses the term ‘‘managers’’ in an economic (rather than organizational) connotation as the persons or entities that are able to make decisions on behalf of, or that impact, another person or entity. Thus, managers in this context would include covered persons such as senior executive officers and significant risk-takers. 318 The literature in economics and finance typically refers to a principal-agent model to describe the employment relationship between shareholders and managers of a firm. The principal (shareholder) hires an agent (manager) to operate the firm. More generally, the principal-agent model is also used to describe the relationship between managers and stakeholders. For example, see Jensen, M., Meckling, W. 1976. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 theory mainly focuses on the principalagent relationship between managers and shareholders, an agency problem may also exist between managers and taxpayers and between managers and debtholders. For example, certain levels of risk-taking (e.g., those associated with investments in R&D-intensive activities) may be optimal 319 for shareholders but considered to be excessive for debtholders. In general, debtholders are likely to require a rate of return on their investment that is proportionate to the riskiness of the firm and to put in place covenants in the contracts governing the debt that restrict those managerial actions that, in their view, may constitute inappropriate risk-taking but that shareholders may find appropriate.320 Tying managerial compensation to firm performance aims at aligning the incentives of management with the interests of shareholders.321 Managers are likely to be motivated by drivers other than their explicit compensation, including for example career advancements, personal pride, and job retention concerns. Beyond that, making their compensation in part depend on firm performance could incentivize managers to exert effort and make decisions that maximize shareholder value. In a principal-agent relationship between shareholders and managers, there may be an incentive misalignment that may give rise to agency problems between the parties: For example, managers may take on projects that benefit their personal wealth but do not necessarily increase the value of the firm. Absent a variable component in the compensation arrangements that encourages risk-taking, risk averse and Structure. Journal of Financial Economics 3, 305– 360. 319 The economic literature uses the term of ‘‘optimal’’ (‘‘suboptimal’’) level of risk-taking in a technical manner to describe the alignment (misalignment) in risk preferences between managers and a particular stakeholder. Here ‘‘optimal’’ means from the point of view of a particular stakeholder (e.g., shareholders). Hereafter, consistently with the economic literature, the SEC’s economic analysis uses these terms without any normative connotation or implication. 320 Both managers and shareholders have an incentive to engage in activities that promise high payoffs if successful even if they have a low probability of success. If such activities turn out well, managers and shareholders capture most of the gains, whereas if they turn out badly debtholders bear most of the costs. In the principalagent relationship between managers and debtholders, inappropriate risk taking would amount to managers’ actions that transfer risks from shareholders to debtholders and that benefit shareholders at the expense of debtholders. See Jensen, M., Meckling, W. 1976. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics 3, 305– 360. 321 See Ibid. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 undiversified managers 322 may take less risk than is optimal from the point of view of shareholders.323 With an aim to incentivize managers to take on risk that is optimal for shareholders and to attract and retain managerial talent, managerial compensation arrangements most often include incentive-based compensation, which is the variable component of compensation that serves as an incentive or a reward for performance.324 Incentive-based compensation arrangements typically include 325 performance-based compensation whose award is conditional on achieving specified performance measures that are evaluated over a certain time period (i.e., short-term and long-term incentive plans), in absolute terms or in relation to a peer group. It encompasses a wide range of forms of compensation instruments. Among these forms, equity-based compensation (e.g., performance share units, restricted stock units, and stock option awards) ties managerial wealth to stock performance to motivate managers to take actions— exert effort and take risks—that are more directly aligned with the interests of shareholders. Equity awards are typically subject to multi-year vesting schedules and vesting conditions restricting managers from unwinding their equity positions during vesting periods. Relatedly, some managers are often prohibited from hedging their 322 The differential degree of diversification between managers’ and shareholders’ portfolios may lead to a misalignment of managerial incentives from optimal risk-taking from the point of view of shareholders. In general, executives are relatively undiversified compared to the average investor, because a significant fraction of executives’ wealth is invested into the companies they operate, through the value of their firmspecific human capital and their portfolio holdings, including their compensation-related claims. The concentration of managerial wealth in their employer company may lead to managerial aversion towards value-enhancing but risky projects since such projects can place undiversified managerial wealth at heightened levels of risk. See Hall, B., and Murphy, K. 2002. Stock Options for Undiversified Executives. Journal of Accounting and Economics 33, 3–42. 323 Most managers would operate in a multiperiod framework. In this environment, managers would still have incentives to exert effort and make decisions that maximize shareholder value due to career concerns and expectations about future wages. 324 Incentive-based compensation addresses the fact that shareholders cannot observe how much effort managers exert or should exert. Because shareholders do not know and cannot specify every action managers should take in every scenario, shareholders delegate many of the decisions to managers by compensating them based on the results from those decisions. 325 See, for example, Frydman, C., and R. Saks, 2010. Executive Compensation: A New View from a Long-Term Perspective, 1936–2005. Review of Financial Studies 23, 2099–2138. PO 00000 Frm 00091 Fmt 4701 Sfmt 4702 37759 equity positions in their firm’s stock against any downside in the stock value. Incentivizing managers through compensation to take on shareholders’ preferred amount of risk requires a delicate balancing act, because different combinations of amounts, components and features of incentive-based compensation may make managerial pay more or less sensitive to firm risk than the level that is desired by shareholders to maximize their return. In particular, different combinations may make pay a nonlinear (in particular, convex) function of performance; in other words, a greater increment in payoffs is realized in the case of high performance, compared to when performance is moderate or poor. While there has been ample debate about how certain characteristics of incentive-based compensation may affect pay convexity and induce risk-taking, the economic literature has not conclusively identified a specific amount, component, or feature of incentivebased compensation that uniformly leads to inappropriate risk-taking, due to differential facts and circumstances at both the firm level and individual level. For example, stock options and risk grants are often seen as a form of incentive-based compensation that, under certain conditions, may lead to incentives for taking inappropriate risk from shareholders’ point of view.326 Compared to cash incentives or restricted stock units, stock options have an asymmetric payoff structure since they provide the option holder with unlimited upside potential and limited downside. In particular, given that a positive outcome from risk-taking is a positive payoff, whereas a negative outcome does not symmetrically penalize the option holder, the design of stock options is likely to encourage managers to undertake risks. The empirical research on the effect of stock options on risk-taking does in general support a positive relation between option-based compensation and risktaking;327 however, as a whole, the academic evidence is mixed on whether stock options induce inappropriate risk326 See Frydman and Jenter. CEO Compensation. Annual Review of Financial Economics (2010). 327 See Guay, W. 1999. The sensitivity of CEO wealth to equity risk: An analysis of the magnitude and determinants. Journal of Financial Economics 53, 43–71. Stock options, as opposed to common stockholdings, increase the sensitivity of CEOs’ wealth to equity risk. The study documents a positive relation between the convexity in compensation arrangements and stock return volatility suggesting that such compensation arrangements are related to riskier investing and financing decisions. Stock options are mostly used in companies where underinvestment is valueincreasing but risky projects may lead to significant losses in the value of these companies. E:\FR\FM\10JNP2.SGM 10JNP2 37760 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 taking from the point of view of shareholders. Some studies show that the relation between option-based compensation and risk-taking incentives is not uniform across different firms, and the incentives to undertake risk may vary depending on certain conditions.328 For example, options that are deep in-themoney may lead the option holder to moderate risk exposure to protect the value of the option. On the other hand, options that are deep out-of-the-money may provide incentives for excessive risk-taking. Additionally, there is significant variation across companies with regard to the use of options in compensation arrangements. Stock options are a relatively more significant component of compensation arrangements for executives in companies where risk-taking is important for maximizing shareholder value.329 Another example of a characteristic in incentive-based compensation arrangements that is commonly considered to potentially provide incentives for actions that carry undesired risks is the disproportionate use of short-term (e.g., measured over a period of one year) performance measures (i.e., accounting, stock pricebased, or nonfinancial measures) that may steer managers toward shorttermism without adequate regard of the long-term risks potentially posed to long-term firm value.330 In doing so, managers may reap the rewards of their actions in the short run but may not participate in the potentially negative outcomes that may materialize in the long run. Short-termism may lead to 328 See Ross, S. 2004. Compensation, Incentives, and the Duality of Risk Aversion and Riskiness. Journal of Finance 59, 207–225; Carpenter, J. 2000. Does Option Compensation Increase Managerial Risk Appetite? Journal of Finance 55, 2311–2332. Both studies question the common belief that stock options unequivocally induce holders to undertake more risk. Although the asymmetric payoff structure of options is likely to encourage risktaking in some cases, there are also circumstances where options may lead to decreased appetite for risk taking by option holders. 329 See Guay (1999). 330 See Bizjak, J., Brickley, J., Coles, J. 1993. Stock-based incentive compensation and investment behavior. Journal of Accounting and Economics 16, 349–372. The authors argue that managerial concern about current stock prices could lead management to distort optimal investment decisions in an effort to influence the current stock price. Such short-termism is likely to be exacerbated when there is a significant information asymmetry between management and investors. The study argues that compensation arrangements with longer horizons are a potential solution to such behavior, and finds that firms with higher information asymmetries between management and shareholders actually use compensation arrangements with relatively longer horizons. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 investment distortions in the long run, such as under- 331 or overinvestment,332 that are potentially detrimental to shareholder value. Some academic studies suggest that managers’ focus on short-term performance may arise simply out of their reputation and career concerns, and compensation awards tied to short-term performance measures may accentuate the tendency toward short-termism.333 Studies document that short-term incentive plans or annual bonuses typically represent a small fraction of executive compensation.334 Additionally, a recent study provides evidence of a significant increase in the number of firms granting multi-year 331 See Stein, J. 1989. Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior. Quarterly Journal of Economics 104, 655– 669. 332 See Bebchuk, L., Stole, L. 1993. Do Short-Term Objectives Lead to Under- or Overinvestment in Long-Term Projects? Journal of Finance 48, 719– 729. The paper develops a model showing that, depending on the nature of the information asymmetry between management and shareholders, either under- or over-investment in long-run projects is likely to occur. When shareholders cannot observe the level of investment in long-term projects, the model predicts that managers would underinvest. When shareholders can observe the level of investment but not the productivity of such investment, then managers have incentives to overinvest. 333 See Narayanan, M.P. 1985. Managerial Incentives for Short-Term Results. Journal of Finance 40, 1469–1484; and Stein, J. 1989. Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior. Quarterly Journal of Economics 104, 655–669. These studies examine managerial incentives to focus on shorter-term performance at the expense of longer-term value. When managers have information about firm decisions that investors do not have, focusing on short-term performance may be an optimal strategy from managers to enhance their perceived skill and reputation, as well as achieve higher compensation. The studies also argue that even if the market anticipates such short-termism from managers, the optimal strategy for managers would still be to focus on short-term results. Narayanan (1985) also shows that short-termism can be partially curbed by offering longer-term contracts to managers. A survey of Chief Financial Officers indicates that, among other motivations, career concerns and reputation act as leading motivations for the significant focus of executives on delivering shortterm performance (e.g., quarterly earnings expectations). The survey also documents that executives are willing to forgo long-term value enhancing activities and projects in order to deliver on short-term performance targets. See Graham, J., Harvey, C., and Rajgopal, S. 2005. The Economic Implications of Corporate Financial Reporting. Journal of Accounting and Economics 40, 3–73. 334 See Frydman, C., and R. Saks, 2010. Executive Compensation: A New View from a Long-Term Perspective, 1936–2005. Review of Financial Studies 23, 2099–2138. The paper documents the evolution of various characteristics of executive compensation arrangements for the 50 largest U.S. companies since 1936. Long-term pay including deferred bonuses in the form of restricted stock and stock options comprised the largest part of executive compensation in recent years. For example, 35% of total executive pay for these companies was in the form of long-term bonuses in the form of restricted stock in 2005. PO 00000 Frm 00092 Fmt 4701 Sfmt 4702 accounting-based performance incentives to their chief executive officers (‘‘CEOs’’).335 Firms with relatively less volatile accounting performance measures and a stronger presence of long-term shareholders are more likely to utilize these compensation arrangements. As a whole, the academic evidence is mixed on whether short-term incentive plans induce inappropriate risk-taking from the point of view of certain shareholders. However, there is evidence that certain equity-based compensation arrangements may provide incentives for earnings management 336 and misreporting 337 that could lead to lower long-term shareholder value. Finally, there is also evidence that compensation contracts with relatively shorter horizons are positively related (in a statistical sense) to proxies for earnings management.338 335 See Li, Z., and L. Wang, 2013. Executive Compensation Incentives Contingent on Long-Term Accounting Performance, Working Paper. The study documents a significant increase in the use of longterm accounting performance plans for CEOs of S&P500 companies. More specifically, the study documents that 43% of S&P500 companies used long-term accounting performance plans in CEO compensation arrangements in 2008, compared to 16% of S&P500 companies in 1996. In general terms, these plans usually rely on a three-year performance measurement period of various accounting measures of performance such as earnings, revenues, cash flows and other metrics to determine payouts to CEOs in the form of mostly equity or cash. The paper does not find evidence that such compensation arrangements are used by CEOs to extract excessive compensation. 336 See Bergstresser, D., Philippon, T. 2006. CEO incentives and earnings management. Journal of Financial Economics 80, 511–529. The paper presents evidence that highly incentivized CEOs, as measured by the significance of stock and options in CEOs’ compensation arrangements, are more likely to engage in earnings management that misrepresents the true economic performance of a company, with the intent to personally profit from such misrepresentation of performance. Although tying CEOs’ wealth to company performance aims at aligning the incentives of CEOs with those of shareholders, the strength of such incentives may lead to unintended consequences such as incentives to misrepresent company performance in efforts to increase the value of their compensation. 337 See Burns, N., Kedia, S. 2006. The impact of performance-based compensation on misreporting. Journal of Financial Economics 79, 35–67. The study provides empirical evidence that CEOs whose option portfolios are more sensitive to the stock price of the company are more likely to misreport their performance. The paper does not find any evidence that the sensitivity of other components of performance-based compensation to stock price, such as restricted stock and bonuses, are related to the propensity to misreport performance. The asymmetric payoff structure of stock options provides incentives to CEOs to misreport because of the limited downside risk associated with the detection of misreporting. 338 See Gopalan, R., Milbourn, T., Song, F., and Thakor, A. 2014. Duration of Executive Compensation. Journal of Finance 69, 2777–2817. The paper constructs a measure of executive pay duration that reflects the vesting periods of different pay components to investigate its association with E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 The presence of a number of mitigating factors may explain why evidence is inconclusive on the effects of incentive-based compensation on inappropriate risk-taking. One such factor is corporate governance and, more specifically, board of directors oversight over executive compensation. The board of directors, as an agent of shareholders, may monitor managers and review their performance (e.g., through the compensation committee of the board of directors) in the case of decreases in shareholder value that, among other factors, may be a result of inappropriate risk-taking.339 Also, corporate boards may attempt to determine compensation arrangements for executives in a way that aligns executives’ interests with those of shareholders. The empirical evidence on the effectiveness of board of directors oversight over executive compensation is mixed. One study finds evidence suggesting that certain boards are not effective in setting executive compensation because executives are often rewarded for performance due to luck.340 Another study provides evidence that CEOs play an important role in the nomination and selection of board of directors members, suggesting that board of directors oversight may be impaired as a result.341 Other studies short-termism. Pay duration is positively related to growth opportunities, long-term assets, R&D intensity, lower risk and better recent stock performance. Longer CEO pay duration is negatively related with income increasing accruals. 339 While the SEC is not aware of any literature that directly examines inappropriate risk-taking and managerial retention decisions, there is evidence in the academic literature documenting a higher likelihood of managerial turnover following poor performance measured with stock returns or accounting measures of performance (See for example, Engel, E., Hayes, R., and Wang, X. 2003. CEO Turnover and Properties of Accounting Information. Journal of Accounting and Economics 36, 197–226; and Farell, K., and Whidbee, D. 2003. The Impact of Firm Performance Expectations on CEO Turnover and Replacement Decisions. Journal of Accounting and Economics 36, 165–196.). 340 See Bertrand, M., and S. Mullainathan, 2001. Are CEOs rewarded for luck? The ones without principals are. Quarterly Journal of Economics 116, 901–932. The paper examines whether the component of firm performance that is outside of managerial control is related to managerial compensation. According to the efficient contracting view of compensation, i.e. compensation arrangements are used to mitigate principal-agent problems, executives should not be rewarded (nor penalized) for performance due to luck. The authors propose a ‘skimming view’ for managerial compensation where CEOs capture the compensation setting process and find evidence that CEOs of oil companies get rewarded when changes in oil prices induce favorable changes in company performance. See also Bebchuk, L.A., Fried, J.M., Walker, D.I., 2002. Managerial power and rent extraction in the design of executive compensation. University of Chicago Law Review 69, 751–846. 341 See Coles, J., Daniel, N., and Naveen, L. Coopted Boards. 2014. Review of Financial Studies 27, 1751–1796. The study examines whether VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 find that firms with strong governance are better than firms with weak governance at monitoring the CEO and have better control of size and structure of CEO pay.342 Another example of a mitigating factor is the implementation of risk controls over business activities that academic studies have generally found effective at curbing inappropriate risktaking. One study 343 examines the relation between risk controls at bank holding companies (‘‘BHCs’’) and outcomes related to risk-taking, such as the fraction of loans that are nonperforming, during the financial crisis. In this study, the strength and quality of risk controls are proxied by the independent directors that are appointed after the current CEO assumed office are effective monitors of the CEO. The findings show that there is a difference in the monitoring efficiency between independent directors holding their position prior to the current CEO’s appointment vs. independent directors that join the board of directors after the current CEO has assumed office (Co-opted board members). The percentage of ‘co-opted’ board members in a company is negatively related with various measures of board monitoring. For example, these companies tend to pay their CEOs more and have lower turnover-performance sensitivity (i.e., CEOs are less likely to be fired following deteriorating firm performance). The study questions whether independent directors appointed after CEO assumed office are really independent to the CEO. Relatedly, another study finds that on average directors receive a very high level of votes in elections, in the post-SOX era. The evidence points to the fact that if a director is slated, she is elected. However, the study also finds evidence that lower levels of director votes lead to reductions in ‘abnormal’ compensation and an increase in the level of CEO turnover. This latter result is particularly strong when these directors serve as chair or members of the compensation committee. See Cai, J., Garner, J., and Walking R. 2009. Journal of Finance 64, 2389–2421. 342 See Core, J., R.W. Holthausen, and D.F. Larcker. 1999. Corporate Governance, Chief Executive Officer Compensation, and Firm Performance. Journal of Financial Economics 51, 371–406. The paper finds that board and ownership structure explain differences in CEO compensation across firms to a significant extent. Weaker governance structures are related to greater agency problems resulting in higher CEO compensation. See Chhaochharia, V., and Grinstein, Y. 2009. CEO Compensation and Board Structure. Journal of Finance 64, 231–261, showing that companies that were least compliant with new regulations issued in 2002 by NYSE and NASDAQ (regarding governance listing standards) decreased compensation to their CEOs to a significant extent. The decrease in CEO compensation is mainly attributable to decreases in bonus and stock-based compensation. The results suggest that requirements for board of directors structure and procedures have a significant effect on the structure and size of CEO compensation. See also Fahlenbrach, R. 2009. Shareholder Rights, Boards, and CEO Compensation. Review of Finance 13, 81– 113, finding evidence of a substitution effect between compensation and other governance mechanisms. 343 See Ellul, A., Yerramilli, V. 2013. Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies. Journal of Finance 68, 1757– 1803. PO 00000 Frm 00093 Fmt 4701 Sfmt 4702 37761 existence, independence, experience and centrality of the Chief Risk Officer and the corresponding Risk Committee. The study finds that BHCs with strong risk controls during years preceding the crisis had lower frequencies of underperforming loans and better operating and stock performance during the crisis. In this study, this relation was not significant in the years outside of the financial crisis indicating that strong risk controls, as measured by this study, curtailed extreme risk exposures only during the financial crisis. Another study 344 shows that lenders with relatively powerful risk managers, as measured by the level of the risk manager’s compensation relative to the level of named executive officers’ compensation, experience lower loan default rates, interpreting this finding as evidence that strong risk management is effective in reducing the origination of low quality loans. Another mechanism that could play a mitigating role at curtailing the potential effects of incentive-based compensation on inappropriate risk-taking is reputation and career concerns of executives. On one hand, some studies show that managers’ concerns about the effects of current performance on their future compensation are important in affecting managerial incentives, even in the absence of formal compensation contracts.345 For example, executives with greater career concerns typically have an incentive to take less risk than optimal for the company 346 and an executive’s pay-for-performance sensitivity is higher as the executive becomes older.347 This suggests that 344 See Keys, B., Mukherjee, T., Seru, A., Vig, V. 2009. Financial regulation and securitization: Evidence from subprime loans. Journal of Monetary Economics 56, 700–720. 345 See Gibbons, Robert, and Kevin J. Murphy. 1992. Optimal incentive contracts in the presence of career concerns: Theory and evidence, Journal of Political Economy 100, 468–505. The paper shows that career concerns can have important effects on incentives even in the absence of formal contracts. The importance of career concerns as a motivating mechanism is particularly relevant for younger managers whose ability is not yet established in the labor market. Moreover, the evidence shows that CEOs’ pay-for-performance sensitivity is stronger for CEOs closer to retirement, consistent with the idea that career concerns are not strong for older CEOs and are thus re-enforced through formal contracts. 346 See Holmstrom, B. 1999. Managerial Incentive Problems: A Dynamic Perspective. Review of Economic Studies 66, 169–182. The study models incentives for effort and risk taking by agents in the presence of career concerns. With regards to risk taking, the model shows that younger managers whose talent or ability is not yet known to the market may be reluctant to choose risky projects that are optimal from a shareholders’ perspective. 347 See Gibbons, Robert, and Kevin J. Murphy, 1992. Optimal incentive contracts in the presence E:\FR\FM\10JNP2.SGM Continued 10JNP2 37762 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 inappropriate risk-taking could be less severe for younger executives, for whom there are more periods over which to spread the reward for their efforts.348 On the other hand, as mentioned above, some studies also argue that career concerns can lead executives to focus on delivering short-term performance to enhance their present reputation, at the expense of long-term value.349 Some studies argue that compensation structures did not encourage inappropriate risk-taking and that managers were severely penalized since their portfolio values suffered considerably during the financial crisis.350 According to these studies, executives held significant amounts of their financial institutions’ equity in the form of stock options and restricted stock when the crisis occurred and the value of these holdings declined dramatically and quickly, wiping out most of their value. The fact that executives were still significantly exposed to firm performance by holding on to stock options and restricted stock units when the crisis occurred can be viewed as an indicator that these executives had no knowledge of the significant risks associated with their actions.351 According to this view, of career concerns: Theory and evidence, Journal of Political Economy 100, 468–505. 348 Young CEOs are likely to differ in other dimensions such as character, knowledge, and experience and hence establishing a causal effect of career concerns on risk taking could be difficult. See Cziraki, P., and M. Xu, 2013. CEO career concerns and risk-taking, working paper. 349 See Narayanan, M.P. 1985. Managerial Incentives for Short-Term Results. Journal of Finance 40, 1469–1484; and Stein, J. 1989. Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior. Quarterly Journal of Economics 104, 655–669. 350 See Murphy, K. 2009. Compensation Structure and Systemic Risk. U.S.C. Marshall School of Business Working Paper. Compensation for CEOs and other named executive officers (NEOs) significantly suffered during the crisis. For TARP recipient institutions: Bonuses declined by approximately 80% from 2007 to 2008, and the value of stock options and restricted stock held by NEOs declined by more than 80% during the same time period. Executive compensation also significantly declined for non-TARP recipients but the decline was lower than for TARP recipients. 351 See Fahlenbrach, R., Stulz, R. 2011. Bank CEO Incentives and the Credit Crisis. Journal of Financial Economics 99, 11–26. The study examines the link between bank performance during the crisis and CEO incentives from compensation arrangements preceding the crisis. The evidence shows that banks whose CEOs’ incentives were better aligned with the interests of shareholders performed worse during the crisis. The authors argue that a potential explanation for their findings is that CEOs with better aligned incentives undertook higher risks before the crisis; such risks were not suboptimal for shareholders at the point in time when they were undertaken. This explanation is also corroborated by the fact that CEOs did not unload their equity holdings prior to the crisis and, as a result, their wealth significantly declined. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 executives were held accountable and penalized upon the realization of the risks undertaken. However, some other studies argue that, whereas bank executives lost significant amounts of wealth tied to their stock and stock option holdings during the crisis, they also received significant amounts of compensation during the years leading up to the financial crisis.352 Significant amounts of short-term bonuses were paid in the years preceding the crisis, even to executives of financial institutions that failed soon thereafter. While bank executives walked away with significant gains during the years leading up to the crisis, investors suffered significant losses in their investments in these institutions and, in some cases, taxpayers provided capital support to save these institutions from default. Thus, the underlying actions that generated significant positive performance and resulted in significant payouts to executives in the short run were also responsible for the realization of the associated risks in the long run. Another study 353 finds that risk-taking incentives for CEOs at large commercial banks substantially increased around 352 See Bebchuk, L., Cohen, A., Spamann, H. 2010. The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000– 2008. Yale Journal on Regulation 27, 257–282. The study presents details regarding payouts made to CEOs and executives of Bear Sterns and Lehman Brothers during the 2000–2008 period. During the 2000–2008 period, executive teams at Bear Sterns cashed out a total of $1.4 billion in cash bonuses and equity sales whereas the executives at Lehman cashed out a total of $1 billion. The authors argue that the divergence between how top executives and their shareholders fared may suggest that pay arrangements provided incentives for excessive risk taking. See Bhagat, S., Bolton, B. 2013. Bank Executive Compensation and Capital Requirements Reform. Working Paper. The study examines, among other things, 2000–2008 net payoffs to CEOs of 14 financial institutions that received TARP assistance during the crisis. Consistent with the findings of Bebchuk et al. (2010), this study shows that CEOs of TARP assisted institutions cashed out significant amounts of compensation prior to the crisis, but also suffered significant losses when the crisis hit. The authors find that TARP CEOs cashed out significantly higher amounts of compensation during the 2000–2008 period compared to other institutions that did not receive TARP assistance; the finding is interpreted as evidence that TARP CEOs were aware of the increased risks associated with their actions and significantly limited their exposure to firm performance before the crisis hit. 353 See DeYoung, R., Peng, E., Yan, Meng. 2013. Executive Compensation and Business Policy Choices at U.S. Commercial Banks. Journal of Financial and Quantitative Analysis 48, 165–196. The study examines CEOs’ risk-taking incentives at large commercial banks over the 1995–2006 period. The authors link the increase in risk-taking incentives at these banks to growth opportunities due to deregulation. They find that board of directors moderated CEO risk-taking incentives but this effect is absent at the largest banks with strong growth opportunities and a history of highly aggressive risk-taking incentives. PO 00000 Frm 00094 Fmt 4701 Sfmt 4702 2000 and suggests that this increase in risk-taking incentives was, at least partly, a response to growth opportunities resulting from deregulation. The study also finds that CEOs responded to the increased risktaking incentives by increasing both systematic and idiosyncratic risks. CEOs with strong risk-taking incentives were also more likely to invest in mortgage backed securities; this finding is interpreted as knowledge on behalf of these CEOs regarding the risks associated with such investments. Finally, the study finds that, whereas boards of directors responded by moderating risk-taking incentives in situations where these incentives were particularly strong, such an effect was absent at the very largest banks with strong growth opportunities. Finally, there are also studies that argue that compensation structures were not responsible for the differential risktaking and performance of financial institutions during crises. In particular, a study argues that the differential risk culture across banks determines the differential performance of these institutions.354 For example, banks that performed poorly during the 1998 crisis were also found to perform poorly, and had higher failure rates, during the recent financial crisis. Another recent study argues that, prior to 2008, risktaking was inherently different across financial institutions and the fact that high-risk financial institutions paid high amounts of compensation to their executives was not an indicator of excessive compensation practices but represented compensation for the additional risk to which executives’ wealth was exposed.355 The study 354 See Fahlenbrach, R., Prilmeier, R., Stulz, R. 2012. This Time Is the Same: Using Bank Performance in 1998 to Explain Bank Performance during the Recent Financial Crisis. Journal of Finance 67, 2139–2185. The paper examines whether inherent business models or/and culture drive certain banks to perform worse during crises. The study documents that banks that performed poorly, performance measured in terms of stock returns, after Russia’s default in 1998 were also likely to perform poorly during the recent financial crisis. These banks had greater degrees of leverage, relied more on short-term market funding and grew faster during the years leading up to both crisis periods. The authors interpret their findings as being attributable to differential risk-taking cultures across banks that persist over time. 355 See Cheng, I., Hong, H., Scheinkman, J. 2015. Yesterday’s Heroes: Compensation and Risk at Financial Firms. Journal of Finance 70, 839–879. The paper examines the link between managerial pay and risk taking in the financial industry. Specifically, the paper builds upon efficient contracting theory to predict that managers in companies facing greater amounts of uncontrollable risk would require higher levels of compensation. Given that higher levels of uncontrollable risk expose managerial compensation to increased risk, risk averse managers require additional E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules suggests that at financial institutions, compensation was the result of efficient contracting between managers and shareholders. The study did not find support for the view that compensation determined risk-taking and ultimately led to the failure of many institutions. Taken all together, while there is debate about certain amounts, components, and features of incentivebased compensation that potentially encourage risk-taking, the existing academic literature does not provide conclusive evidence about a specific type of incentive-based compensation arrangement that leads to inappropriate risk-taking without taking into account other considerations, such as firm characteristics or other governance mechanisms. In particular, there may be mitigating factors—some more effective than others—that allow efficient contracting to develop compensation arrangements for managers to align managerial interests with shareholders’ interests and provide incentives for maximization of shareholder value. If it is the case that some institutions are able to contract efficiently for compensation arrangements, for any such institution that is a covered BD or IA with large balance sheet assets, and if such institution does not pose potentially negative externalities on taxpayers, the proposed rule may curtail the pay convexity resulting from such efficient contracting between managers and shareholders with potential unintended consequences. In particular, unintended consequences may include curbing risk-taking incentives to a level that is lower than what shareholders deem optimal, with consequent negative effects on efficiency and shareholder value. These potential negative effects on efficiency and shareholder value could manifest themselves in a number of ways. For example, the lower-thanoptimal level of risk-taking could affect covered BDs’ and IAs’ transactions for their own accounts as well as operations that involve customers and clients. The SEC expects that whether such consequences occur would depend on the specific facts and circumstances of each covered BD or IA. In addition, the proposed rule may result in losses of managerial talent that may migrate from covered institutions to firms in different industries or compensation for the increased risk exposure. Using various measures of arguably uncontrollable company risk, such as lagged risk measures and risk measures when the company had an IPO, the authors find a positive relation between current compensation and historical measures of risk. They interpret their results as inherent differences in risk among financial companies driving differences in compensation levels among these companies. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 abroad, especially if CEOs have developed, in recent decades, general managerial skills that are transferable across firms and industries, as some studies assert.356 It should be noted, however, as the discussion in the Preamble suggests, that some foreign regulators (e.g., in UK) have adopted stricter limits on incentive-based compensation. Thus, some foreign regulators’ restrictions on incentivebased compensation may limit the likelihood of human capital migrating to foreign institutions subject to those restrictions. Moreover, given that incentive-based compensation is also designed to attract and retain managerial talent, the proposed rule may result in an increased level of total compensation to make up for the limits imposed to award opportunities, for the decrease in present value of the awards that are deferred, or for the increase in the uncertainty associated with the fact that managers may not be able to retain the compensation awards due to the potential for forfeiture during the deferral period and/or clawback during the period following vesting of such awards. If these unintended consequences occur, they may contribute to reduce the competitiveness of certain U.S. financial institutions in their role of intermediation, potentially affecting other industries. On the other hand, for those covered institutions, including BDs and IAs with large balance sheets, that do have the potential to generate negative externalities, the proposed rule may result in better alignment of incentives between managers at these institutions and taxpayers and hence may have potential benefits by lowering the likelihood of an outcome that may induce negative externalities. Lowering the likelihood of negative externalities would be beneficial for the long-term health of these institutions, other institutions that are interconnected with those covered institutions and, in turn, the long-term health of the U.S. economy. The extent of these potential benefits, as mentioned above, would depend on specific facts and circumstances at the firm level and individual level. C. Baseline The baseline for the SEC’s economic analysis of the proposed rule includes the current incentive-based compensation practices of those covered 356 See Custodio, Claudia, Miguel Ferreira, and Pedro Matos. 2013. Generalists versus Specialists: Lifetime Work Experience and Chief Executive Officer Pay. Journal of Financial Economics 108, 471–492. PO 00000 Frm 00095 Fmt 4701 Sfmt 4702 37763 institutions that are regulated by the SEC—registered broker-dealers and investment advisers—and the relevant regulatory requirements that may currently affect such compensation practices.357 1. Covered Institutions Section 956(f) limits the scope of the requirements to covered institutions with total assets of at least $1 billion. The proposed rule defines covered institution as a regulated institution that has average total consolidated assets of $1 billion or more. Regulated institutions include covered BDs and IAs. Based on their average total consolidated assets, the proposed rule further classifies covered institutions into three levels: Level 1 covered institutions with average total consolidated assets greater than or equal to $250 billion; Level 2 covered institutions with average total consolidated assets greater than or equal to $50 billion, but less than $250 billion; and Level 3 covered institutions with average total consolidated assets greater than or equal to $1 billion, but less than $50 billion. In the case of BDs and IAs, a Level 1 BD or IA is a covered institution with average total consolidated assets greater than or equal to $250 billion, or a covered institution that is a subsidiary of a depository institution holding company that is a Level 1 covered institution. A Level 2 BD or IA is a covered institution with average total consolidated assets greater than or equal to $50 billion that is not a Level 1 covered institution; or a covered institution that is a subsidiary of a depository institution holding company that is a Level 2 covered institution. A Level 3 BD or IA is a covered institution with average total consolidated assets greater than or equal to $1 billion that is not a Level 1 covered institution or Level 2 covered institution Table 1 shows the number of covered BDs and IAs as of December 31, 2014, sorted by the size of a BD or IA as a covered institution by itself, without considering the size of that covered institution’s parent depository holding company, if any (hereafter, ‘‘unconsolidated Level 1,’’ ‘‘unconsolidated Level 2,’’ and ‘‘unconsolidated Level 3’’ BDs and 357 When referencing investment advisers, the SEC’s economic analysis references those institutions that meet the definition of investment adviser under section 202(a)(11) of the Investment Advisers Act, including any such institutions that may be prohibited or exempted from registering with the SEC under the Investment Advisers Act and any that are exempt from registration but are reporting. E:\FR\FM\10JNP2.SGM 10JNP2 37764 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules IAs).358 We use 2014 data in our analysis because this is the most recent year for which compensation data is available. From FOCUS reports, there were 131 BDs with total assets above $1 billion at the end of calendar year 2014.359 From Item 1(O) of Form ADV the SEC estimated that, out of 11,702 IAs registered with the SEC, or reporting to the SEC as an exempt reporting adviser, 669 IAs had total assets of at least $1 billion as of December 31, 2014, although the SEC lacks information that allows it to further classify these IAs as Level 1, Level 2, or Level 3 covered institutions.360 TABLE 1—NUMBER OF BROKER-DEALERS AND INVESTMENT ADVISERS Unconsolidated Level 1 Institution Broker-dealers (BDs) ....................................................................... Investment advisers (IAs) ................................................................ i. Broker-Dealers In 2014, 4,416 unique BDs filed FOCUS reports. Of these 4,416 BDs, seven had total assets greater than $250 billion (Level 1 BDs), 13 had total assets Unconsolidated Level 2 7 n/a Unconsolidated Level 3 13 n/a between $50 billion and $250 billion (unconsolidated Level 2 BDs), and 111 had total assets between $1 billion and $50 billion (unconsolidated Level 3 BDs) in 2014.361 As shown in Table 2, 111 n/a Total 131 669 these unconsolidated Level 3 BDs had total assets equal to $9.6 billion on average and $3.7 billion in median; and about 70 percent (78 out of 111) of them had total assets below $10 billion. TABLE 2—SIZE DISTRIBUTION OF BDS Number of BDs BD size Below $1 billion .................................................................... $1–$49 billion (Unconsolidated Level 3) ............................. $50–$250 billion (Unconsolidated Level 2) ......................... Over $250 billion (Level 1) .................................................. Mean size ($ billion) Median size ($ billion) 4,285 111 $0.02 9.6 $0.001 3.7 ........................ ........................ ........................ 13 ........................ ........................ ........................ 7 ........................ ........................ ........................ ........................ ........................ ........................ 90.6 ........................ ........................ ........................ 312.3 ........................ ........................ ........................ ........................ ........................ ........................ 80.3 ........................ ........................ ........................ 275.2 ........................ ........................ ........................ Size range ($ billion) <=10 10–20 20–30 30–40 >40 50–100 100–$150 150–200 >200 250–300 300–350 350–400 >400 Number of BDs per size range 78 16 3 12 2 9 2 2 0 4 2 0 1 mstockstill on DSK3G9T082PROD with PROPOSALS2 The SEC’s analysis indicates that, in 2014, all of the unconsolidated Level 1 and unconsolidated Level 2 BDs were subsidiaries of a holding company or parent institution. Of these parent institutions, only one was not a depository institution holding company. The majority of the unconsolidated Level 3 BDs were also part of a larger corporate structure. It should be noted that some parent institutions owned more than one BD. Out of the 111 unconsolidated Level 3 BDs, 21 BDs were non-reporting, stand-alone institutions (i.e., entities that are not part of a larger corporate structure). In Table 3, the parent institutions of the affected BDs are classified into Level 1, Level 2, or Level 3, based on the ultimate parent’s total consolidated assets.362 As of the end of 2014, there were 23 unique Level 1 parents and 9 unique Level 2 parents that owned covered Level 1, unconsolidated Level 2, and unconsolidated Level 3 BDs. An additional 18 unique parents were Level 3 covered institutions, and those owned only unconsolidated Level 3 BDs. The SEC was not able to classify 29 parent institutions due to the lack of data on their total consolidated assets. 358 The terms ‘‘unconsolidated Level 1 covered institution,’’ ‘‘unconsolidated Level 2 covered institution,’’ and ‘‘unconsolidated Level 3 covered institution’’ used in the SEC’s economic analysis differ from the terms ‘‘Level 1 covered institution,’’ ‘‘Level 2 covered institution,’’ and ‘‘Level 3 covered institution’’ as defined in the proposed rule. 359 Total assets are taken from FOCUS report, Part II Statement of Financial Condition. The assets reported in the FOCUS report are required to be consolidated total assets if a BD has subsidiaries. 360 Form ADV requires IAs to report consolidated balance sheet assets. The 669 number includes 59 IAs that are not registered with the SEC but are reporting. 361 For purposes of this analysis, the SEC determined the unconsolidated level of each BD. For example, if a BD alone had total assets between $1 billion and $50 billion at the end of at least one calendar quarter in 2014, it was classified in this economic analysis as an unconsolidated Level 3 BD. Similarly, if a BD alone had total assets between $50 and $250 billion (greater than $250 billion) in at least one quarter in 2014, it was classified in this economic analysis as an unconsolidated Level 2 (Level 1) BD. This classification method differs from the proposed rule. Thus, some of the unconsolidated Level 2 and unconsolidated Level 3 BDs discussed in this economic analysis may be Level 1 and Level 2 covered institutions after consolidation and for purposes of the proposed rule. Given that an unconsolidated Level 1 BD alone has greater than or equal to $250 billion in total assets, an unconsolidated Level 1 BD would be a Level 1 covered institution for purposes of the proposed rule, regardless of consolidation. 362 The name of the ultimate parent was obtained using the company information in the Capital IQ database. The SEC found total assets information for public parents in the Compustat database. Total assets information for some of the private parents the SEC found in the Capital IQ database. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 PO 00000 Frm 00096 Fmt 4701 Sfmt 4702 E:\FR\FM\10JNP2.SGM 10JNP2 37765 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules TABLE 3—DISTRIBUTION OF BDS BY LEVEL SIZE OF THE PARENT BD as a subsidiary of a BD as a stand-alone institution Level 1 parent Level 2 parent Level 3 parent Parent size n/a Number of unconsolidated Level 1 BDs .............................. Number of unique parents ................................................... Number of public parents .................................................... Median BD assets ($ billion) ................................................ Median parent assets ($ billion) .......................................... Number of unconsolidated Level 2 BDs .............................. Number of unique parents ................................................... Number of public parents .................................................... Median BD assets ($ billion) ................................................ Median parent assets ($ billion) .......................................... Number of unconsolidated Level 3 BDs .............................. Number of unique parents ................................................... Number of public parents .................................................... Median BD assets ($ billion) ................................................ Median parent assets ($ billion) .......................................... 7 7 7 $275.2 $1,882.9 13 11 11 $80.3 $1,702.1 18 14 14 $9.5 $850.8 0 ........................ ........................ ........................ ........................ 0 ........................ ........................ ........................ ........................ 11 9 8 $4.0 $127.7 0 ........................ ........................ ........................ ........................ 0 ........................ ........................ ........................ ........................ 23 19 17 $3.0 $9.2 0 ........................ ........................ ........................ ........................ 0 ........................ ........................ ........................ ........................ 36 29 ........................ $4.4 n/a 0 ........................ ........................ ........................ ........................ 0 ........................ ........................ ........................ ........................ 23 ........................ ........................ ........................ ........................ Total number of unique parents ................................... 23 9 19 29 ........................ Total number of public parents ..................................... 23 8 17 ........................ ........................ The majority of BDs that were subsidiaries were held by a parent registered with the SEC as a reporting institution (i.e., public company). All parents of Level 1 BDs and almost all of the parents of unconsolidated Level 2 BDs were public companies, while 39 out of the 71 unique parents of unconsolidated Level 3 BDs were public companies. Twenty three BDs were not subsidiaries but stand-alone companies that were private Level 3 BDs. ii. Investment Advisers The SEC does not have a precise way of distinguishing among the largest IAs because Form ADV requires an adviser to indicate only whether it has $1 billion or more in assets on the last day of its most recent fiscal year.363 In addition, the information contained on Form ADV relates only to registered investment advisers and exempt reporting advisers, while the proposed rule would apply to all investment advisers.364 As of December 2014, there were 669 IAs with assets of at least $1 billion, of which 129 IAs were affiliated with banking or thrift institutions.365 For the remaining 540 IAs the SEC does not have information on how many of them are stand-alone companies and how many are affiliated with non-bank parent companies. Of the 669 IAs, 51 are dually registered as BDs with the SEC.366 Of the 129 IAs affiliated with banking or thrift institutions, 39 IAs are affiliated with banks and thrifts with $50 billion or more in assets. Of the 39 IAs, 10 IAs were affiliated with banks and thrift institutions with assets between $50 billion and $250 billion; and 23 IAs were affiliated with banks and thrift institutions with assets of more than $250 billion. As Table 4 shows, the 39 IAs have 25 unique parent institutions and most of these parent institutions (17) are public companies. TABLE 4—DISTRIBUTION OF 39 IAS AFFILIATED WITH LEVEL 1 AND LEVEL 2 BANKS AND THRIFTS, BY LEVEL SIZE OF THE PARENT IA as a subsidiary of a Level 1 parent mstockstill on DSK3G9T082PROD with PROPOSALS2 Number of IAs .............................................................................................................................. Number of unique parents ........................................................................................................... Number of public parents ............................................................................................................ 363 See Item 1.O of Part 1A of Form ADV. As noted above, the SEC has not historically examined its regulated entities’ use of incentive-based employee compensation. In this regard, Form ADV does not contain information with respect to such practices. 364 By its terms, the definition of ‘‘covered financial institution’’ in section 956 includes any institution that meets the definition of ‘‘investment adviser’’ under the Investment Advisers Act, regardless of whether the institution is registered as an investment adviser under that Act. Most investment advisers (including registered investment advisers, exempt reporting advisers, or otherwise) currently do not report to the SEC their VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 average total consolidated assets, so the SEC is unable to determine with particularity how many have average total consolidated assets greater than or equal to $1 billion and less than $50 billion, greater than or equal to $50 billion and less than $250 billion, or greater than or equal to $250 billion. The estimates used in this section with respect to investment advisers, however, are based on data reported by registered investment advisers and exempt reporting advisers with the SEC on Form ADV, because the SEC estimates that it is unlikely that investment advisers that are prohibited from registering with the SEC would be subject to the proposed rule. PO 00000 Frm 00097 Fmt 4701 Sfmt 4702 Level 2 parent 23 10 10 Parent size n/a 10 9 7 6 6 0 365 Form ADV requires an adviser to indicate whether it has a ‘‘related person’’ that is a ‘‘banking or thrift institution,’’ but does not require an adviser to identify a related person by type (e.g., a depository institution holding company). See Item 7 of Part 1A and Item 7.A of Schedule D to Form ADV. These estimates are therefore limited by the information reported by registered investment advisers and exempt reporting advisers in their Forms ADV and has necessitated manual referencing of the institutions specified. 366 Because the data presented below for the effects on BDs and IAs are presented separately, in aggregate, they may overstate the costs and other economic effects for dual registrants. E:\FR\FM\10JNP2.SGM 10JNP2 37766 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 2. Current Incentive-Based Compensation Practices The SEC does not have information on the incentive-based compensation practices of the BDs and IAs themselves. The main reason why the SEC lacks such information is that BDs and IAs are generally not public reporting companies and as a result they do not provide the type of compensation information that a public reporting company would file with the SEC as part of its communications with shareholders. Notwithstanding these limitations on the data regarding the incentive-based compensation arrangements at BDs or IAs, when the BDs or IAs are subsidiaries of public reporting companies, the SEC has information for the public reporting company that is the parent of these BDs and IAs. In particular, the information on incentive-based compensation practices for named executive officers (‘‘NEOs’’) is annually disclosed in proxy statements and annual reports filed with the SEC. NEOs typically include the principal executive officer, the principal financial officer, and three most highly compensated executives.367 Given that it lacks data on the BDs and IAs themselves, for the purposes of this economic analysis, the SEC uses data on incentive-based compensation of the NEOs at the parent institutions, which for unconsolidated Level 1 and unconsolidated Level 2 BDs are mostly bank holding companies,368 as an 367 For a company that is not a smaller reporting company, Item 402(a)(3) of Regulation S–K defines named executive officers as: (1) All individuals serving as the company’s principal executive officer or acting in a similar capacity during the last completed fiscal year (PEO), regardless of compensation level; (2) All individuals serving as the company’s principal financial officer or acting in a similar capacity during the last completed fiscal year (PFO), regardless of compensation level; (3) The company’s three most highly compensated executive officers other than the PEO and PFO who were serving as executive officers at the end of the last completed fiscal year; and (4) Up to two additional individuals for whom disclosure would have been provided under the immediately preceding bullet point, except that the individual was not serving as an executive officer of the company at the end of the last completed fiscal year. 368 For Level 1 and unconsolidated Level 2 BDs, the SEC’s analysis indicates that, as of December 2014, two of their 20 unique parent institutions are non-bank holding companies (one investment management firm and one investment bank/ brokerage). For the 39 IAs described in Table 4, six of their 25 unique parent institutions are not bank VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 indirect measure of incentive-based compensation practices at the subsidiary level.369 The SEC also analyzes the incentive-based compensation of public reporting institutions with assets between $1 billion and $50 billion, many of which are not bank holding companies, because it is possible that size may be a determinant of incentive-based compensation arrangements and thus the incentive-based compensation of an unconsolidated Level 3 BD or IA may be more similar to that of a public reporting institution with assets between $1 billion and $50 billion. While the SEC utilizes the abovereferenced public reporting company data, it should be noted that there are a number of caveats that may impact the SEC’s analysis. First, the incentivebased compensation arrangement at the subsidiary level may differ from that of the parent level due to either the difference between the size of the subsidiary relative to the size of the parent, or because the business model of the subsidiary is different from that of the parent. More specifically, the incentive-based compensation arrangement of bank holding companies may be different than that of BDs or IAs given the fundamentally differing natures of the underlying business models and the composition of their respective balance sheets. Further, the incentive-based compensation practices at a public reporting company could be different than those at a non-public reporting company. The SEC also does not have information about incentivebased compensation of non-NEOs and of those employees included in the definition of significant risk-takers under the proposed rule. These caveats mean that the SEC’s analysis, which is mainly based on data from public bank holding companies, may not accurately reflect incentive-based compensation practices at BDs and IAs. To address this lack of data, the SEC has holding companies, For unconsolidated Level 3 BDs, 20 of the 42 unique parent institutions for which data on their size is available are not bank holding companies. 369 It is also possible that the compensation practices between Level 1 parent and unconsolidated Level 2 subsidiary (or between Level 2 parent and unconsolidated Level 3 subsidiary) may be closer to each other than those of Level 1 parent and unconsolidated Level 3 subsidiary. PO 00000 Frm 00098 Fmt 4701 Sfmt 4702 supplemented its analysis with anonymized supervisory data from the Board and the OCC, with limitations to the generalizability of the analysis on non-NEOs and significant risk-takers similar to the ones discussed above. i. Named Executive Officers Table 5A presents data on the compensation structure of NEOs at Level 1, Level 2, and Level 3 parent public reporting institutions of unconsolidated Level 1, unconsolidated Level 2, and unconsolidated Level 3 BDs as of the end of fiscal year 2014.370 In addition to the CEO and the CFO, NEOs typically include the chief operating officer (‘‘COO’’), the general counsel (‘‘GC’’), and the heads of business units such as wealth management and investment banking. As shown in Table 5A, incentive-based compensation is a significant component of NEO compensation at parent institutions. It is approximately 90 percent of total compensation for Level 1 parent institutions and 85 percent for Level 2 parent institutions (median values are also reported in parentheses).371 Additionally, a sizable fraction of incentive-based compensation is in the form of longterm incentive compensation, which is mainly awarded in the form of stock, stock options, or debt instruments.372 The SEC observes that the use of stock options varies by size of the parent institution: Stock options represent on average 6 percent of long-term incentive compensation for Level 1 parents, while they represent approximately 20 percent of long-term incentive compensation for Level 2 parents.373 370 Data comes from Compustat’s ExecuComp database. Out of 30 unique Level 1 and Level 2 parent institutions of Level 1, Level 2, and Level 3 BDs, compensation data is not available for 16 parent institutions. 371 Incentive-based compensation is determined as Total compensation as reported in SEC filings— Salary. 372 Long-term incentive compensation is determined using the following items from Compustat’s ExecuComp database: Total compensation as reported in SEC filings—Salary— Bonus—Other annual compensation. Short-term incentive compensation is determined as Bonus + Other annual compensation. 373 This is consistent with evidence of decreased use of stock options in compensation arrangements over the last decade, with companies replacing the use of stock options with restricted stock units. See Frydman and Jenter, CEO Compensation, Annual Review of Financial Economics (2010). E:\FR\FM\10JNP2.SGM 10JNP2 37767 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules TABLE 5A—COMPENSATION STRUCTURE OF BD PARENT INSTITUTIONS BY LEVEL SIZE Level 1 parent Table 5B presents similar statistics for the compensation structures of Level 1 and Level 2 parent institutions of IAs that were affiliated with banks and thrift institutions with assets of more than $50 billion.374 The summary statistics for the parent companies of IAs mirrors the statistics for the BDs’ parent companies: A significant portion of NEO compensation is in the form of incentive-based compensation, most of which is long-term incentive Level 3 parent 90% (90%) 15% (0%) 74% (81%) 6% (0%) 68% (69%) 5.5 (5) 10 Incentive-based compensation as percent of total compensation .............................................. Short-term incentive compensation as percent of total compensation ....................................... Long-term incentive compensation as percent of total compensation ........................................ Option awards as percent of long-term incentive compensation ................................................ Stock awards as percent of long-term incentive compensation ................................................. Number of NEOs per institution .................................................................................................. Number of parent institutions with available compensation data ................................................ Level 2 parent 85% (86%) 1% (0%) 85% (86%) 20% (18%) 40% (37%) 5.3 (5) 4 83% (87%) 21% (0%) 62% (77%) 4% (0%) 44% (49%) 5.4 (5) 7 compensation that comes in the form of stock awards.375 Both Level 1 and Level 2 IA parents exhibit relatively little use of options. TABLE 5B—COMPENSATION STRUCTURE OF LEVEL 1 AND LEVEL 2 IA PARENT INSTITUTIONS Level 1 parent Incentive compensation as percent of total compensation ..................................................................................... Short-term incentive compensation as percent of total compensation ................................................................... Long-term incentive compensation as percent of total compensation .................................................................... Option awards as percent of long-term incentive compensation ............................................................................ Stock awards as percent of long-term incentive compensation ............................................................................. Number of NEOs per institution .............................................................................................................................. Number of parent institutions with available compensation data ............................................................................ Table 6A provides summary statistics for types of incentive-based compensation currently awarded by parent institutions of BDs, their vesting periods, and the specific measures on which these awards are based.376 All types of parent institutions use cash in their short-term incentive compensation. Only 12 percent of Level 1 parent institutions, and none of the Level 2 parent institutions, defer shortterm incentive compensation that is Level 2 parent 90% (90%) 20% (28%) 70% (65%) 8% (0%) 71% (73%) 5.2 (5) 8 84% (94%) 2% (0%) 82% (84%) 9% (0%) 51% (55%) 5.2 (5) 5 awarded in cash only. A significant fraction of Level 1 parent institutions awards short-term incentive compensation in the form of cash and stock. TABLE 6A—TYPE AND FREQUENCY OF USE OF INCENTIVE-BASED COMPENSATION AWARDS—LEVEL 1, LEVEL 2, AND LEVEL 3 BD PARENT INSTITUTIONS Short-term incentive compensation Long-term incentive compensation mstockstill on DSK3G9T082PROD with PROPOSALS2 Level 1 parent Number of parent institutions with available compensation data. Fraction of total compensation: CEO ................................................ Other NEOs .................................... Award: Cash only—percent of institutions .. percent that defer cash ............ Cash & stock—percent of institutions. Avg percent of stock in ST IC Avg deferral for stock .............. Restricted stock-percent of institutions. Avg percent of LT IC ............... Avg vesting period ................... Type of vesting: percent with pro-rata ........ Level 2 parent Level 3 parent Level 1 parent Level 2 parent 16 ................... 5 ..................... 13 ................... 16 ................... 5 ..................... 13. 25% ................ 27% ................ 44% ................ 45% ................ 39% ................ 59% ................ 52% ................ 50% ................ 45% ................ 40% ................ 60%. 40%. 44% ................ 12% ................ 56% ................ 100% .............. 0% .................. 0% .................. 100% .............. 9% .................. 0% .................. 6% .................. 6% .................. 6% .................. 0% .................. 0% .................. 0% .................. 0%. 0%. 9%. 55%. 3 years. ........................ ........................ ........................ 56% ................ 60% ................ 100%. ........................ ........................ ........................ ........................ ........................ ........................ 36% ................ 3.5 years ........ 26% ................ 3.3 years ........ 75%. 3.4 years. ........................ ........................ ........................ 87% ................ 100% .............. 82%. 374 There is an overlap between the parent institutions of BDs and IAs: About half of the IAs’ parents are also parents of BDs and included in Table 5A. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 375 This is not surprising given that approximately half of the IAs’ parent institutions are also parent institutions of BDs and included in Table 5A. PO 00000 Frm 00099 Fmt 4701 Sfmt 4702 Level 3 parent 376 Data for tables 6A through 10B is collected from the 2015 and 2007 proxy statements, 10–Ks, and 20–Fs of the Level 1, Level 2, and Level 3 parent institutions. E:\FR\FM\10JNP2.SGM 10JNP2 37768 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules TABLE 6A—TYPE AND FREQUENCY OF USE OF INCENTIVE-BASED COMPENSATION AWARDS—LEVEL 1, LEVEL 2, AND LEVEL 3 BD PARENT INSTITUTIONS—Continued Short-term incentive compensation Long-term incentive compensation Level 1 parent percent with cliff ................ Performance stock—percent of institutions. Avg percent of LT IC ............... Avg performance period .......... percent with perf period <3yrs. percent with vesting .......... Avg vesting period ................... Type of vesting: percent with pro-rata ........ percent with cliff ................ Options—percent of institutions ...... Avg percent of LT IC ............... Avg vesting period ................... Notional bonds—percent of institutions. Avg percent of LT IC ............... Avg vesting period ................... Performance measures: EPS or Net income ......................... ROA ................................................ ROE ................................................ Pre-tax income ................................ Capital strength ............................... Efficiency ratios ............................... Strategic goals ................................ TSR ................................................. Level 2 parent Level 3 parent Level 1 parent Level 2 parent ........................ ........................ ........................ ........................ ........................ ........................ 13% ................ 88% ................ 0% .................. 80% ................ 18%. 36%. ........................ ........................ ........................ ........................ ........................ ........................ ........................ ........................ ........................ 53% ................ 3.7 years ........ 6% .................. 42% ................ 3 years ........... 0% .................. 44%. 2 years. 100%. ........................ ........................ ........................ ........................ ........................ ........................ 14% ................ 3.7 years. 0% .................. 0%. ........................ ........................ 0% .................. ........................ ........................ 0% .................. ........................ ........................ 0% .................. ........................ ........................ 0% .................. ........................ ........................ ........................ ........................ ........................ ........................ 100%. 0%. 12% ................ 4% .................. 3.5 years ........ 6% .................. 60% ................ 20% ................ 3.3 years ........ 0% .................. 18%. 39%. 3 years. 0%. ........................ ........................ ........................ ........................ ........................ ........................ 30%. 5 years. 44% ................ 6% .................. 44% ................ 25% ................ 31% ................ 13% ................ 19% ................ 19% ................ 100% .............. 40% ................ 0% .................. 0% .................. 0% .................. 40% ................ 25% ................ 25% ................ 31% ................ 0% .................. 31% ................ 62% ................ 0% .................. 0% .................. 23% ................ 46% ................ 19% ................ 19% ................ 44% ................ 6% .................. 6% .................. 6% .................. 13% ................ 56% ................ 50% ................ 25% ................ 50% ................ 0% .................. 0% .................. 0% .................. 0% .................. 75% ................ 38%. 0%. 31%. 54%. 0%. 0%. 23%. 54%. A significant percentage of long-term incentive compensation of BD parent institutions comes in the form of restricted or performance stock.377 Restricted stock accounts for about 36 percent of long-term incentive compensation at Level 1 parent institutions and approximately 26 percent at Level 2 parent institutions. It has a vesting period of approximately 3.5 years. Performance stock awards are more popular: Over 80 percent of Level 1 and Level 2 parent institutions employ performance stock, which on average accounts for approximately 53 percent of the long-term incentive compensation of Level 1 parents and 42 percent of that of Level 2 parents. Performance stock awards are frequently evaluated using total shareholder return (‘‘TSR’’), return on equity (‘‘ROE’’), return on assets (‘‘ROA’’), earnings per share (‘‘EPS’’), or a combination of TSR and one or more accounting measures of performance over an average of 3.7 years for Level 1 parent institutions and 3 years for Level 2 parent institutions. About 14 percent of Level 1 parent institutions impose deferral after the performance period for performance stock. The average deferral period for these awards is approximately 4 years. Consistent with the results in Table 5A above, stock options do not appear Level 3 parent to be a popular component of incentivebased compensation arrangements among Level 1 parent institutions. They are more frequently used by Level 2 parent institutions, for which options account for approximately 20 percent of long-term incentive compensation. One of the Level 1 parents also uses debt instruments as a part of NEOs’ long-term incentive compensation, which fully vest after five years (i.e. cliff vest). Similar results are obtained when examining the compensation practices of Level 1 and Level 2 parent institutions of IAs, as the summary statistics in Table 6B suggest. TABLE 6B—TYPE AND FREQUENCY OF USE OF INCENTIVE-BASED COMPENSATION AWARDS—LEVEL 1 AND LEVEL 2 IA PARENT INSTITUTIONS mstockstill on DSK3G9T082PROD with PROPOSALS2 Short-term incentive compensation Long-term incentive compensation Level 1 parent Number of parent institutions with available compensation data ................... Fraction of total compensation: CEO ......................................................................................................... Other NEOs ............................................................................................. 377 Restricted stock includes actual shares or share units that are earned by continued employment, often referred to as time-based VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 Level 2 parent Level 1 parent 10 ................... 6 ..................... 10 ................... 6. 23% ................ 27% ................ 26% ................ 27% ................ 64% ................ 58% ................ 63%. 59%. awards. Performance stock consists of stockdenominated actual shares or share units (performance shares) and grants of cash or dollar- PO 00000 Frm 00100 Fmt 4701 Sfmt 4702 Level 2 parent denominated units (performance units) earned based on performance against predetermined objectives over a defined period. E:\FR\FM\10JNP2.SGM 10JNP2 37769 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules TABLE 6B—TYPE AND FREQUENCY OF USE OF INCENTIVE-BASED COMPENSATION AWARDS—LEVEL 1 AND LEVEL 2 IA PARENT INSTITUTIONS—Continued Short-term incentive compensation Long-term incentive compensation Level 1 parent Award: Cash only—percent of institutions ........................................................... percent that defer cash .................................................................... Cash & stock—percent of institutions ..................................................... Avg percent of stock in ST IC .......................................................... Avg deferral for stock ....................................................................... Restricted stock—percent of institutions ................................................. Avg percent of LT IC ........................................................................ Avg vesting period ............................................................................ Type of vesting: percent with pro-rata ................................................................. percent with cliff ........................................................................ Performance stock—percent of institutions ............................................. Avg percent of LT IC ........................................................................ Avg performance period ................................................................... percent with perf period <3yrs .................................................. percent with vesting .................................................................. Avg vesting period ............................................................................ Type of vesting: percent with pro-rata ................................................................. percent with cliff ........................................................................ Options—percent of institutions .............................................................. Avg percent of LT IC ........................................................................ Avg vesting period ............................................................................ Performance measures: EPS or Net income .................................................................................. ROA ......................................................................................................... ROE ......................................................................................................... Pre-tax income ........................................................................................ Capital strength ....................................................................................... Efficiency ratios ....................................................................................... Strategic goals ......................................................................................... TSR .......................................................................................................... Table 7A reports whether incentivebased compensation of NEOs at Level 1, Level 2 parent Level 1 parent 60% ................ 10% ................ 40% ................ 50%. 3 years. ........................ ........................ ........................ 83% ................ 0% .................. 17% ................ 0% .................. 0% .................. 10% ................ 0%. 0%. 17%. ........................ ........................ ........................ 80% ................ 51% ................ 3.5 years ........ 67%. 30%. 3.8 years. ........................ ........................ ........................ ........................ ........................ ........................ ........................ ........................ ........................ ........................ ........................ ........................ ........................ ........................ ........................ ........................ 100% .............. 0% .................. 80% ................ 42% ................ 3.9 years ........ 13% ................ 13% ................ 4 years. 100%. 0%. 100%. 56%. 2.6 years. 0%. 0%. ........................ ........................ 0% .................. ........................ ........................ ........................ ........................ 0% .................. ........................ ........................ 100%. 0%. 10% ................ 25% ................ 4 years ........... 50%. 28%. 3.2 years. 60% 10% 40% 10% 30% 30% 20% 30% 67% ................ 17% ................ 33% ................ 0% .................. 0% .................. 17% ................ 17% ................ 17% ................ 20% ................ 20% ................ 60% ................ 0% .................. 10% ................ 10% ................ 20% ................ 50% ................ 50%. 17%. 67%. 0%. 17%. 17%. 17%. 17%. ................ ................ ................ ................ ................ ................ ................ ................ Level 2, and Level 3 parent institutions of BDs is deferred or subject to Level 2 parent clawback, forfeiture, and certain prohibitions.378 TABLE 7A—CURRENT DEFERRAL, CLAWBACK, FORFEITURE AND CERTAIN PROHIBITIONS FOR NEOS AT LEVEL 1, LEVEL 2, AND LEVEL 3 BDS PARENT INSTITUTIONS mstockstill on DSK3G9T082PROD with PROPOSALS2 Level 1 parent Number of parent institutions with available compensation data ................................................ Number of NEOs: Total number of NEOs ......................................................................................................... Average number of NEOs per institution ............................................................................. Deferred compensation: Institutions with deferred compensation ............................................................................... Average percent of deferred compensation: CEO ............................................................................................................................... Other NEOs ................................................................................................................... Average number of years deferred ...................................................................................... Type of compensation deferred: Institutions with cash ............................................................................................................ Institutions with stock ........................................................................................................... Institutions with bonds .......................................................................................................... Clawback and forfeiture: Institutions with clawback ..................................................................................................... Institutions with forfeiture ...................................................................................................... Prohibitions: Institutions prohibiting hedging ............................................................................................. 378 From the disclosures provided by reporting companies on clawback, forfeiture and certain VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 prohibitions, the SEC is able to establish whether a reporting company currently uses policies that are PO 00000 Frm 00101 Fmt 4701 Sfmt 4702 Level 2 parent Level 3 parent 16 5 13 104 6 24 5 66 5 100% 80% 100% 75% 73% 3.5 52% 49% 2.6 65% 43% 3.3 19% 100% 6% 25% 100% N/A 8% 100% 8% 100% 100% 80% 60% 92% 85% 75% 60% 62% in line with the proposed rule, but was not able to establish compliance with certainty. E:\FR\FM\10JNP2.SGM 10JNP2 37770 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules TABLE 7A—CURRENT DEFERRAL, CLAWBACK, FORFEITURE AND CERTAIN PROHIBITIONS FOR NEOS AT LEVEL 1, LEVEL 2, AND LEVEL 3 BDS PARENT INSTITUTIONS—Continued Level 1 parent Institutions prohibiting volume-driven incentive-based compensation ................................. Institutions prohibiting acceleration of payments except in case of death and disability .... Maximum incentive-based compensation: Average percent ................................................................................................................... Risk Management: Institutions with Risk Committees ........................................................................................ Institutions with fully independent Compensation Committee ............................................. Institutions where CROs review compensation packages ................................................... Level 2 parent Level 3 parent N/A 70% N/A 14% N/A 9% 155% 190% 134% 100% 93% 31.3% 67% 88% 20% 62% 83% 15% mstockstill on DSK3G9T082PROD with PROPOSALS2 In general, the SEC’s analysis of the compensation information disclosed in proxy statements and annual reports by parent institutions of covered BDs suggests that NEO compensation practices at most of the parent institutions are in line with the main requirements and prohibitions in the proposed rule. This may not be surprising given that the baseline already reflects a regulatory response to the financial crisis.379 For example, all Level 1 parents and 80 percent of Level 2 parents of BDs require some form of deferral of incentive-based executive compensation. The average Level 1 parent institution defers 75 percent of incentive-based compensation awarded to CEOs and 73 percent awarded to other NEOs, which is above the minimum deferral amount that would be required by the proposed rule. In a similar vein, an average of 52 percent of incentive-based compensation awarded to CEOs and 49 percent awarded to other NEOs is deferred at Level 2 parent institutions, similar to what would be required by the proposed rule. The length of the deferral period at Level 1 and Level 2 parent institutions is also currently in line with what would be required by the proposed rule: On average, 3.5 years for NEOs at Level 1 parent institutions and approximately 3 years for those at Level 2 parent institutions. Regarding the type of incentive-based compensation that is being deferred, both Level 1 and Level 2 parent institutions defer equity-based compensation. One of the Level 1 parent institutions uses debt instruments as incentive-based compensation and defers it as well. Only a fraction of them (20 percent of Level 1 and 25 percent of Level 2 parent institutions), however, currently defer incentive-based compensation in cash; the proposed rule would require deferral of substantial portions of both cash and equity-like instruments for senior executive officers and significant risk-takers at Level 1 and Level 2 covered institutions. Thus, for both Level 1 and Level 2 parent institutions the current composition of their deferred compensation appears to conform to the proposed rule requirements with respect to equity-like instruments, but only a few Level 1 and Level 2 parent institutions appear to conform to the proposed rule requirements with respect to deferral of cash. Some of the other requirements and prohibitions for Level 1 and Level 2 covered institutions in the proposed rule are also currently in place at the parent institutions of covered BDs. For example, all of the Level 1 parent institutions and a large majority of Level 2 parent institutions require that the incentive-based compensation awards of NEOs be subject to clawback and forfeiture provisions. The frequency of the use of clawback and forfeiture by Level 1 and Level 2 parent institutions is higher than that reported by a commenter 380 based on the results of a study.381 The commenter did not specify, however, when the study was done, nor the number and type of companies covered by the study. A majority of parent institutions also have prohibitions on hedging.382 Consistent with the proposed prohibition of relying solely on relative performance measures when awarding incentive-based compensation, all of the Level 1 and Level 2 parent institutions currently use a mix of absolute and relative performance measures in their incentive-based compensation arrangements. Additionally, most Level 1 parent institutions prohibit acceleration of compensation payments except in the cases of death or disability, whereas very few Level 2 parent institutions do that. The average maximum incentive-based compensation opportunity is 155 percent of the target amount for Level 1 parent institutions and 190 percent for Level 2 parent institutions, which is above what would be permitted by the proposed rules. In the SEC’s analysis of the compensation disclosure, the SEC did not find any mention about prohibition of volume-driven incentivebased compensation as would be proposed by the rule. Similar results are obtained when analyzing the current practices of the Level 1 and Level 2 parent institutions of IAs (Table 7B). All IA parent institutions defer NEO compensation, on average, for three years. Almost all parent companies subject incentivebased compensation of NEOs to clawback and forfeiture and prohibit hedging transactions. 379 See, 2010 Federal Banking Agency Guidance, available at: https://www.federalreserve.gov/ newsevents/press/bcreg/20100621a.htm. 380 All references to commenters in this economic analysis refer to comments received on the 2011 Proposed Rule. 381 See comment letter from Financial Services Roundtable (May 31, 2011). The Roundtable conducted a study of a portion of its membership. Data was collected on the risk management strategies and the procedures for determining compensation since 2008. 382 The proposed rule would prohibit covered institutions from purchasing hedging instruments on behalf of covered persons. The statistics regarding hedging prohibitions presented in Table 7A and Table 7B, and Table 9A and Table 9B refer to complete prohibition regarding the use of hedging instruments by senior executives and directors respectively. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 PO 00000 Frm 00102 Fmt 4701 Sfmt 4702 E:\FR\FM\10JNP2.SGM 10JNP2 37771 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules TABLE 7B—CURRENT DEFERRAL, CLAWBACK, FORFEITURE AND CERTAIN PROHIBITIONS FOR NEOS AT LEVEL 1 AND LEVEL 2 IA PARENT INSTITUTIONS Level 1 parent Number of parent institutions with available compensation data ............................................................................ Number of NEOs: Total number of NEOs ..................................................................................................................................... Average number of NEOs per institution ......................................................................................................... Deferred compensation: Institutions with deferred compensation ........................................................................................................... Average percent of deferred compensation:. CEO ........................................................................................................................................................... Other NEOs ............................................................................................................................................... Average number of years deferred .................................................................................................................. Type of compensation deferred:. Institutions with cash ........................................................................................................................................ Institutions with stock ....................................................................................................................................... Institutions with bonds ...................................................................................................................................... Clawback and forfeiture: Institutions with clawback ................................................................................................................................. Institutions with forfeiture .................................................................................................................................. Prohibitions: Institutions prohibiting hedging ......................................................................................................................... Institutions prohibiting volume-driven incentive-based compensation ............................................................. Institutions prohibiting acceleration of payments but for death and disability ................................................. Maximum incentive-based compensation: Average percent ............................................................................................................................................... Risk Management: Institutions with Risk Committees .................................................................................................................... Institutions with fully independent Compensation Committee ......................................................................... Institutions where CROs review compensation packages ............................................................................... To examine how the use of the proposed rule’s requirements and prohibitions has changed since the financial crisis, in Tables 8A and 8B the SEC reports the use of incentive-based compensation deferral, clawback, forfeiture, and some of the rule prohibitions by the Level 1 and Level 2 parent institutions of BDs and IAs in year 2007, just prior to the financial crisis. A comparison with the results in Tables 7A and 7B shows that just prior to the financial crisis Level 1 and Level 2 covered institutions deferred less of NEOs’ incentive-based compensation compared to what they defer nowadays. Level 2 parent 10 6 53 5 32 5 100% 100% 77% 71% 3.6 69% 68% 3.3 20% 100% 0% 67% 100% 0 100% 100% 100% 83% 90% N/A 70% 67% N/A 0% 148% 188% 100% 80% 50% 100% 89% 33% More importantly, the use of clawback and forfeiture in 2007 was far less common than it is now: For example, none of these institutions reported using clawback arrangements as of year 2007. Additionally, fewer covered institutions had risk committees in year 2007. TABLE 8A—DEFERRAL, CLAWBACK, FORFEITURE AND CERTAIN PROHIBITIONS FOR NEOS AT LEVEL 1 AND LEVEL 2 BD PARENT INSTITUTIONS IN YEAR 2007 mstockstill on DSK3G9T082PROD with PROPOSALS2 Level 1 parent Number of parent institutions with available compensation data ............................................................................ Number of NEOs: Total number of NEOs ..................................................................................................................................... Average number of NEOs per institution ......................................................................................................... Deferred compensation: Institutions with deferred compensation ........................................................................................................... Average percent of deferred compensation: CEO ........................................................................................................................................................... Other NEOs ............................................................................................................................................... Average number of years deferred .................................................................................................................. Type of compensation deferred: Institutions with cash ........................................................................................................................................ Institutions with stock ....................................................................................................................................... Clawback and forfeiture: Institutions with clawback ................................................................................................................................. Institutions with forfeiture .................................................................................................................................. Prohibitions: Institutions prohibiting hedging ......................................................................................................................... Institutions prohibiting volume-driven incentive-based compensation ............................................................. Institutions prohibiting acceleration of payments except in case of death and disability ................................ Maximum incentive-based compensation: Average percent ............................................................................................................................................... Risk Management: Institutions with Risk Committees .................................................................................................................... VerDate Sep<11>2014 00:24 Jun 10, 2016 Jkt 238001 PO 00000 Frm 00103 Fmt 4701 Sfmt 4702 E:\FR\FM\10JNP2.SGM 10JNP2 Level 2 parent 16 5 101 6 26 5 100% 100% 49% 51% 3.3 34% 28% 3 0% 100% 40% 100% 0% 27% 0% 40% 14% N/A 67% 0% N/A 20% 186% N/A 60% 20% 37772 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules TABLE 8A—DEFERRAL, CLAWBACK, FORFEITURE AND CERTAIN PROHIBITIONS FOR NEOS AT LEVEL 1 AND LEVEL 2 BD PARENT INSTITUTIONS IN YEAR 2007—Continued Level 1 parent Institutions with fully independent Compensation Committee ......................................................................... Institutions where CROs review compensation packages ............................................................................... Thus, the analysis suggests that following the financial crisis, most Level 1 and Level 2 parent institutions of BDs and IAs have adopted to a certain extent some of the provisions and Level 2 parent 93% 0% 100% 0% prohibitions that would be required by the proposed rule. TABLE 8B—DEFERRAL, CLAWBACK, FORFEITURE AND CERTAIN PROHIBITIONS FOR NEOS AT LEVEL 1 AND LEVEL 2 IA PARENT INSTITUTIONS IN YEAR 2007 Level 1 parent Number of parent institutions with available compensation data ............................................................................ Number of NEOs: Total number of NEOs ..................................................................................................................................... Average number of NEOs per institution ......................................................................................................... Deferred compensation: Institutions with deferred compensation ........................................................................................................... Average percent of deferred compensation: CEO ........................................................................................................................................................... Other NEOs ............................................................................................................................................... Average number of years deferred: ................................................................................................................. Type of compensation deferred: Institutions with cash ........................................................................................................................................ Institutions with stock ....................................................................................................................................... Clawback and forfeiture: Institutions with clawback ................................................................................................................................. Institutions with forfeiture .................................................................................................................................. Prohibitions: Institutions prohibiting hedging ......................................................................................................................... Institutions prohibiting volume-driven incentive-based compensation ............................................................. Institutions prohibiting acceleration of payments but for death and disability ................................................. Maximum incentive-based compensation Risk Management: Average percent ............................................................................................................................................... Institutions with Risk Committees .................................................................................................................... Institutions with fully independent Compensation Committee ......................................................................... Institutions where CROs review compensation packages ............................................................................... Table 9A lists the most frequent triggers for clawback and forfeiture, which include some type of misconduct and adverse performance/outcome. About 19 percent of Level 1 parent institutions use improper or excessive risk-taking as a trigger for forfeiture and clawback. About 88 percent of Level 1 parent institutions use misconduct, and 75 percent of Level 1 parent institutions Level 2 parent 10 5 53 5 26 5 100% 100% 45% 53% 3.3 44% 33% 3.5 20% 100% 40% 100% 0% 40% 0% 40% 20% N/A 40% 0% N/A 100% 223% 60% 100% 0% N/A 0% 100% 0% also use adverse performance as triggers for clawback, similar to the proposed rules. TABLE 9A—PERCENTAGE OF LEVEL 1, LEVEL 2, AND LEVEL 3 BD PARENT INSTITUTIONS BY TRIGGER FOR FORFEITURE AND CLAWBACK Level 1 parents Level 2 parents Level 3 parents Trigger mstockstill on DSK3G9T082PROD with PROPOSALS2 Forfeiture: % of firms Adverse performance/outcome ................ Misconduct/gross/detrimental conduct ..... Improper/excessive risk-taking ................ Managerial failure .................................... Restatement/inaccurate reporting ............ Voluntary resignation/retirement .............. Misuse of confidential information/competitive activity ...................................... Policy/regulatory breach .......................... For-cause termination .............................. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 Clawback: % of firms Forfeiture: % of firms Clawback: % of firms Forfeiture: % of firms Clawback: % of firms 75 88 19 6 19 13 75 88 19 6 19 13 20 40 0 0 40 0 20 60 0 0 60 0 0 57 14 0 71 0 9 63 18 0 73 0 ........................ 6 6 ........................ 6 6 ........................ 0 0 ........................ 0 20 29 0 14 0 0 0 PO 00000 Frm 00104 Fmt 4701 Sfmt 4702 E:\FR\FM\10JNP2.SGM 10JNP2 37773 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules TABLE 9A—PERCENTAGE OF LEVEL 1, LEVEL 2, AND LEVEL 3 BD PARENT INSTITUTIONS BY TRIGGER FOR FORFEITURE AND CLAWBACK—Continued Level 1 parents Level 2 parents Level 3 parents Trigger Forfeiture: % of firms Number of parent institutions with available compensation data ....................... 16 The use of forfeiture and clawback triggers is similar for IA parent institutions, as Table 9B shows. A Clawback: % of firms Forfeiture: % of firms ........................ Clawback: % of firms 5 Forfeiture: % of firms ........................ significant number of Level 1 parent institutions use adverse performance Clawback: % of firms 13 ........................ and misconduct as triggers for both clawback and forfeiture. TABLE 9B—TRIGGERS FOR FORFEITURE AND CLAWBACK OF LEVEL 1 AND LEVEL 2 IA PARENT INSTITUTIONS Level 1 parents Trigger Forfeiture: % of firms Adverse performance/outcome ........................................................................ Misconduct/gross/detrimental conduct ............................................................ Improper/excessive risk-taking ........................................................................ Managerial failure ............................................................................................ Restatement/inaccurate reporting .................................................................... Misuse of confidential information/competitive activity .................................... For-cause termination ...................................................................................... Number of parent institutions with available compensation data .................... Some of the provisions of the proposed rule (e.g., prohibition of hedging) would apply to covered persons that are non-employee directors who receive incentive-based compensation at Level 1 and Level 2 covered institutions. Table 10A presents 80 60 40 0 10 10 10 10 Level 2 parents Clawback: % of firms Forfeiture: % of firms 80 70 40 0 30 10 10 ........................ summary statistics on the current compensation practices of Level 1, Level 2, and Level 3 parent public institutions of BDs with respect to their nonemployee directors. The data shows that most of the Level 1 parent institutions and all of the Level 2 parent institutions Clawback: % of firms 33 50 17 0 33 33 33 6 33 67 17 17 50 17 17 ........................ provide incentive-based compensation to their non-employee directors, and this compensation comes mainly in the form of deferred equity. Additionally, a large percentage of both Level 1 and Level 2 parents prohibit hedging by non-employee directors. TABLE 10A—INCENTIVE-BASED COMPENSATION OF NON-EMPLOYEE DIRECTORS OF BD PARENTS Level 3 parents Level 1 parents Percentage of institutions with non-employee directors receiving IBC .............................. Non-employee director IBC as percentage of total compensation .................................... Type of IBC: Deferred equity ............................................................................................................ Options ........................................................................................................................ Vesting (average number of years) .................................................................................... Percentage of institutions prohibiting hedging by non-employee directors ........................ The analysis of non-employee director compensation at the Level 1 and Level 2 parent institutions of IAs in Table 10B shows similar results: In all of the Level 2 parents 77% .................. 56% .................. 100% ................ 46% .................. 100%. 55%. 90% .................. 10% .................. 2.6 years ........... 70% .................. 100% ................ 50% .................. 2.3 years ........... 100% ................ 100%. 8%. 1.9 years. 25%. parent institutions non-employee directors receive incentive-based compensation and a significant fraction of parent institutions prohibit hedging transactions related to incentive-based compensation. mstockstill on DSK3G9T082PROD with PROPOSALS2 TABLE 10B—INCENTIVE-BASED COMPENSATION OF NON-EMPLOYEE DIRECTORS OF IA PARENTS Level 1 Percentage of institutions with non-employee directors receiving IBC ............................................................. Non-employee director IBC as percentage of total compensation ................................................................... Type of IBC: Deferred equity ........................................................................................................................................... Options ....................................................................................................................................................... Vesting (average number of years) ................................................................................................................... Percentage of institutions prohibiting hedging by non-employee directors ...................................................... VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 PO 00000 Frm 00105 Fmt 4701 Sfmt 4702 E:\FR\FM\10JNP2.SGM Level 2 100% ................ 56% .................. 100%. 46%. 90% .................. 0% .................... 1.5 years ........... 78% .................. 100%. 17%. 1.6 years. 83%. 10JNP2 37774 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules ii. Executives Other Than Named Executive Officers While the above statistics are based on publicly disclosed information on compensation for the five most highly compensated executive officers at parent institutions, the proposed rule would apply to any executive officer, employee, director or principal shareholder (covered persons) who receives incentive-based compensation. Thus, the data presented above may not be representative for non-NEOs. To provide some evidence on the current incentive-based compensation arrangements of non-NEOs, the SEC uses anonymized supervisory data from the Board. It should be noted that the composition of the supervisory data sample could be different than that of the Level 1 and Level 2 parent institutions analyzed above. To alleviate this potential selection problem, Table 10 compares NEO and non-NEO compensation arrangements only for the supervisory data sample. Also, the supervisory data comes from banks, while the data above is from bank holding companies. Because there may be differences in incentive-based compensation arrangements and policies at the bank level and the bank holding company level, the supervisory data analysis could yield different results compared to the results presented in the tables above. Since the supervisory data does not identify NEOs and non-NEOs but identifies the managerial position of each executive, the SEC uses an indirect approach to separate the two groups of executives. From the proxy statements of Level 1 and Level 2 parent institutions, the SEC identifies the executives that are most often included in the definition of NEOs, in addition to the CEO and the CFO. These executives are the COO, the GC, and often the heads of wealth management or investment banking. The SEC then classifies these executives as NEOs and any other executive as non-NEO. Table 11 presents summary statistics for NEOs and non-NEOs based on the supervisory data. Similar to NEOs, non-NEOs tend to have a significant fraction of long-term incentive compensation in the form of restricted stock units (‘‘RSUs’’) and performance stock units (‘‘PSUs’’) that is deferred on average for about three years. Only 36 percent of institutions in the sample used cash as incentive-based compensation for non-NEOs and a significant fraction (on average about 50 percent across institutions that use cash as incentive-based compensation) of the cash incentive-based compensation is deferred. Similarly, 45 percent of the deferred incentive-based compensation for non-NEOs was in the form of restricted stock and 54 percent was in the form of performance share units. Fifty percent of the institutions in the sample used options as incentive-based compensation for non-NEOs, with average vesting period of approximately 3.7 years. TABLE 11—EXISTING COMPENSATION ARRANGEMENTS FOR NEO AND NON-NEO EXECUTIVES Non-NEOs mstockstill on DSK3G9T082PROD with PROPOSALS2 Number of institutions with available compensation data ........................... Number of executives .................................................................................. ST IC/total IC ............................................................................................... Deferred IC/total IC ...................................................................................... Options/total IC ............................................................................................ percent of institutions with options .............................................................. Deferred IC subject to clawback and forfeit/deferred IC ............................. Types of IC compensation used: Cash: percent of institutions using cash ......................................................... cash as percent of deferred IC ............................................................ length of vesting ................................................................................... type of vesting ...................................................................................... RSUs: percent of institutions using RSUs ....................................................... RSU as percent of deferred IC ............................................................ length of vesting ................................................................................... type of vesting ...................................................................................... PSUs: percent of institutions using PSUs ....................................................... PSU as percent of deferred IC ............................................................. performance period .............................................................................. length of vesting ................................................................................... type of vesting ...................................................................................... Options: percent of institutions using options ..................................................... Options as percent of deferred IC ........................................................ length of vesting ................................................................................... type of vesting ...................................................................................... iii. Significant Risk-Takers The proposed rule requirements also would apply to significant risk-takers who receive incentive-based compensation. Because data on the compensation of significant risk-takers is not publicly available, the SEC relies on bank supervisory data from the OCC VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 14 ................................................ 112 .............................................. 41% ............................................. 60% ............................................. 12% ............................................. 70% ............................................. 57% ............................................. 14. 50. 40%. 64%. 13%. 70%. 61%. 36% ............................................. 48% ............................................. 3 years ........................................ 40% immediate, 60% pro-rata .... 36%. 50%. 3 years. 40% immediate, 60% pro-rata. 64% ............................................. 45% ............................................. 3.2 years ..................................... 11% immediate, 89% pro-rata .... 64%. 47%. 3.2 years. 11% immediate, 89% pro-rata. 64% ............................................. 54% ............................................. 3 years ........................................ 3 years ........................................ 78% immediate, 22% pro-rata .... 64%. 56%. 3 years. 3 years. 78% immediate, 22% pro-rata. 50% ............................................. 18% ............................................. 3.7 years ..................................... 100% pro-rata ............................. 50%. 19%. 3.7 years. 100% pro-rata. to provide some evidence on the current practices regarding significant risk-taker compensation at covered institutions. In the OCC anonymized data, banks identify material risk-takers and specific compensation arrangements for them. The definition of a material risk-taker is similar, but not identical, to that of a significant risk-taker in the proposed PO 00000 Frm 00106 Fmt 4701 NEOs Sfmt 4702 rule. Based on supervisory data from three Level 2 covered institutions, it seems that the incentive-based compensation of material risk-takers is subject to deferral, clawback and forfeiture. The fraction of incentivebased compensation that is subject to deferral depends on the size of the compensation a material risk-taker E:\FR\FM\10JNP2.SGM 10JNP2 37775 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules receives. As Table 12 suggests, the percentage deferred varies, with some exceptions, from 40 percent to 60 percent. The average length of the deferral period is three years. TABLE 12—DEFERRAL POLICY FOR MATERIAL RISK-TAKERS AT THREE LEVEL 2 COVERED INSTITUTIONS Institutions Deferral percent Forfeiture/ clawback Institution 1 ...................................... Institution 2 ...................................... Institution 3 ...................................... 40%–60% .................................................................................................. 40% ........................................................................................................... 10%–40%, 40% if bonus >$750,000 ........................................................ Yes ................. Yes ................. Yes ................. Due to the lack of data, the SEC is unable to shed light on current significant risk-taker compensation practices with respect to some of the other proposed rule requirements such as the use of hedging or the type of compensation that is being deferred (cash vs. stock vs. options). In addition, the data is based on information from only three Level 2 covered institutions. It is also worth noting that the OCC data is at the bank subsidiary level, not the depository institution holding company level. Thus, it is possible that the features of the compensation of significant risk-takers at the bank subsidiary level may not be representative of the compensation of significant risk-takers at BDs and IAs. iv. Covered Persons at Subsidiaries mstockstill on DSK3G9T082PROD with PROPOSALS2 Length of deferral (years) Economic theory suggests that, in large, complex, and interconnected financial institutions that are perceived to receive implicit government guarantee, managers of these institutions could have the incentive to take on more risk than they would have taken had there been no implicit government backstops, thus creating negative externalities for taxpayers. As discussed above, the proposed rule could decrease the likelihood of such negative externalities. To the extent that certain BDs and IAs pose high risk that may lead to externalities, covered persons likely would therefore include those individuals who, by virtue of receiving incentive-based compensation, are in a position of placing significant risks. Under the proposed rule, senior executive officers and significant risktakers of BDs and IAs that are covered institutions would be considered covered persons. The proposed rule would require consolidation of subsidiaries of BHCs that are themselves covered institutions for the purpose of applying certain rule requirements and prohibitions to covered persons. As a result of this proposed consolidation, covered persons employed at BDs and IAs would be subject to the same requirements as the covered persons of their parent institutions, even though the BDs and IAs may be of a smaller size, and hence otherwise treated at a lower level, than their parent institutions. This proposed consolidation would significantly affect unconsolidated Level 3 BDs because most of them are held by Level 1 and Level 2 covered institutions, as well as Level 3 IAs that are held by Level 1 and Level 2 covered institutions. The proposed consolidation would also affect unconsolidated Level 2 BDs and IAs that are held by Level 1 covered institutions because those BDs and IAs will also become Level 1 covered institutions for the purposes of the rule. As of December 2014, there were 29 unconsolidated Level 3 BDs whose parent institutions are Level 1 and Level 2 institutions (Table 3); only one of those parent institutions was not a covered institution as defined by the rule. Additionally, there were 38 unconsolidated Level 3 BDs whose parents were private institutions; while it is possible that some of these may be Level 1 or Level 2 institutions, the SEC lacks data to determine their size. With respect to the proposed rule requirements, the current compensation arrangements of NEOs of Level 3 parent institutions exhibit some important differences compared to Level 1 and Level 2 parent institutions. For example, Level 3 parent institutions typically defer a smaller fraction of NEOs’ incentive-based compensation (Table 7A), defer cash less frequently (Table 7A), and tend to use more options as part of their incentive-based compensation arrangements (Table 6A), compared to Level 1 and Level 2 parent institutions. On the other hand, Level 3 covered institutions, like Level 1 and Level 2 covered institutions, tend to apply forfeiture and clawback and prohibit hedging (Table 7A). The proposed rule also would require consolidation with respect to certain significant risk-takers. Under the proposed definition of significant risktaker, employees of a subsidiary that could put substantial capital of the parent institution at risk would be deemed significant risk-takers of the parent institution, and the proposed rule requirements would apply to them in the same manner as the significant risk-taker at their parent institutions. Because data on the compensation of significant risk-takers is not publicly available, the SEC relies on bank supervisory data from the OCC regarding the current compensation practices for significant risk-takers at Level 3 financial institutions; the SEC does not have data on the compensation arrangements at Level 1 and Level 2 institutions. Table 13 shows summary statistics for the compensation arrangements of significant risk-takers at Level 3 covered institutions. The compensation arrangements of significant risk-takers of Level 3 covered institutions seem similar to those of NEOs of Level 3 covered institutions. It is also worth noting that the OCC data is at the bank subsidiary level, not the depository institution holding company level. Thus, it is possible that the features of the compensation of significant risk-takers at the bank subsidiary level may not be representative of the compensation of significant risk-takers at BDs and IAs. TABLE 13—EXISTING COMPENSATION ARRANGEMENTS FOR SIGNIFICANT RISK-TAKERS OF LEVEL 3 COVERED INSTITUTIONS Significant risk-takers Number of institutions with available compensation data ..................................................................................... VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 PO 00000 Frm 00107 Fmt 4701 Sfmt 4702 3 3 3 E:\FR\FM\10JNP2.SGM 5. 10JNP2 37776 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules TABLE 13—EXISTING COMPENSATION ARRANGEMENTS FOR SIGNIFICANT RISK-TAKERS OF LEVEL 3 COVERED INSTITUTIONS—Continued Significant risk-takers ST IC/total IC ......................................................................................................................................................... Deferred IC/total IC ................................................................................................................................................ Deferred IC subject to clawback and forfeit/deferred IC ....................................................................................... Types of IC compensation used: Cash: percent of institutions using cash ................................................................................................................... cash as percent of deferred IC ...................................................................................................................... length of vesting ............................................................................................................................................. type of vesting ................................................................................................................................................ RSUs: percent of institutions using RSUs ................................................................................................................. RSU as percent of deferred IC ...................................................................................................................... length of vesting ............................................................................................................................................. type of vesting ................................................................................................................................................ PSUs: percent of institutions using PSUs ................................................................................................................. PSU as percent of deferred IC ....................................................................................................................... performance period ........................................................................................................................................ length of vesting ............................................................................................................................................. type of vesting ................................................................................................................................................ Options: percent of institutions using options ............................................................................................................... Options as percent of deferred IC .................................................................................................................. length of vesting ............................................................................................................................................. type of vesting ................................................................................................................................................ 3. Regulatory Baseline The existing regulatory environment, especially after the financial crisis of 2007–2008, is also relevant to the current compensation practices of covered institutions and the effects of the proposed rulemaking. Several guidance and codes that specifically target incentive-based compensation have been adopted by various financial regulators that may also apply to some BDs and IAs. Some of those prescribe compensation practices and suggest prohibitions that are similar to the requirements and prohibitions in the proposed rules. mstockstill on DSK3G9T082PROD with PROPOSALS2 i. Guidance on Sound Incentive Compensation Policies In June 2010, the U.S. Federal Banking Agencies 383 adopted the Guidance on Sound Incentive Compensation Policies.384 The guidance applies to banking institutions and, because most of the parents of Level 1 and Level 2 BDs are bank holding companies subject to the guidance, its principles may apply to these BDs as well if the compensation structures at subsidiaries are similar to those at the parent institutions and the parent institution determines to implement 383 The Federal Banking Agencies, as of 2010, were the Board, OCC, FDIC, and Office of Thrift Supervision. 384 See, 2010 Federal Banking Agency Guidance, available at: https://www.federalreserve.gov/ newsevents/press/bcreg/20100621a.htm. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 relatively uniform incentive-based compensation policies for the consolidated institution. The guidance may also apply to the 39 IAs that are affiliated with banks and thrift institutions with assets of more than $50 billion. The guidance is designed to prevent incentive-based compensation policies at banking institutions from encouraging imprudent risk-taking and to aid in the development of incentive-based compensation policies that are consistent with the safety and soundness of the institution. It has three key principles providing that compensation arrangements at a banking institution should: (a) Provide employees with incentives that appropriately balance risk and reward; (b) be compatible with effective risk management and controls; and (c) be supported by strong corporate governance, including active and effective oversight by the institution’s board of directors. Similar to the proposed rules, this guidance applies to senior executives and other employees who, either individually or as a part of a group, have the ability to expose the relevant banking institution to a material level of risk. The guidance suggests several methods of balancing risk and rewards: Risk adjustment of awards; deferral of payment; longer performance periods; and reduced sensitivity to short-term performance. PO 00000 Frm 00108 Fmt 4701 Sfmt 4702 77%. 23%. 89%. 80%. 22%. 0.33 years. 100% pro-rata. 100%. 31%. 3 years. 40% immediate, 60% pro-rata. 80%. 12%. 1.9 years. 3 years. 80% immediate, 20% pro-rata. 20%. 25%. NA. NA. ii. UK Prudential Regulatory Authority Remuneration Code The SEC notes that for BDs and IAs whose parents are regulated by foreign authorities, the foreign regulatory framework with respect to incentivebased compensation may also be relevant for compliance with the proposed rules.385 For example, in 2010, the UK PRA adopted four remuneration codes that apply to banks and investment firms and share important similarities with the proposed rules.386 For instance, the SYSC 19A remuneration code imposes a deferral of at least 40 percent for not less than 3– 5 years. For higher earners, at least 60 percent has to be deferred. The code applies to senior management, risk takers, staff engaged in control functions, and any employee receiving compensation that takes them into the same income bracket as senior management and risk takers, whose professional activities have a material impact on the firm’s risk profile. The code also requires that at least 50 percent of any bonus must be made in shares, share-linked instruments or 385 For example, 3 Level 1 and Level 2 BDs have parent institutions that are subject to the UK PRA rules. 386 There are four codes: SYSC 19A (covering Deposit Taker and Investment firms), SYSC 19B (covering Alternative Investment Fund Managers), SYSC 19C—BIPRU (covering Investment firms), and SYSC 19D (covering Dual-regulated firms Remuneration Code). See https://www.thefca.org.uk/remuneration. E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules other equivalent non-cash instruments of the firm. These shares should be subject to an appropriate retention period. Firms also need to disclose details of their remuneration policies at least annually. In July 2014, the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) published two joint consultation papers ‘‘aimed at improving individual responsibility and accountability in the banking sector.’’ 387 The papers seek feedback on proposed changes to the rules for remuneration for UK banks and PRA-designated investment firms.388 The PRA and FCA’s new proposed rules follow recommendations made by the UK Parliamentary Commission on Banking Standards, ‘‘Changing Banking for Good,’’ published in June 2013, and are a response to the major role played by banks in the financial crisis in 2007– 2008 and allegations of the attempted manipulation of LIBOR. Their new proposed rules were deemed necessary because the current rule on individual accountability is ‘‘often unclear or confused’’ 389 and thus undermines public trust in the banking sector and the financial regulators. The PRA and FCA proposed that banks defer bonuses for a minimum of 7 years for senior managers and 5 years for other material risk-takers. Financial institutions would be able to recover variable pay even if it was paid out or vested for up to 7 years after the award date. D. Scope of the Proposed Rule mstockstill on DSK3G9T082PROD with PROPOSALS2 1. Levels of Covered Institutions The proposed rule would create a tiered system of covered institutions based on an institution’s average total consolidated assets during the most recent consecutive four quarters.390 387 See ‘‘Prudential Regulation Authority and Financial Conduct Authority Consult on Proposals to Improve Responsibility and Accountability in the Banking Sector,’’ Press Release by the Financial Conduct Authority, (July 30, 2014), available at: https://www.fca.org.uk/news/pra-and-fca-consulton-proposals-to-improve-responsibility-andaccountability-in-the-banking-sector. 388 See ‘‘Strengthening Accountability in Banking: A New Regulatory Framework for Individuals,’’ PRA CP14/13, Consultation Paper, July 2014, available at: https://www.fca.org.uk/news/cp14-13strengthening-accountability-in-banking. See also, ‘‘Strengthening the Alignment of Risk and Reward: New Remuneration Rules,’’ PRA CP14/14, Consultation Paper, July 2014, available at: https:// www.fca.org.uk/news/cp14-14-strengthening-thealignment-of-risk-and-reward. 389 See FSA Consultation Paper 14/13: Strengthening accountability in banking: a new regulatory framework for individuals (https:// www.fca.org.uk/news/cp14-13-strengtheningaccountability-in-banking). 390 For IAs, the tiered system would be based on year end balance sheet assets (excluding nonproprietary assets). VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 There are three levels of covered institutions: Level 1, Level 2, and Level 3 covered institutions. Some of the proposed rule requirements (e.g., deferral of compensation, forfeiture and clawback) would apply differentially to covered institutions based on their size tier, with more stringent restrictions on the incentive-based compensation arrangements at larger institutions (i.e., Level 1 and Level 2 covered institutions). In general, the importance of financial institutions in the economy tends to be positively correlated with their size. This is apparent from the use of implicit ‘‘too-big-to-fail’’ policies by governments and central banks, providing support to large financial institutions at times of financial crises because of their importance to the greater financial system.391 In a similar vein, the 2010 Federal Banking Agency Guidance prescribes stricter compensation rules and related riskmanagement and corporate governance practices for large and more complex banking institutions.392 There are various measures developed to estimate the amount of risk 393 posed by an institution to the greater financial system. One study finds that the degree of leverage, maturity mismatch and the size of the institution are all related to a measure of systemic importance and risk.394 Another study finds that institution size, degree of leverage and covariance of the institution’s stock with the market during distress are related to the systemic risk contribution of an institution.395 Moreover, an 391 See, for example, Frederic Mishkin, Financial Institutions. 392 Large banking institutions include, in the case of banking institutions supervised by (i) The Board, large, complex banking institutions as identified by the Board for supervisory purposes; (ii) the OCC, the largest and most complex national banks as defined in the Large Bank Supervision booklet of the Comptroller’s Handbook; (iii) the FDIC, large, complex insured depository institutions (IDIs). See, 2010 Federal Banking Agency Guidance, available at: https://www.federalreserve.gov/newsevents/press/ bcreg/20100621a.htm. 393 See Bisias et al. 2012. A Survey of Systemic Risk Analytics. Office of Financial Research, Working Paper. 394 See Adrian, T., Brunnermier, M. 2011. COVAR. American Economic Review, forthcoming. The paper proposes a measure for systemic risk contribution by financial institutions. The forwardlooking measure of systemic risk contribution is significantly related to lagged characteristics of financial institutions such as size, leverage, and maturity mismatch. 395 See Brownlees, C., Engle, R. 2015. SRISK: A Conditional Capital Shortfall Index for Systemic Risk Measurement. Working Paper. The paper develops a measure of systemic risk contribution of a financial firm. This measure associates systemic risk with the capital shortfall a financial institution is expected to experience conditional on a severe market decline. The measure is a function of the firm’s size, degree of leverage and the expected equity loss conditional on a market downturn. PO 00000 Frm 00109 Fmt 4701 Sfmt 4702 37777 academic study of the financial crisis states that the size of an institution is likely to magnify the impact of failure to the entire financial system.396 In terms of defining systemic importance, bank holding companies with assets over $50 billion are required to disclose to the Board on an annual basis, three indicators related to their systemic risk: Institution size, interconnectedness and complexity.397 By setting stricter restrictions on the incentive-based compensation arrangements at Level 1 and Level 2 covered institutions, the tiered approach could benefit taxpayers. To the extent that stricter incentive-based compensation rules are effective at curbing inappropriate risk-taking, this could lessen the default likelihood for Level 1 and Level 2 covered institutions, thus increasing the likelihood that taxpayers would not have to incur costs to rescue important institutions. Moreover, if the stricter incentive-based compensation rules lower the likelihood of default for Level 1 and Level 2 covered institutions, the likelihood of default for smaller institutions could decrease as well, to the extent that smaller institutions are exposed to counterparty risks due to their connection with larger Level 1 and Level 2 covered institutions. Consolidation requirements aside, the tiered approach also would not impose as great a compliance burden on smaller Level 3 covered institutions for which the proposed rule requirements on deferral, forfeiture and clawback, and some other prohibitions and requirements do not apply. To the extent that compliance costs have a fixed component that may have a disproportionate impact on smaller institutions, excluding Level 3 covered institutions from more burdensome requirements would not place them at a competitive disadvantage compared to Level 1 and Level 2 covered institutions. Moreover, to the extent that executives’ incentives become distorted due to the implicit government guarantee, this is less likely to be the case for Level 3 covered institutions due to their relatively smaller size. Thus, the potential benefits of the proposed rule may be less substantial for smaller covered institutions since such institutions are less likely to be in a 396 See French et al. 2010. Squam Lake Report: Fixing the Financial System. Princeton University Press. 397 Size is correlated with the two other measures of systemic importance, complexity and interconnectedness. See FSOC 2015 Annual Report, available at: https://www.treasury.gov/initiatives/ fsoc/studies-reports/Documents/2015%20 FSOC%20Annual%20Report.pdf. E:\FR\FM\10JNP2.SGM 10JNP2 37778 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 position to take risks that may lead to externalities. However, to the extent that the stricter proposed requirements for incentivebased compensation arrangements at Level 1 and Level 2 covered institutions induce less than optimal risk-taking incentives for covered persons from shareholders’ point of view, this could result in a decrease in firm value and hence lower returns for the shareholders of these institutions. Additionally, the stricter requirements for Level 1 and Level 2 covered institutions could make it more difficult to attract and retain human capital, thus creating competitive disadvantages in the labor market for these institutions. If these institutions become disadvantaged due to their stricter compensation requirements, they might be forced to increase overall compensation to be able to compete for managerial talent with firms that are not affected by the proposed rules. As discussed above, besides an institution’s average total consolidated assets, other indicators (for example, the size of that institution’s open counterparty positions in a market) not perfectly correlated with size could be a proxy for the importance of financial institutions to the financial sector and the broader economy. If size is not a good proxy for the importance of a financial institution, then the proposed rule would likely pose a disproportionate compliance burden on larger institutions while not covering institutions that may be more significant to the overall financial system under different proxies for importance. The proposed thresholds for identifying Level 1 covered institutions (over $250 billion) and Level 2 covered institutions (between $50 billion and $250 billion) are similar to those used by banking regulators in other contexts. For example, the $250 billion is used by Basel III as a threshold to identify core banks that must adopt the Basel standards; and the $50 billion threshold is used in a number of sections of the Dodd-Frank Act.398 The use of these two thresholds might place a higher compliance burden on institutions that, 398 For example, sections 165 and 166 of the Dodd-Frank Act require the Board to establish enhanced prudential standards for nonbank financial companies supervised by the Board and bank holding companies with total consolidated assets of $50 billion or more. In prescribing more stringent prudential standards, the Board may, on its own or pursuant to a recommendation by the Council in accordance with section 115, differentiate among companies on an individual basis or by category, taking into consideration their capital structure, riskiness, complexity, financial activities (including the financial activities of their subsidiaries), size, and any other risk-related factors that the Board deems appropriate. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 are close to, but just above the threshold compared to institutions that are close, but just below the threshold. For example, a BD that has a size of $49 billion is likely to be similar in many aspects to a BD that has a size of $51 billion. Yet, with the current cutoff points, the former would not be subject to deferral, forfeiture and clawback, and other prohibitions in the proposed rule, while the latter would be. By covering various types of financial institutions (e.g., banks, BDs, IAs, thrifts, etc.) with at least $1 billion in assets, section 956 and the proposed rule implicitly assume that larger institutions pose higher risks, including risks that may impact the financial system at large. This assumption may not hold true for certain institutions. For example, in the case of BDs and IAs, which may have a much narrower scope of activities than a comparably sized commercial bank, the narrower range of activities could limit their impact on the overall financial system. On the other hand, larger BDs and IAs may pose higher risks than smaller BDs and IAs. Also, at least one study has suggested that the interconnectedness of financial institutions generally could affect multiple financial institutions in a crisis and impact otherwise unrelated parts of the larger financial system.399 Another study asserts that financial institutions, including broker-dealers, have become highly interrelated and less liquid in the past decade, thus increasing the level of risk in the financial sector.400 399 See, for example, Bisias D., M. Flood, A.W. Lo, and S. Valavanis, 2012. A Survey of Systemic Risk Analytics. Office of Financial Research, Working paper, available at: https://www.treasury.gov/ initiatives/wsr/ofr/Documents/OFRwp0001_Bisias FloodLoValavanis_ASurveyOfSystemicRisk Analytics.pdf. On page 9, the authors argue that ‘‘In a world of interconnected and leveraged institutions, shocks can propagate rapidly throughout the financial network, creating a selfreinforcing dynamic of forced liquidations and downward pressure on prices.’’ The study discusses the interconnectedness between financial institutions in general and does not focus on the potential role of BDs and IAs. 400 See Billio M., M. Getmansky, A.W. Lo, and L. Pelizzon. 2012. Econometric Measures of Connectedness and Systemic Risk in the Finance and Insurance Sectors, Journal of Financial Economics, 104, 535–559. The study examines and finds evidence that banks, brokers, hedge funds and insurance companies have become highly interrelated during the last decade, thus increasing the level of systemic risk in the financial sector. For example, insurance companies have had little to do with hedge funds until recently when these companies expanded into markets such as providing insurance for financial products and credit default swaps. Such activities have potential implications for systemic risk when conducted on a large scale. PO 00000 Frm 00110 Fmt 4701 Sfmt 4702 2. Senior Executive Officers and Significant Risk-Takers The requirements under the proposed rule would place differential restrictions on compensation arrangements of covered persons. Within each covered institution, the proposed rule would create different categories of covered persons, which include any executive officer, employee, director, or principal shareholder that receives incentivebased compensation. While the proposed rule would apply to directors or principal shareholders who receive incentive-based compensation, the SEC’s baseline analysis suggests that most of the parent institutions provide incentive-based compensation to nonemployee directors but none of them provide such compensation arrangements to principal shareholders that are neither executives nor nonemployee directors. Below, the SEC focuses the discussion of the economic effects of the proposed rule on two types of covered persons: Senior executive officers and significant risk-takers. As discussed above, a senior executive officer is defined as a covered person who holds the title or, without regard to title, salary, or compensation, performs the function of one or more of the following positions at a covered institution for any period of time in the relevant performance period: President, executive chairman, CEO, CFO, COO, chief investment officer, chief legal officer, chief lending officer, chief risk officer, chief compliance officer, chief audit executive, chief credit officer, chief accounting officer, or head of a major business line or control function (as defined in the proposed rule). A significant risk-taker is defined as a covered person, other than a senior executive officer, who receives compensation of which at least onethird is incentive-based compensation and is: Either (1) placed among the highest 5 percent in annual base salary and incentive-based compensation among all covered persons (excluding senior executive officers) of a Level 1 covered institution or of any covered institution affiliate, or (2) placed among the highest 2 percent in annual base salary and incentive-based compensation among all covered persons (excluding senior executive officers) of a covered Level 2 covered institution or of any covered institution affiliate, or (3) may commit or expose 0.5 percent or more of the common equity tier 1 capital, or in the case of a registered securities broker or dealer, 0.5 percent or more of the tentative net capital, of the covered institution or of any affiliate of the covered institution E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules that is itself a covered institution, or (4) is designated as a significant risk-taker by the SEC or the covered institution. The proposed rule would impose differential requirements on compensation arrangements of senior executive officers and significant risktakers conditional on the size of the covered institution. Regarding senior executive officers, at least 60 percent of a senior executive officer’s incentivebased compensation would be required to be deferred at a Level 1 covered institution, whereas 50 percent would be the minimum deferral amount for a senior executive officer at a Level 2 covered institution. Regarding significant risk-takers, 50 percent of a significant-risk-taker’s incentive-based compensation at a Level 1 covered institution would be required to be deferred as compared to 40 percent for a significant risk-taker’s incentive-based compensation at a Level 2 covered institution. Moreover, the minimum deferral period for all covered persons at Level 1 covered institutions would be four years for qualifying incentive-based compensation and two years for incentive-based compensation received under long-term incentive plans whereas the deferral period for covered persons at a Level 2 covered institution would be three years for qualifying incentive-based compensation and one year for compensation received under long-term incentive plans. In general, the proposed rule would impose relatively stricter requirements for compensation arrangements of individuals who are more likely to be in a position to execute or authorize actions with accompanying risks that may have a significant impact on the financial health of the covered institution or of any covered institution affiliate. Specifically, the proposed rule would require a higher percentage of incentive-based compensation to be deferred for senior executive officers compared to significant risk-takers at covered institutions. If senior executive officers are in a position to make decisions that have a more significant impact on the degree of risk a covered institution takes than significant risktakers, then the higher percentages of deferral amounts for senior executive officers appear to be commensurate with the degree of inappropriate risk-taking in which they could engage. This would likely provide proportionately stronger disincentives for inappropriate risktaking by individuals that are more likely to be able to expose the covered institution to greater amounts of risk, thus potentially benefiting taxpayers and other stakeholders. In general, if certain significant risk-takers (e.g., VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 traders with the ability to place significant bets that could endanger the financial health of the covered institution or of any affiliate of the covered institution) could engage in more or similarly significant risk-taking than senior executive officers, the proposed rules would place less stringent requirements on the compensation arrangements of such significant risk-takers compared to senior executive officers, lowering risktaking disincentives for significant risktakers and/or imposing a potential higher cost to senior executive officers. However, the proposed rules may also create an incentive for senior executive officers to monitor significant risk-takers in those situations when they do not directly supervise such significant risktakers. While the definition of senior executive officer would be primarily based on job function, the definition of significant risk-taker would be based on multiple criteria. To identify significant risk-takers, one direct approach would require knowledge of their authority to expose their institution to material amounts of risk. This risk-based approach has intuitive appeal because it relates the application of the rules to the potential for risk taking. Such an approach could, however, be designed in many different ways, including differences relating to determining the appropriate risk-based measure, whether it should be applied to individuals or a group (e.g., a trader or a trading desk), and whether it would be appropriate to subject all trading activity to the same risk-based measure (e.g., U.S. treasury securities versus collateralized mortgage obligations). One of the criteria in the definition of significant risk-takers in the proposed rules is based on individuals’ relative size of annual base salary and incentivebased compensation within a covered institution and its affiliates. If the highest paid individuals at BDs and IAs are the ones that could place BDs and IAs, or their parent institutions, at risk of insolvency, then the use of this criterion is likely to reasonably identify individuals that are significant risktakers and as a result lower the likelihood of inappropriate risks being undertaken and potentially safeguard the health of these institutions and the broader economy. If, however, the highest paid individuals at BDs and IAs are not likely to be able to expose their parent institution to significant risks, this criterion may be overly inclusive, resulting in individuals being designated as significant risk-takers without possessing the ability to inflict PO 00000 Frm 00111 Fmt 4701 Sfmt 4702 37779 substantial losses on BDs or IAs, or their parent institutions. This may impose restrictions on the compensation of those individuals and as a consequence may put BDs and IAs at a disadvantage in hiring or retaining human capital. BDs and IAs may have to increase the compensation of affected individuals to offset the restrictions imposed by the proposed rule. For IAs that are covered institutions in another capacity and BDs, the proposed rules would also identify significant risk-takers using a measure of their ability to expose the covered institution to risks. More specifically, a person that receives compensation of which at least one-third is incentivebased compensation and may commit or expose 0.5 percent or more of the common equity tier 1 capital, or in the case of a registered securities broker or dealer, 0.5 percent or more of the tentative net capital, of the covered institution or of any affiliate of the covered institution would be a significant risk-taker. As discussed above, the Agencies are proposing the exposure test because individuals who have the authority to expose covered institutions to significant amounts of risk can cause material financial losses to covered institutions. For example, in proposing the exposure test, the Agencies were cognizant of the significant losses caused by actions of individuals, or a trading group, at some of the largest financial institutions during and after the financial crisis that began in 2007. In the case of a covered institution that is a subsidiary of another covered institution and is smaller than its parent, this particular criterion of the significant risk-taker definition could result in individuals being classified as significant risk-takers who do not have the ability to expose significant amounts of the parent’s capital to risk. Additionally, under the proposed definition of significant risk-taker, a covered person of a BD or IA subsidiary of a parent institution that is a Level 1 or Level 2 covered institution may be designated as a significant risk-taker relative to: (i) In the case of a BD subsidiary, the size of the BD’s tentative net capital or; (ii) in the case of both BD and IA subsidiaries, the tentative net capital or common equity tier 1 capital of any section 956 affiliate of the BD or IA, if the covered person has the ability to commit capital of the affiliate, even if the BD or IA subsidiary has significantly fewer assets than its parent. Because the BD subsidiary would be treated as a Level 1 or Level 2 covered institution due to its parent, a covered person of a BD that is a E:\FR\FM\10JNP2.SGM 10JNP2 37780 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 relatively smaller subsidiary would be subject to more stringent compensation restrictions than would an employee of a comparably sized BD that is not a subsidiary of a Level 1 or Level 2 covered institution. As a consequence, if such a designated significant risk-taker of a smaller BD subsidiary of a Level 1 or Level 2 covered institution is not in a position to undertake actions that place the entire institution at risk, then the proposed approach may impose disproportionately stricter compensation restrictions on such covered person. An alternative would be to use an individual’s level of compensation as a proxy for his or her ability or authority to undertake risks within a corporate structure. The main assumption under this approach would be that there is a positive link between an individual’s total compensation and that individual’s authority to commit significant amounts of capital at risk at the covered institution or any affiliate of the covered institution. A benefit of the total compensation-based approach would be the implementation simplicity in the identification of significant risk-takers. However, the main challenge would be the determination of the total compensation threshold that would appropriately qualify individuals as significant risk-takers. On one hand, setting the total compensation threshold too low could impose incentive-based compensation restrictions on individuals that do not have authority to undertake significant risks. As a result, it is possible that incentive-based compensation requirements imposed on individuals that do not have significant risk-taking authority could lead to a disadvantage in the efforts of the institutions to attract and retain talent. On the other hand, setting the total compensation threshold too high could impose incentive-based compensation restrictions on an incomplete set of significant risk-takers, limiting the potential benefits of the proposed rule. 3. Consolidation of Subsidiaries The proposed rule would subject covered institution subsidiaries of a depository institution holding company that is a Level 1 or Level 2 covered institution to the same requirements as the depository institution holding company. In this manner, the proposed rule would capture the effect that risktaking within the subsidiaries of a depository institution holding company could have on the parent, and the negative externalities that could result for taxpayers. For example, covered persons at a $10 billion BD subsidiary of a depository VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 institution holding company that is a Level 1 covered institution would be treated as covered persons of a Level 1 covered institution and subject to the proposed requirements and prohibitions applicable to covered persons at a Level 1 covered institution. One benefit of the proposed approach is the implementation simplicity of the proposed rule since the parent institution’s size would determine the requirements for all covered persons in the covered institution’s corporate structure. Such an approach also has the advantage that it may cover situations where the subsidiary could potentially expose the consolidated institution to substantial risks. This could be the case if for example the parent institution has provided capital to the subsidiary and the subsidiary is large enough that its failure would represent a significant loss for the parent institution. Moreover, such an approach curbs the possibility that a covered institution might place significant risk-takers in a smaller unregulated subsidiary, in order to evade the compensation restrictions of the proposed rule for individuals with authority to expose the institution to significant amounts of risk. There may also be costs associated with the proposed consolidation approach. The main disadvantage of such approach is that it may impose requirements and prohibitions on individuals employed in smaller subsidiaries that are less likely to be in a position to expose the institution to significant risks. Thus, the assumptions underlying the rule’s consolidation may not be accurate in all cases. The proposed rules’ treatment of subsidiaries would depend on their size and the size of their parent, and also on the effect that risk-taking within those subsidiaries could have on the potential failure of the parent institution and the potential risk that such a failure could impose on the overall financial system and the subsequent negative externality that this could create for taxpayers. For example, if the parent institution does not explicitly provide capital or implicitly guarantee the subsidiary’s positions, the proposed rules would impose similar requirements on the incentive-based compensation of individuals with different abilities to expose the institution to risk. Such compensation requirements may impose costs on individuals in these subsidiaries, and it might affect the ability of these subsidiaries to compete for managerial talent with stand-alone companies of the same size as the subsidiary. If that were the case, the subsidiaries of larger parent institutions PO 00000 Frm 00112 Fmt 4701 Sfmt 4702 may have to provide additional pay to individuals to compensate for the relatively stricter compensation requirements and prohibitions. If these additional compensation requirements are significantly costly, there may be incentives for smaller subsidiaries to spin-off from their parents and operate as stand-alone firms to avoid the stricter compensation requirements that would be applicable based on the size of the parent institution. Additionally, the costs of the proposed consolidation approach would depend on how different the current incentive-based compensation arrangements of a subsidiary are from those of its parent institution. If the compensation arrangements of BDs’ and IAs’ covered persons are similar to those of their parent institutions (e.g., they use similar deferral percentages and terms, prohibit hedging, etc.), then the proposed consolidation approach is not likely to lead to significant compliance costs for BDs and IAs. The 2010 Federal Banking Agency Guidance has significantly limited differences in compensation arrangements between financial institutions and their subsidiaries. If, however, the compensation arrangements at BDs and IAs more closely resemble the compensation structures of financial institutions of similar size, than the proposed rule’s consolidation requirement may lead to significant compliance costs. Unconsolidated Level 3 BDs and IAs are most likely to be affected by this proposition. The parent institutions of Level 3 BDs, to the extent that they are owned by one, are mainly Level 1 and Level 2 covered institutions. Although the SEC does not have data about the parent institutions of Level 3 IAs, the SEC expects that they would also be mainly Level 1 and Level 2 covered institutions. As shown above, compensation practices at Level 3 parent institutions differ significantly from Level 1 and Level 2 parent institutions on a number of dimensions: They defer a smaller fraction of NEOs incentive-based compensation (Table 7A), defer cash less frequently (Table 7A), and tend to use more options as part of their incentive-based compensation (Table 6A) compared to Level 1 and Level 2 parent institutions. They also rather infrequently prohibit hedging with respect to non-employee directors that receive incentive-based compensation (Table 10A). If the compensation arrangements of unconsolidated Level 3 BDs and IAs are similar to those of Level 3 parent institutions, under the proposed rule they would need to make significant E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules changes to certain features of their compensation arrangements to be compliant with the proposed rule. On the other hand, to the extent that their current compensation practices are not optimal from the perspective of taxpayers and other stakeholders of such BDs and IAs, there may be potential benefits. This point holds for the remainder of the economic analysis where the SEC discusses the potential costs and benefits to unconsolidated Level 3 BDs and IAs of a larger covered institution from applying the proposed rule requirements and prohibitions. An alternative to the proposed consolidation approach would be to use the subsidiary’s size to determine its status as a Level 1, Level 2, or Level 3 covered institution. For example, a $10 billion BD subsidiary of a Level 1 depository institution holding company would be treated as a Level 3 covered institution and covered persons within the subsidiary would be subject to all requirements and prohibitions applicable to a Level 3 covered institution. This alternative approach would not entail the potential costs identified in the proposed approach described above. However, differential application of the rule depending on subsidiary size could provide covered institutions with an incentive to reorganize their operations by placing significant risk-takers into relatively smaller subsidiaries to bypass the proposed requirements. This type of behavior, however, might be mitigated in some circumstances by the proposed rule’s prohibition on such indirect actions: A covered institution must not indirectly, or through or by any other person, do anything that would be unlawful for such covered institution to do directly under this part. Moreover, this type of behavior would be constrained by the fact that the SEC’s capital requirements for broker-dealers require that the broker-dealer itself carry the necessary capital for all brokerdealer positions.401 Additionally, the rule’s definition of a significant risktaker would treat any employee of the subsidiary with the ability to commit certain amount of capital or to create risks for the parent institution as a significant risk-taker of the parent, further limiting the ability of institutions to bypass the proposed requirements by placing such individuals into relatively smaller subsidiaries. 401 See 17 CFR 15c3–1(a). VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 E. Potential Costs and Benefits of the Proposed Rule’s Requirements and Prohibitions In the following sections, the SEC provides an analysis of the potential costs and benefits associated with the proposed rule’s requirements and prohibitions and possible alternatives.402 For purposes of this analysis, the SEC addresses the potential economic effects for covered BDs and IAs resulting from the statutory mandate and from the SEC’s exercise of discretion together, recognizing that it is often difficult to separate the costs and benefits arising from these two sources. The SEC also requests comment on any economic effect the proposed requirements may have on covered BDs and IAs. The SEC appreciates comments that include both qualitative information and data quantifying the costs and the benefits identified in the analysis or alternative implementations of the proposed rule. 1. Limitations on Excessive Compensation The proposed rule would prohibit covered institutions from establishing or maintaining any type of incentive-based compensation arrangement, or any feature of any such arrangement, that encourages inappropriate risk-taking by providing a covered person with excessive compensation, fees, or benefits or that could lead to material loss for the institution. The proposed rule would not define excessive compensation; instead, it would use a principles-based approach that would provide covered institutions with the flexibility to structure incentive-based compensation arrangements that do not constitute excessive compensation based on several factors that are outlined below. These factors would include: The total size of a covered person’s compensation; the compensation history of the covered person and other individuals with comparable expertise at the institution; the financial condition of the covered institution; compensation practices at comparable institutions based upon such factors as 402 Commenters on the 2011 Proposed Rule suggested more expansive discussion and analysis of economic effects of the proposed rulemaking on items such as the ability of covered institutions to compete for talent acquisition and retention (See, for example, letters by the U.S. Chamber and FSR), and also on the effects of the rule on risk taking incentives and its consequences for covered institutions’ ability to compete (See, for example, FSR). Below, the SEC’s economic analysis outlines and discusses potential economic effects of the various rule provisions, including items identified in comment letters discussing economic considerations. PO 00000 Frm 00113 Fmt 4701 Sfmt 4702 37781 asset size, geographic location, and the complexity of the covered institution’s operations and assets; for postemployment benefits, the projected total cost and benefit to the covered institution; and any connection between the covered person and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the covered institution. The flexibility that the proposed rule provides would likely benefit covered institutions by allowing them to tailor the incentive-based compensation arrangements to the skills and job requirements of each covered person and to the nature of a particular institution’s business and the risks thereof instead of applying a ‘‘one size fits all’’ approach. The differences in the size, complexity, interconnectedness, and degree of competition in the market for managerial talent among the institutions covered by the proposed rule make excessive compensation difficult to define universally. As mentioned above, a principlesbased approach is likely to provide greater discretion to covered institutions in tailoring compensation arrangements that do not provide incentives for inappropriate risk-taking. Such discretion may potentially allow for differential interpretation among covered institutions on what constitutes excessive compensation and as a consequence, differential compensation arrangements even for similar institutions could be designed. Given the flexibility inherent under a principles-based approach, it is also possible that in fact some compensation contracts to covered persons constitute excessive compensation that could lead to inappropriate risk-taking, particularly if the compensation setting process is not efficient or unbiased.403 It is also possible that boards of directors may find it difficult to evaluate whether a compensation arrangement creates excessive compensation that could lead to inappropriate risk-taking. As such, it is likely that governance mechanisms in place would be crucial for institutions to benefit from the flexibility of the principles-based approach and avoid the potential costs described above. An alternative would be a more prescriptive approach in defining compensation arrangements that constitute excessive compensation. For example, an explicit definition of excessive compensation could be provided for covered institutions. As mentioned above, such an approach has 403 For example, see Coles, J., Daniel, N., and Naveen, L. Co-opted Boards. 2014. Review of Financial Studies 27, 1751–1796. E:\FR\FM\10JNP2.SGM 10JNP2 37782 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules the disadvantage of restricting compensation arrangement options for covered institutions and thus an increased likelihood that inefficient compensation arrangements would be applied to at least some covered institutions, given the significant differences among covered institutions and covered persons. 2. Performance Measures The proposed rule would require covered institutions to use a variety of performance measures when determining the incentive-based compensation of covered persons. Incentive-based compensation arrangements would be required to include a mix of financial (i.e., accounting and stock-based) measures and non-financial measures, with the ability for non-financial measures to override financial measures when appropriate. Additionally, any amounts to be awarded under the arrangement would be subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance. There is evidence in the economic literature suggesting that non-financial measures of performance are incremental predictors of long-term financial performance relative to financial measures of performance, and provide important information about executives’ performance.404 Moreover, non-financial measures of performance in compensation arrangements may better capture progress or milestones of strategic goals that may be unique to specific institutions.405 Thus, the proposed requirement to use a mix of the two types of measures would likely provide more relevant information to enable covered institutions to set up incentive compensation arrangements for covered persons. In addition, the flexibility that the proposed rule would provide to covered institutions to adjust the compensation awards based on various factors would allow covered institutions to tailor their compensation arrangements to their specific circumstances. The baseline analysis suggests that many of the public parent institutions of some BDs and IAs already use a mix of financial and non-financial measures in determining the incentive-based compensation awards of senior executive officers. To the extent that BDs and IAs use a similar mix of measures to determine the incentivebased compensation awards of their senior executive officers, the SEC expects the costs of compliance with this provision of the proposed rule to be relatively low. If BDs and IAs do not use the same mixture of financial and nonfinancial measures as their parents, or do not rely on non-financial measures when determining the compensation of their senior executive officers and significant risk-takers, the compliance costs associated with this particular rule requirement may be significant. Such costs may be in the form of additional expenditures related to hiring compensation consultants and/or lawyers to design compensation schemes and assure the compliance of newly designed compensation schemes with the proposed rule. The SEC has attempted to quantify such costs using data reported by Level 1, Level 2, and Level 3 covered institutions that are parents of BDs and IAs. Table 14 provides some summary statistics on the use of compensation consultants and the fees paid to those over the period 2007–2014.406 Based on the results in the table, Level 1 and Level 2 covered institutions use on average two compensation consultants, while Level 3 covered institutions use one compensation consultant on average. If a Level 1 BD or IA has to hire compensation consultant(s) to help them meet this rule requirement, it may incur costs of approximately $185,515 per year. If an unconsolidated Level 2 BD or IA has to hire compensation consultant(s) to help them meet this rule requirement, it may incur costs of approximately $77,000 per year.407 If an unconsolidated Level 3 BD or IA, because of the consolidation requirement, has to hire compensation consultant(s) to help meet this rule requirement, it may incur costs of approximately $18,788 per year. These costs could be higher if the compensation consultant is asked to provide additional services other than compensation consulting services. These costs could be lower, however, if the parent institutions of BDs and IAs already employ compensation consultants and could extend their services to meet the proposed rule requirements for BDs and IAs. TABLE 14—THE USE AND COSTS OF COMPENSATION CONSULTANTS BY CERTAIN LEVEL 1, LEVEL 2, AND LEVEL 3 COVERED INSTITUTIONS THAT ARE PARENTS OF BDS AND IAS, 2007–2014 Average number of compensation consultants used Median fees for consulting services to the compensation committee 2 2 1 185,515 77,000 18,788 mstockstill on DSK3G9T082PROD with PROPOSALS2 Level 1 ......................................................................................................................................... Level 2 ......................................................................................................................................... Level 3 ......................................................................................................................................... 404 See, e.g., Banker, R., G. Potter, and D. Srinivasan, 1999. An Empirical Investigation of an Incentive Plan that Includes Nonfinancial Performance Measures. The Accounting Review 75, 65–92. The study examines whether non-financial measures of performance, specifically customer satisfaction, are incremental predictors of future performance and whether inclusion of such measures of performance in compensation contracts is efficient. The study finds that customer satisfaction is incremental in predicting future financial performance and inclusion of such performance measure in compensation contracts leads to improved future performance. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 405 See, e.g., Ittner, C., D. Larcker, and T. Randall, 2003. Performance Implications of Strategic Performance Measurement in Financial Services Firms. Accounting, Organizations and Society 28, 715–741. The study uses a sample of 140 U.S. financial services firms to examine the relation between measurement system satisfaction, economic performance, and two general approaches to strategic performance measurement: Greater measurement diversity and improved alignment with firm strategy and value drivers. The study finds evidence that firms making more extensive use of a broad set of financial and non-financial measures than firms with similar strategies or value drivers have higher measurement system satisfaction and stock market returns. PO 00000 Frm 00114 Fmt 4701 Sfmt 4702 Number of institutions 406 Data used in the table comes from the ISS database. 407 We note that while we report the median consulting fee for covered institutions in Table 14, the average compensation consultant fees are higher. For example, for Level 1 covered institutions the average consulting fee is $198,673, for Level 2 covered institutions the average consulting fee is $293,501, and for Level 3 covered institutions the average consulting fee is $59,828. The presence of outliers in the compensation consulting fee data and the small sample size are the reason for the large difference between average and median consulting fee. E:\FR\FM\10JNP2.SGM 10JNP2 7 9 6 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules 3. Board of Directors Additionally, the proposed rule would require that the board of directors of covered institutions oversee a covered institution’s incentive-based compensation program, and approve incentive-based compensation arrangements for senior executive officers or any material exceptions or adjustments to incentive-based compensation policies or arrangements. Since overseeing and approving executive compensation arrangements is one of the primary functions of the compensation committee of the corporate board, the SEC believes that this rule requirement would not impose significant compliance costs on covered institutions that already have compensation committees. Moreover, because the baseline analysis suggests that the majority of the parents of some covered institutions already employ most of the requirements and limitations of the proposed rule, it may not be particularly costly for boards of directors or compensation committees to comply with the proposed rule. However, there might be additional compliance costs for covered institutions if the board of directors or the compensation committee have to exert incremental effort (i.e., meet more frequently) in designing and approving compensation arrangements. Additionally, if because of the rule’s definition of significant risk-takers the compensation committee of a covered institution has to cover a much larger number of employees and consider additional factors than it does at present, this may increase compliance costs. For covered BDs and IAs that do not have compensation committees, the board of directors as a whole may be able to oversee and approve executive compensation arrangements. Thus, for such BDs and IAs the compliance costs of this rule requirement could result in more time being spent for the board of directors on these issues, which might entail higher directors’ fees and possibly additional compensation consulting costs. mstockstill on DSK3G9T082PROD with PROPOSALS2 4. Disclosure and Recordkeeping The proposed rule would require all covered institutions to create annually and maintain for a period of at least 7 years records that document the structure of all its incentive-based compensation arrangements and demonstrate compliance with the proposed rule. At a minimum, these must include copies of all incentivebased compensation plans, a record of who is subject to each plan, and a VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 description of how the incentive-based compensation program is compatible with effective risk management and controls. The SEC is proposing an amendment to Exchange Act Rule 17a–4(e) 408 and Investment Advisers Act Rule 204–2 409 to require that registered broker-dealers maintain and investment advisers, respectively, the records required by the proposed rule, in accordance with the recordkeeping requirements of Exchange Act Rule 17a–4 and Investment Advisers Act Rule 204–2, respectively. Exchange Rule 17a–4 and Investment Advisers Act Rule 204–2 establish the general formatting and storage requirements for records that registered broker-dealers and investment advisers, respectively, are required to keep. For the sake of consistency with other broker-dealer and investment adviser records, the SEC believes that registered broker-dealers and investment advisers, respectively, should also keep the records required by the proposed rule, in accordance with these requirements. The proposed recordkeeping requirement would assist covered BDs and IAs in monitoring incentive-based compensation awards and payments and comparing them with actual risk outcomes to determine whether incentive-based compensation payments to senior executive officers and significant risk-takers lead to inappropriate risk-taking. The proposed recordkeeping requirement would also help BDs and IAs to modify the incentive-based compensation arrangements of senior executive officers and significant risk-takers, if, over time, incentive-based compensation paid does not appropriately reflect risk outcomes. These records would be available to SEC staff for examination, which may enhance compliance and facilitate oversight. This proposed requirement would likely impose compliance costs on covered institutions. The SEC expects the magnitude of the compliance costs to depend on whether broker-dealers and investment advisers already have a system in place to generate information regarding their compensation practices for internal use (e.g., for reports to the board of directors or the compensation committee) or for required disclosures under the Exchange Act (for reporting companies). To the extent that such existing platforms can be expanded to produce the records required under the proposed rule, the SEC expects this 408 17 409 17 PO 00000 CFR 240.17a–4(e). CFR 275.204–2. Frm 00115 Fmt 4701 Sfmt 4702 37783 requirement to impose lower compliance costs on these institutions. The compliance costs associated with this particular proposed rule requirement would likely be higher for covered institutions that may not be generating such information, if for example they are not subject to related reporting obligations, or may not keep the type and detail of records that would be required under the proposed rule. Given that all Level 1 and unconsolidated Level 2 BDs, and most unconsolidated Level 3 BDs and IAs, are non-reporting companies, the SEC expects that the recordkeeping costs associated with the rule may be substantial for these BDs and IAs. The SEC notes, however, that because it does not have information on the compensation reporting and recordkeeping at the subsidiary level, the SEC may be overestimating compliance costs for BDs and IAs with reporting parent institutions. For example, if the parent institution reports and keeps records of the incentive-based compensation arrangements at the subsidiary level, and on the same scale and detail as required by the proposed rule, it is possible that the compliance costs for such BDs could be lower than the compliance costs for BDs with nonreporting parent institutions. Since the SEC does not have data on how many covered IAs have parent institutions, it is also possible that a significant number of these IAs may be stand-alone companies and therefore could have higher costs to comply with the proposed rule compared to covered IAs and BDs that are part of reporting parent institutions. According to the 2010 Federal Banking Agency Guidance, a banking organization should provide an appropriate amount of information concerning its incentive compensation arrangements for executive and nonexecutive employees and related riskmanagement, control, and governance processes to shareholders to allow them to monitor and, where appropriate, take actions to restrain the potential for such arrangements and processes to encourage employees to take imprudent risks. Such disclosures should include information relevant to employees other than senior executive officers. The scope and level of the information disclosed by the institution should be tailored to the nature and complexity of the institution and its incentive compensation arrangements. Thus, private covered institutions that are banking institutions and apply the policies of the 2010 Federal Banking Agency Guidance may already be E:\FR\FM\10JNP2.SGM 10JNP2 37784 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 collecting the information that would be required by the proposed rule. The SEC expects the compliance costs to be lower for such covered institutions, to the extent that there is an overlap between the information collected under the 2010 Federal Banking Agency Guidance and the information that would be required for disclosure and recordkeeping under the proposed rule. The BDs and IAs that are stand-alone non-reporting firms or have nonreporting parent institutions that are not banking institutions would most likely be the ones to incur higher compliance costs of disclosure and recordkeeping. By requiring covered institutions to create and maintain records of incentive-based compensation arrangements for covered persons at all covered BDs and IAs, the proposed recordkeeping requirement is expected to facilitate the SEC’s ability to monitor incentive-based compensation arrangements and could potentially strengthen incentives for covered institutions to comply with the proposed rule. As a consequence, an increase in investor confidence that covered institutions are less likely to be incentivizing inappropriate actions through compensation arrangements may occur and potentially result in greater market participation and allocative efficiency, thereby potentially facilitating capital formation. As discussed above, it is difficult for the SEC to estimate compliance costs related to the specific provision. However, for covered institutions that do not currently have a similar reporting system in place, there could be significant fixed costs that may disproportionately burden smaller covered BDs and IAs and hinder competition. Overall, the SEC does not expect the effects of the proposed recordkeeping requirements on efficiency, competition and capital formation to be significant. 5. Reservation of Authority Under the proposed rule, an Agency may require a Level 3 covered institution with average total consolidated assets greater than or equal to $10 billion and less than $50 billion to comply with some or all of the provisions of §§ 5 and 7 through 11of the proposed rule applicable to Level 1 and Level 2 covered institutions if the agency determines that such Level 3 covered institution’s complexity of operations or compensation practices are consistent with those of a Level 1 or Level 2 covered institution. This proposed rule requirement would allow the SEC to treat senior executive officers and significant risk- VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 takers at BDs and IAs that have total consolidated assets below $50 billion as covered persons of a Level 1 or Level 2 covered institution, because, for example, the complexity of the BDs’ and IAs’ operations or risk profile could have a significant impact on the overall financial system and could generate negative spillover effects for taxpayers. As a result, the number of BDs and IAs that would be subject to the portions of the proposed rule applicable to Level 1 and Level 2 covered institutions may increase relative to the estimates presented in the baseline.410 The proposed requirement may increase compliance costs for these BDs and IAs. As shown above, Level 3 parent institutions differ significantly from Level 1 and Level 2 parent institutions on a number of dimensions: They tend to defer a smaller fraction of NEOs incentive-based compensation (Table 7A), tend to defer cash less frequently (Table 7A), and tend to use more options as part of their incentivebased compensation (Table 6A) compared to Level 1 and Level 2 parent institutions. They also use rather infrequently the prohibition of hedging with respect to non-employee directors that receive incentive-based compensation (Table 9A). If the compensation arrangements of Level 3 BDs and IAs are similar to those of Level 3 parent institutions, then for Level 3 BDs and IAs that are designated as Level 1 or Level 2 covered BDs and IAs by an Agency, the proposed rule is likely to require significant changes to certain features of their compensation arrangements to be in compliance. F. Potential Costs and Benefits of Additional Requirements and Prohibitions for Level 1 and 2 Covered Institutions 1. Mandatory Deferral The proposed rule would require a minimum amount of annual incentivebased compensation to be deferred for a minimum number of years for senior executive officers and significant risktakers at Level 1 and Level 2 covered institutions. For senior executive officers and significant risk-takers at Level 1 and Level 2 BDs and IAs, such requirement is expected to establish a minimum accountability horizon with respect to the outcomes of actions of these individuals, including the 410 As discussed above in the Baseline section, as of the end of 2014, there were 33 BDs with total consolidated assets between $10 and $50 billion. Due to the lack of data, the SEC cannot determine the number of IAs with total consolidated assets between $10 and $50 billion. PO 00000 Frm 00116 Fmt 4701 Sfmt 4702 realization of longer-term risks that may be associated with such actions. As discussed above, from an economic standpoint, managerial actions carry associated risks, and the horizon over which such risks unfold is uncertain. If the risk realization horizon is longer than the performance period used to measure and compensate the performance of senior executive officers and significant risk-takers, they may have an incentive to undertake projects that deliver strong short-term performance at the potential expense of long-term value. A minimum compensation deferral period aims to curb incentives for such undesired behavior by increasing senior executive officers’ and significant risk-takers’ accountability for the potential adverse outcomes of their actions that may be realized in the long run, which in turn may discourage short-termism and inappropriate risk-taking and as a consequence lower the likelihood of default for the covered institution and the potential risk such a default could pose to the greater financial system. As discussed above, the proposed minimum deferral periods required by the proposed rule for Level 1 and Level 2 BDs and IAs covered institutions would relate to the horizons over which the risks in these institutions may be realized. The deferral periods are likely to overlap with a traditional business cycle to identify outcomes associated with a senior executive officer’s or significant risk-taker’s performance and risk-taking activities. As noted, the business cycle reflects periods of economic expansion or recession, which typically underpin the performance of the financial sector. There might be specific facts and circumstances (for example, the variety of assets held, the changing nature of those assets over time, the normal turnover in assets held by financial institutions, and the complexity of the business models of BDs and IAs) that may affect the horizon over which risks may be realized for particular covered institutions, so a uniform deferral period may be more or less aligned with the horizon over which a particular covered institution realizes certain risks. With regard to the type of incentivebased compensation instruments to be deferred, the rule proposes to require deferred compensation to consist of substantial amounts of both cash and equity-linked instruments. Whereas deferred equity-linked compensation would be subject to both upside potential (for example, if the stock price of the firm increases during the deferral period) and downside risk, the cash component of deferred compensation E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 would be mainly subject to downside risk, thus resembling the payoff structure of a debt security. More specifically, the cash component of deferred compensation would not appreciate in value if firm performance during the deferral period is positive, but would be subject to downward adjustment, forfeiture, and clawback if, for example, the executive has engaged in inappropriate risk-taking that results in poor performance during the performance, deferral and post-deferral periods respectively. This asymmetry in the payoff structure of the cash component of deferred compensation is expected to provide incentives for responsible risk-taking by covered persons thus lowering the likelihood of default at these institutions as well as the corresponding risk to the greater financial system posed by certain large, complex, and interconnected institutions.411 Economic studies suggest a negative relation between precrisis levels of managerial debt holdings and measures of default risk during the crisis for bank holding companies— bank holding companies whose executives held larger debt holdings were less likely to default.412 411 The academic literature provides evidence regarding the effect of compensation instruments resembling a debtholder’s payoff and the effect of such compensation instruments on various aspects of the agency costs of debt. For example, there is evidence of a negative relation between levels of inside debt and the cost of debt; see Anantharaman et al. 2013. Inside debt and the design of corporate debt contracts. Management Science 60, 1260–1280. Also, studies have documented a negative relation between inside debt and restrictiveness of debt covenants and demand for accounting conservatism, and a positive relation between CEO inside debt and firm liquidation values; see Chen, F., Y. Dou, and X. Wang. 2010. Executive Inside Debt Holdings and Creditors’ Demand for Pricing and Non-Pricing Protections. Working Paper. With respect to the mechanism through which inside debt holdings lead to lower firm risk, evidence suggests that such firms apply more conservative investment as well as financing choices. Inside debt in particular has been shown to be negatively related to future stock return volatility, a marketbased measure of risk; see Cassell, Cory A., Shawn X. Huang, Juan Manuel Sanchez, and Michael D. Stuart. 2012. The relation between CEO inside debt holdings and the riskiness of firm investment and financial policies. Journal of Financial Economics 103, 588–610. It must be noted that the academic literature proxies for such debt-like compensation instruments mostly through pensions and other forms of deferred compensation. Such instruments may not fully resemble the characteristics of deferred cash under the rule, particularly with respect to the horizon of deferral as well as the vesting schedules (pro-rata vs. cliff-vesting). 412 See Bennett et al. (2015). Inside Debt, Bank Default Risk, and Performance during the Crisis. Journal of Financial Intermdiation 24, 487–513. The study examines the relation between pre-crisis levels of inside equity vs. inside debt holdings by bank holding company CEOs and risk and performance of these BHCs during the crisis. The findings reveal a negative relation between pre- VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 37785 As mentioned above, the deferral requirements of the proposed rule for senior executive officers and significant risk-takers at the largest covered institutions are also consistent with international standards on compensation. Having standards that are generally consistent across jurisdictions would ensure that covered institutions in the United States, compared to their non-U.S. peers, are on a level playing field in the global competition for talent. The mandatory deferral requirements of the proposed rule may impose significant costs on affected BDs and IAs.413 As a consequence of the mandatory deferral requirement, the wealth of covered persons would be likely less diversified and more tied to prolonged periods of a covered institution’s performance. This potential deterioration of wealth diversification may induce covered persons to demand an increase in pay which could result in higher compensation-related costs for covered institutions.414 This increase in compensation costs may be necessary in order for covered institutions to be able to both attract and retain human talent. The SEC notes, however, that there may be other factors affecting the ability of a covered institution to attract and retain human talent, such as the supply of talent and non-pecuniary benefits of employment at covered institutions. These factors may exacerbate or mitigate the potential increase in compensation costs. For example, if senior executive officers and significant risk-takers value non-pecuniary job benefits such as prestige, networking, and visibility, these benefits may offset the costs associated with deterioration in the diversification of their portfolios. As a result of the proposed compensation deferral requirement, covered persons at BDs and IAs may be incentivized to curb inappropriate risktaking given the increased accountability over their actions. There could be situations, however, where bonus deferral could actually lead to an increase in risk-taking incentives.415 For example, if firm performance during the deferral period significantly declines and causes a significant loss in the value of deferred compensation, senior executive officers and significant risktakers could potentially have an incentive to engage in high-risk actions in an effort to recoup at least some of the value of their deferred compensation. As discussed above, deferral of the cash component of compensation resembles the payoff structure of debt and as a consequence may expose managerial compensation to risk without a corresponding upside. Whereas this may provide incentives to covered persons to avoid actions that would expose a covered institution to higher likelihood of default and for important institutions risks to the financial system, such incentives may result in misalignment of interests between managers and shareholders and potentially harm shareholder value. Several studies suggest that managers with significant debt instruments in their compensation arrangement tend to undertake a more conservative approach in managing their firms.416 The significant use of debt in compensation arrangements is viewed negatively by shareholders: Stock prices of companies whose executives hold significant debt positions experience a decrease upon disclosure of such compensation arrangements.417 Thus, whereas the utilization of debt-like instruments in compensation arrangements in important institutions may lower the risk to the greater financial system, this may come at the expense of shareholder value at these institutions. One commenter suggested that the proposed rule could cause covered institutions to perform in a less competitive way given lower incentives for risk-taking.418 Alternatively, the Agencies could have proposed higher deferral percentages and/or longer deferral horizons. Some commenters 419 suggested more stringent deferral requirements, such as a longer deferral crisis CEO inside debt holdings and default risk during the crisis, and higher supervisory ratings for these BHCs before the crisis. 413 Several commenters raised accounting related issues with respect to covered institutions’ financial statements under the proposed rule (see, e.g., KPMG, CEC) and tax related issues with respect to individuals affected by the proposed rule (see, e.g., KPMG, MFA, SIFMA, CEC, PEGCC). 414 Three commenters argued that the proposed rule could result in unintended consequences such as higher fixed compensation or other benefits (See FSR, WLF, U.S. Chamber). 415 See Leisen, D. (2014). Does Bonus Deferral Reduce Risk Taking? Working Paper. The paper develops a model comparing risk-taking incentives from bonuses with and without deferral. The results challenge the common belief that bonus deferral unequivocally leads to reduced risk-taking incentives; under certain conditions, deferral of bonus could lead to stronger risk-taking incentives during the deferral period. 416 See Anantharaman, D., V.W. Fang, and G. Gong. 2014. Inside Debt and the Design of Corporate Debt Contracts. Management Science 60, 1260– 1280; Chen et al. (2010); and Cassell et al. (2012). 417 See Wei, C., and Yermack, D. (2011). 418 See FSR. 419 It should be noted that comments were based on the 2011 Proposed Rule’s 3-year deferral period (as opposed to the 4-year deferral period currently proposed). PO 00000 Frm 00117 Fmt 4701 Sfmt 4702 E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37786 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules horizon,420 a higher percentage subject to deferral,421 and holding the entire deferred amount back until the end of the deferral period.422 For example, the Agencies could have selected a sevenyear deferral for senior executive officers and a five-year horizon deferral horizon for significant risk-takers, similar to the rules that the Prudential Regulation Authority has recently proposed in the UK. Such long deferral periods may have allowed for longerterm risks to materialize and thus be accounted for when calculating managerial compensation. On the other hand, as mentioned above, longer deferral periods could result in inappropriate risk-taking if firm performance during the deferral period significantly declines and causes a significant loss in the value of deferred compensation. Additionally, a longer deferral period increases the probability that financial performance is impacted by actions or factors that are not related to covered persons’ actions and as such result in an inefficient compensation contract. Moreover, lengthening of the deferral period is likely to lead to increased liquidity issues for covered persons since their compensation cannot be cashed out on a timely basis to meet their liquidity needs. Finally, it is also possible that further prolonging of the deferral period could create incentives for institutions to shift away from incentive-based compensation and increase the fixed component of compensation. A potential consequence from such action may be distortion of value-enhancing incentives that are generated through incentive-based compensation. Another potential cost from deferral requirements that are more strict could be that affected institutions may not be able to compete and as a consequence lose talent to other sectors that are not subject to the proposed rule. Another alternative could be shorter deferral periods (e.g., deferral period of less than four years for the qualifying incentive-based compensation of senior executive officers at Level 1 covered institutions; for example, 3 years as in the 2011 Proposed Rule) and/or smaller deferral percentages (e.g., deferral of less than 60 percent of qualifying incentivebased compensation for senior executive officers at Level 1 covered institutions; for example, 50 percent as in the 2011 Proposed Rule). A shorter deferral period and/or smaller deferral percentage amount, however, may not provide adequate incentives to covered 420 See AFR, Public Citizen, Chris Barnard, AFSCME, AFL–CIO, Senator Brown. 421 See AFR, Public Citizen, AFSCME. 422 See AFR, Senator Brown, Public Citizen. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 persons to engage in responsible risktaking. On the other hand, if the risk realization horizon is actually shorter than the deferral horizon proposed in the rule, then using a shorter deferral period would avoid exposing covered persons’ wealth to risks that do not result from their actions and would also impose lower liquidity constraints on undiversified executives. From the baseline analysis of current compensation practices, it appears that all of the Level 1 public parent institutions and most of the Level 2 public parent institutions of BDs and IAs already have deferral policies in place similar to the proposed rule requirements. Currently, about 50 percent to 75 percent of incentive-based compensation is deferred for a period of about three years, and the deferral includes NEOs, non-NEOs and significant risk-takers. If the compensation structure of BDs and IAs is similar to that of their parent institutions, and the compensation structure of private institutions is similar to that of public institutions, for the covered BDs and IAs the implementation of the deferred aspect of the proposed rule is unlikely to lead to significant compliance costs. The only potentially significant compliance costs that such covered institutions could incur with respect to the deferral requirement is related to the deferral of cash compensation, which currently only 20 percent to 25 percent of Level 1 and Level 2 covered institutions defer, and the prohibition on accelerated vesting, which very few of the Level 2 covered parent institutions currently use. On the other hand, if the compensation practices of parent institutions are significantly different than those at their subsidiaries, covered BDs and IAs could experience significant compliance costs when implementing the proposed deferral rule. Since the SEC does not have data on how many covered IAs have parent institutions, it is also possible that a significant number of these IAs may be stand-alone companies and therefore could have higher costs to comply with the proposed rule compared to covered IAs and BDs that are part of reporting parent institutions. As discussed above, the SEC has data regarding the incentive-based compensation arrangements at the depository institution holding company parents of Level 1 and unconsolidated Level 2 and unconsolidated Level 3 BDs and IAs because many of those bank holding companies are public reporting companies under the Exchange Act. The SEC lacks information regarding the PO 00000 Frm 00118 Fmt 4701 Sfmt 4702 compensation arrangements of BDs and IAs that are not so affiliated, and hence the SEC cannot accurately assess the compliance costs for those issuers. The same holds true if the incentive-based compensation practices at BDs and IAs are generally different than those at banking institutions, which most of their parent institutions are. Lastly, because some BDs and IAs are subsidiaries of private parent institutions, if there is a significant difference in the compensation practices between public and private covered institutions such private BDs and IAs could face larger compliance costs. To better assess the effects of deferral on compliance costs for BDs and IAs the SEC requests comments on these issues. 2. Options For senior executive officers and significant risk-takers at Level 1 and Level 2 covered institutions, the proposed rule would limit the amount of stock option-based compensation that can qualify for mandatory deferral at 15 percent, effectively placing a cap on the use of stock options as part of the incentive-based compensation arrangements for senior executive officers and significant risk-takers at Level 1 and Level 2 covered institutions.423 This implies that 45 percent of incentive-based compensation would have to be in some other form to fulfill the 60 percent deferral amount for a senior executive officer or significant risk-taker at a Level 1 and Level 2 covered institution. As discussed in the Broad Economic Considerations section, the payoff structure from stock options is asymmetric and thus generates incentives for executives to undertake risks. For the financial services industry in general, economic studies find that higher levels of stock options in compensation arrangements of publicly traded bank CEOs are positively related to multiple measures of risk, such as equity volatility.424 Thus, limiting the 423 If stock options awarded are not part of incentive-based compensation, there is no limit to such awards. 424 See Mehran, H., Rosenberg, J. 2009. The Effect of CEO Stock Options on Bank Investment Choice, Borrowing, and Capital. Federal Reserve Bank of New York. The study finds a positive relation between the use of stock options in bank CEO compensation arrangements and risk-taking as evident by higher levels of equity and asset volatility. The paper also finds that the increased risk exposure in these banks comes from riskier project choices rather than increased use of leverage. See DeYoung, R., Peng, E., Yan, M. 2013. Executive Compensation and Business Policy Choices at U.S. Commercial Banks. Journal of Financial and Quantitative Analysis 48, 165–196. E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 use of stock options in compensation arrangements could result, on average, in lower risk-taking incentives for senior executive officers and significant risktakers at Level 1 and Level 2 covered institutions. As previously noted, however, the link between stock options and risk-taking is not indisputable. For example, a study that examined the effect of a decrease in the provision of stock options in compensation arrangements due to an unfavorable change in accounting rules regarding option expensing, did not identify decreased risk-taking by executives as a response to a decrease in stock options awards.425 The unique characteristics of the financial services sector compared to the rest of the economy—significantly higher leverage,426 interconnectedness with other institutions and markets, and the possibility for negative externalities—may create a conflict of interest between shareholders (managers) of important financial institutions and taxpayers with respect to the optimal level of risk-taking. In other words, shareholders may enjoy the upside of risk-taking actions whereas taxpayers and other stakeholders have to bear the costs associated with such risk-taking. While the literature does not specifically reference BDs and IAs, but rather the financial services sector more generally, the SEC believes that the global point may be applicable to BDs and IAs given that these entities See Chen, C., Steiner, T., Whyte, A. 2006. Does stock option-based executive compensation induce risk-taking? An analysis of the banking industry. Journal of Banking and Finance 30, 915–945. The paper examines whether option-based compensation is related to various measures of risk for a sample of commercial banks. Option-based compensation is positively related to various market measures of risk such as systematic and idiosyncratic risk. However, causality cannot be inferred; risk also has an effect on the structure of compensation arrangements. 425 See Hayes, R., Lemmon, M., Qiu, M., 2012. ‘Stock options and managerial incentives for risk taking: Evidence from FAS 123R’. Journal of Financial Economics 105, 174–190. This study examines the effect of changes in option-based compensation, due to a change in the accounting treatment of stock options in 2005, on risk-taking behavior. Firms significantly reduce the use of stock options in compensation arrangements as a response to the unfavorable treatment of stock options in financial statements. However, the study finds little evidence that the decline in option usage resulted in less risky investment and financial policies. 426 See Bolton, P., Mehran, H., Shapiro, J. 2011. Executive Compensation and Risk Taking. Federal Reserve Bank of New York Staff Reports, available at: https://www.newyorkfed.org/medialibrary/ media/research/staff_reports/sr456.pdf. The report shows the significant difference between the composition of financing for the average nonfinancial firm (having about 40% of debt on its balance sheet), as opposed to the average financial institution (having at least 90% of debt on its balance sheet). VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 constitute a segment of the financial services sector. In addition, many BDs and IAs that would be covered by the proposed rule are subsidiaries of bank holding companies and as such these studies may be relevant for them. Thus, for BDs and IAs the use of options in compensation arrangements could potentially amplify this conflict of interest as it provides covered persons with an asymmetric payoff structure and an incentive to undertake risks that may be optimal from shareholders’ point of view but may provide risk-taking incentives to management that could lead to higher likelihood of default at these institutions and potentially increase the risk to the greater financial system. Consequently, capping the use of stock options and curbing covered persons’ incentives for inappropriate risk-taking at BDs and IAs could decrease their likelihood of default, better align managers’ incentives with those of a broader group of stakeholders and limit potential negative externalities generated by the default of particularly important institutions.427 However, although BDs and IAs are financial institutions, any generalization based on the findings in the literature may not be very accurate because BDs and IAs also have some differences with respect to other financial institutions. For example, BDs and IAs differ from other financial institutions with respect to business models, nature of the risks posed by the institutions, and the nature and identity of the persons affected by those risks. To the extent that the asymmetric payoff structure of options encourages covered persons at BDs and IAs to undertake risks that are also suboptimal from a shareholders’ point of view, the proposed rule’s limitation on the use of options as part of compensation arrangements may also improve incentive alignment between executives and shareholders. However, as discussed in the Broad Economic Considerations section, executives may be reluctant to undertake valueincreasing but risky projects due to the undiversified nature of their wealth and as such may engage in actions that lower firm value (i.e., forgo risky but value-increasing projects). For example, an economic study found that low sensitivity of compensation to risk resulted in a loss of firm value due to suboptimal risk-taking by executives in 427 See French et al., 2010. The Squam Lake Report: Fixing the Financial System. Journal of Applied Corporate Finance 22, 8–21; and McCormack, J., Weiker, J. 2010. Rethinking ‘Strength of Incentives’ for Executives of Financial Institutions. Journal of Applied Corporate Finance 22, 25–72. PO 00000 Frm 00119 Fmt 4701 Sfmt 4702 37787 these companies.428 Mechanisms that are put in place to curb such undesired behavior by executives include incentive-based compensation components whose value is generally increasing in risk, such as stock options. Thus, risk-taking incentives induced by options may be valuable in order to provide covered persons at BDs and IAs with incentives to take risks that are desirable by shareholders. As a consequence, a potential cost of the proposed limit to the use of stock options in incentive-based compensation arrangements at covered institutions is the potential for such limit to generate sub-optimally low risktaking incentives for the covered persons at BDs and IAs, potentially leading to lower shareholder values for these institutions. Limiting the amount of stock option based compensation that can qualify for mandatory deferral at 15 percent suggests that a covered institution could theoretically award up to 55 percent of its annual incentive-based compensation in the form of stock options (for senior executive officers and significant risk-takers at Level 1 and Level 2 covered institutions). Based on the SEC’s baseline analysis, it appears that the use of options is increasingly infrequent in incentive-based compensation arrangements at public parent institutions of BDs and IAs. Stock options at Level 1 covered institutions represent about 4 percent of total incentive-based compensation, while at Level 2 covered institutions they represent about 20 percent. If the compensation structure of BDs and IAs is similar to that of their parent institutions, and the compensation structure of private institutions is similar to that of public institutions, the specific restriction imposed by the proposed rule would be unlikely to affect the usage of options at Level 1 or unconsolidated Level 2 BDs and IAs and would likely result in insignificant compliance costs. On the other hand, if the compensation practices of parent institutions are significantly different from those at their subsidiaries, covered BDs and IAs could experience 428 See Low, A., 2009. Managerial risk-taking behavior and equity-based compensation. Journal of Financial Economics 92, 470–490. The study examines changes in risk-taking by CEOs whose firms have become more protected from a takeover due to a change in anti-takeover laws. The study finds that CEOs with compensation arrangements with a low sensitivity of compensation to volatility decrease risk-taking following the adoption of the anti-takeover law, and that such a decrease in risktaking activity is value destroying. The study also shows that as a response, firms increase the sensitivity of CEO compensation to volatility to encourage risk-taking following the adoption of the anti-takeover law. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37788 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules significant compliance costs when implementing the specific requirement of the proposed rule. Since the SEC does not have data on how many covered IAs have parent institutions, it is also possible that a significant number of these IAs may be stand-alone companies and therefore could have higher costs to comply with this specific requirement of the proposed rule compared to covered IAs and BDs that are part of reporting parent institutions. As discussed above, BDs and IAs could also incur direct economic costs such as decrease in firm value if the proposed rule leads to lower than optimal use of options in senior executive officers and significant risktakers incentive-based compensation arrangements. The same holds true if the compensation of BDs and IAs is generally different than that of banking institutions, which most of their parent institutions are. Lastly, because some BDs and IAs are subsidiaries of private parent institutions, if there is a significant difference in the compensation practices of public and private covered institutions such BDs and IAs could face large compliance costs and direct economic costs. The SEC does not have data for the use of options at subsidiaries of Level 1 or Level 2 parents, and thus cannot quantify the impact of the proposed rule on those institutions. To better assess the effects of options on compliance costs for BDs and IAs, the SEC requests comments on the use of options in the compensation structures of BDs and IAs below. The Agencies could have selected as an alternative not to place a limit on the use of stock options to meet the minimum required deferral amount requirement for a performance period. Such an alternative would provide covered persons at BDs and IAs with more incentives to undertake risks compared to the alternative the SEC has chosen in the proposed rule. Taxpayers would potentially be worse off under the alternative since the combination of high leverage and government guarantees, coupled with additional risk-taking incentives from stock options could lead to inappropriate risktaking from taxpayers’ point of view. Such an alternative likely would have led to a higher probability of default at covered institutions. For important institutions, such an alternative would also increase the likelihood of risks at the institution also propagating to the greater financial system. On the other hand, it is possible that shareholders would potentially prefer increased risktaking and as a consequence compensation arrangements that VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 3. Long-Term Incentive Plans For senior executive officers and significant risk-takers at Level 1 and Level 2 covered institutions the proposed rule would require a minimum deferral period and a minimum deferral percentage amount of incentive-based compensation awarded through long-term incentive plans (LTIPs), where LTIPs are characterized by having a performance measurement period of at least three years. The proposed rule would require deferral of 60 percent (50 percent) of LTIP awards for senior executive officers of Level 1 (Level 2) covered institutions, and deferral of 50 percent (40 percent) of LTIP awards for significant risk-takers of Level 1 (Level 2) covered institutions. The deferral period for deferred LTIPs must be at least two years for covered persons of Level 1 covered institutions and at least one year for covered persons of Level 2 covered institutions. LTIPs are designed to reward longterm performance, performance that is usually measured over the three-years following the beginning of the performance period.429 Thus, these plans reward long-term performance outcomes and as such generate incentives for long-term value. LTIP awards can be in the form of cash or stock and these awards occur at the end of the performance period. The amount of the award depends on the degree to which the company meets some predetermined performance milestones. These performance milestones can include a variety of accounting-based performance measures, such as sales and earnings, and research shows that the choice of performance measures is related to company specific strategic goals.430 Requiring a minimum percentage of LTIP awards to be deferred would lengthen the period over which senior executive officers and significant risk-takers receive compensation under these plans and subject such compensation to downward adjustment during the performance measurement period (prior to the award) as well as forfeiture and clawback during the deferral and postdeferral periods respectively. Some studies have criticized LTIPs for having short performance periods.431 The limited economic literature on LTIPs currently does not provide a clear indication of the effect of LTIPs on excessive risk-taking. The only study that investigates the role of LTIPs 432 suggests that companies that use them experience improvement in operating performance and their NEOs do not appear to take higher risks. Similar to the discussion on the benefits and costs of mandatory deferral of other forms of incentive-based compensation, deferral of the LTIP award could allow for longterm risks taken by BD and IA senior executive officers and significant risktakers to materialize and thus for their compensation to be more appropriately adjusted for the risks they have taken. LTIP deferral may decrease risk-taking because covered persons may have an incentive to manage the institution such that they receive their full compensation under these plans. If the additional deferral of LTIPs lowers risk-taking incentives at covered BDs and IAs to suboptimally low levels, then firm value at these institutions could suffer as a consequence. However, if the additional deferral of LTIPs mitigates incentives for inappropriate risk-taking at covered BDs and IAs, then such outcome would lower the likelihood of default at these institutions, better align managers’ incentives with those of a broader group of stakeholders, and also lower the likelihood of negative externalities. As an alternative, the Agencies could have selected a larger fraction of LTIPs to be deferred (e.g., more than 60 percent for senior executive officer at a Level 1 covered institution) and increased the LTIPs’ deferral period (e.g., for more than two years for senior executive officers and significant risktakers at Level 1 covered institutions). A longer deferral period for LTIPs would prolong the exposure of senior executive officers’ and significant risk-takers’ compensation to adverse outcomes of their actions. If outcomes of some inappropriate risks are only realized in the longer-term, then prolonging the deferral period for LTIPs would provide incentives to senior executive officers and significant risk-takers to avoid such actions. On the other hand, such an alternative might have exposed senior executive officers and significant risktakers to outcomes of actions that they are less likely to have been responsible for. Additionally, long deferral period for LTIPs could create potential 429 See Frederic W. Cook & Co., Inc. The 2014 Top 250 Report: Long-term incentive grant practices for executives. 430 See Li and Wang (2014). 431 See The alignment gap between creating value, performance measurement, and long-term incentive design, IRRCI research report, 2014. 432 See Li and Wang, 2014. encourage such behavior. From the SEC’s baseline analysis, provided that BDs and IAs have similar compensation arrangements as their parents, the proposed rule should not significantly affect existing compensation arrangements of covered institutions. PO 00000 Frm 00120 Fmt 4701 Sfmt 4702 E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 liquidity issues for senior executive officers and significant risk-takers since their compensation cannot be cashed out on a timely basis to meet their liquidity needs.433 It is also possible that a long deferral period for LTIPs would create incentives for institutions to pay higher fixed pay and as a consequence distort the valueenhancing incentives that are generated through variable pay. As another alternative, the Agencies could have decided to exclude LTIPs from the amount of incentive-based compensation that is to be deferred in a given year. Such an alternative could have excluded a major part of covered persons’ incentive-based compensation arrangements from the deferred amount. LTIPs typically have a performance period of three years, which is shorter than the deferral period proposed in the rulemaking. Under this alternative, not including LTIPs as part of the deferred amount may have limited the ability of the proposed rule to curb inappropriate risk-taking. However, if the current use of LTIPs by covered institutions is consistent with generating optimal risktaking incentives from the perspective of certain shareholders, then not subjecting LTIPs to mandatory deferral would maintain these value-enhancing incentives. 4. Downward Adjustment and Forfeiture For senior executive officers and significant risk-takers at Level 1 and Level 2 covered institutions, the rule proposes placing at risk of downward adjustment all incentive-based compensation amounts not yet awarded for the current performance period and at risk of forfeiture all deferred but not yet vested incentive-based compensation. As the analysis in the baseline section suggests, the triggers for downward adjustment and forfeiture consist of adverse outcomes such as poor financial performance due to significant deviations from approved risk parameters, inappropriate risktaking (regardless of the impact on financial performance), risk management or control failures, and non-compliance with regulatory and supervisory standards resulting in either legal action against the covered institution or a restatement to correct a material error. The compensation of covered persons with either direct accountability or failure of awareness of 433 Interest rates charged to covered persons on loans used to cover their liquidity needs could proxy for the related cost stated in the text. Such costs are likely to be determined by multiple factors (for example, the macroeconomic environment) and vary over time and by individuals making them difficult to quantify. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 an undesirable action would be subject to downward adjustment and/or forfeiture. With regard to the determination of the compensation amount to be downward adjusted or forfeited, the proposed rule would condition the magnitude of the adjustment or forfeiture amounts on both the intent and the participation of covered persons in the event(s) triggering the review, as well as the magnitude of costs generated by the related actions (including financial performance, fines and litigation and related reputational damage). Compensation would be subject to downward adjustment and forfeiture during the performance period and the deferral period, respectively. As a consequence, this requirement would provide incentives to senior executive officers and significant risk-takers at BDs and IAs to avoid inappropriate risktaking since they could be penalized in situations where inappropriate risks had been undertaken, regardless of whether such risks resulted in poor performance. The downward adjustment or forfeiture amounts is conditional on the intent, responsibility and the magnitude of the financial loss caused to the covered institution by inappropriate actions of covered persons. In other words, the penalty imposed on the covered person would increase with the intent, responsibility and the magnitude of financial loss generated. This ‘‘progressiveness’’ characteristic in the proposed rule requirement would imply that the covered person’s incentivebased compensation award would be increasingly at stake. Thus, covered persons would be expected to have incentives to avoid excessive risk-taking in order to secure at least part of incentive-based compensation award. Additionally, provided that senior executive officers and significant risktakers at BDs and IAs may be deemed accountable and risk their compensation for inappropriate actions that were undertaken by other executives or significant risk-takers, they may have an incentive to establish an effective governance system that would monitor risk exposure. Such an incentive and the corresponding actions would strengthen risk oversight within the covered institution and potentially lower the probability that any inappropriate action taken might go undetected. To this point, a recent economic study indicates that bank holding companies with strong risk controls, as proxied by the presence of an independent and strong risk committee, were found to be exposed to lower tail risk, lower amount of underperforming loans, and had better PO 00000 Frm 00121 Fmt 4701 Sfmt 4702 37789 operating and financial performance during the financial crisis.434 On the other hand, the risk of downward adjustment and forfeiture could increase uncertainty on covered persons’ expectations for receiving the compensation. A possibility exists that risks a covered person believes ex-ante to be appropriate may be classified as ex-post inappropriate and thus trigger downward adjustment or forfeiture of related compensation. Such uncertainty about the interpretation of appropriate risk-taking could generate incentives for managers to take approaches with respect to risk-taking that are not optimal from the perspective of shareholders. Such an avoidance of risks, if it occurs, could lead to lower firm value and losses for shareholders. Based on the SEC’s baseline analysis of current compensation practices, it appears that all of the Level 1 public parent institutions and most of the Level 2 public parent institutions already employ forfeiture with respect to deferred compensation. The forfeiture rules are based on various triggers and apply to NEOs, non-NEOs and significant risk-takers. Thus, if the compensation structure of BDs and IAs is similar to that of their parent institutions, and the compensation structure of private institutions is similar to that of public institutions, the implementation of the proposed rule related to forfeiture would be unlikely to lead to significant compliance costs. On the other hand, if the compensation practices of parent institutions are significantly different than those at their subsidiaries (e.g., BDs and IAs do not use downward adjustment and forfeiture in their compensation packages), covered BDs and IAs could experience significant compliance costs when implementing this specific requirement of the proposed rule. Since the SEC does not have data on how many covered IAs have parent institutions, it is also possible that a significant number of these IAs may be stand-alone companies and therefore could have higher costs to comply with this specific requirement of the proposed rule compared to covered IAs and BDs that are part of reporting parent institutions. BDs and IAs could also incur direct economic costs such as decrease in firm value if the proposed rule requirements regarding downward adjustment or forfeiture lead to less risktaking than is optimal from shareholders’ point of view. The same 434 See Ellul, A., Yerramilli, V. 2013. Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies. Journal of Finance 68, 1757– 1803. E:\FR\FM\10JNP2.SGM 10JNP2 37790 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 holds true if the compensation of BDs and IAs is generally different than that of banking institutions, which most of their parent institutions are. Lastly, because some BDs and IAs are subsidiaries of private parent institutions, if there is a significant difference in the compensation practices of public and private covered institutions such BDs and IAs could face large compliance costs and direct economic costs. The SEC does not have data for the use of downward adjustment and forfeiture at subsidiaries of Level 1 or Level 2 parents, and thus cannot quantify the impact of the rule for those institutions. To better assess the effects of downward adjustment and forfeiture on compliance costs for BDs and IAs. The SEC requests comments below. 5. Clawback For senior executive officers and significant risk-takers at Level 1 and Level 2 covered institutions, the proposed rule would require clawback provisions in incentive-based compensation arrangements to provide for the recovery of paid compensation for up to seven years following the vesting date of such compensation. Such a clawback requirement would be triggered when senior executive officers and significant risk-takers are determined to have engaged in fraud, intentional misrepresentation of information used to determine a covered person’s incentive-based compensation, or misconduct resulting in significant financial or reputational harm to the covered institution. Other existing provisions of law contain clawback requirements that potentially have some overlap with those in the proposed rulemaking. Thus, certain covered institutions may have experience with recovering executive compensation via clawback. For example, section 304 of the Sarbanes Oxley Act (‘‘SOX’’) contains a recovery provision that is triggered when a restatement occurs as a result of issuer misconduct. This provision applies only to the chief executive officer (‘‘CEO’’) and chief financial officer (‘‘CFO’’) and the amount of required recovery is limited to compensation received in the year following the first improper filing.435 The Interim Final Rules under section 111 of the Emergency Economic Stabilization Act of 2008 (‘‘EESA’’) required institutions receiving assistance under TARP to mandate Senior Executive Officers to repay compensation if awards based on statements of earnings, revenues, gains, 435 See 15 U.S.C. 7243. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 or other criteria that were later found to be materially inaccurate.436 Relative to either SOX or EESA, the clawback requirement of the proposed rule is more expansive in that its application is not only limited to CEOs and CFOs but would cover any senior executive officer and significant risk-taker in a Level 1 or Level 2 covered institution. In addition to the broader scope of the clawback provision in the proposed rule regarding covered persons, there is also a broader scope with respect to the circumstances that would trigger clawback. More specifically, the proposed rule includes misconduct that resulted in reputational or financial harm to the covered institution as a trigger for clawback. The inclusion of the clawback provision in the incentive-based compensation of senior executive officers and significant risk-takers at BDs and IAs could increase the horizon of accountability with respect to the identified actions that are likely to bring harm to the covered institution. As a consequence of the clawback horizon, senior executive officers and significant risk-takers are likely to have lower incentives to engage in actions that may put the covered institution at risk in the longer run. Moreover, the proposed rule may also increase incentives to senior executive officers and significant risktakers to put in place stronger mechanisms such as governance in an effort to protect their incentive-based compensation from events that may trigger a clawback. Finally, in addition to lowering the incentives of senior executive officers and significant risktakers for undesirable actions that may harm the covered institution, stakeholders of the covered institution are also expected to benefit from the clawback provision since in the event of an action triggering a clawback, any recovered incentive-based compensation amount would accrue to the institution. The fact that incentive-based compensation is to a large extent determined by reported performance, coupled with the lowered incentives for covered persons to intentionally misrepresent information, can lead to improved financial reporting quality for covered institutions. Thus, indirectly the potential to claw back incentivebased compensation that is awarded on 436 Under EESA a ‘‘Senior Executive Officer’’ was defined as an individual who is one of the top five highly paid executives whose compensation was required to be disclosed pursuant to the Securities Exchange Act of 1934. See Department of Treasury, TARP Standards for Compensation and Corporate Governance; Interim Final Rule (June 15, 2009), available at https://www.gpo.gov/fdsys/pkg/FR-200906-15/pdf/E9-13868.pdf. PO 00000 Frm 00122 Fmt 4701 Sfmt 4702 erroneous financial information could generate incentives for high quality reporting. The literature finds that market penalties for reporting failures, as captured by restatements of financial reports, i.e., financial reports of (extremely) low quality, are non-trivial and may translate into an increase in the cost of capital for such firms.437 To the extent that the quality of financial reporting increases as a result of the proposed rule, capital formation may be fostered since the improved information environment may lead to a decrease in the cost of raising capital for covered institutions.438 However, the relatively long clawback horizon may generate uncertainty regarding incentive-based compensation of senior executive officers and significant risk-takers. For example, that could be the case if certain actions that trigger a clawback are outside of a covered person’s control. As a response to the potentially increased uncertainty, senior executive officers and significant risk-takers may demand higher levels of overall compensation, or substitution of incentive-based compensation with other forms of compensation such as salary. Such potential may distort incentives for risk-taking and as a consequence lower shareholder value. Also, the increased allocation of resources to the production of highquality financial reporting may divert resources from other activities that may be value enhancing. Finally, covered persons may have a decreased incentive to pursue those projects that would require more complex accounting judgments, perhaps lowering shareholder value.439 437 See Palmrose, Z., Richardson, V., Scholz, S. 2004. Determinants of Market Reactions to Restatement Announcements. Journal of Accounting and Economics 37, 59–89. This study observes an average abnormal return of ¥9% over the 2-day restatement announcement window for a sample of restatements announced over the 1995– 1999 period. See Hribar, P., Jenkins, N. 2004. The Effect of Accounting Restatements on Earnings Revisions and the Estimated Cost of Capital. Review of Accounting Studies 9, 337–356. This study observes a significant increase in the cost of capital for firms that restated their financial reports due to lower perceived earnings quality and an increase in investors’ required rate of return. 438 See Francis, J., LaFond, R., Olsson, P., Schipper, K. 2005. The Market Pricing of Accruals Quality. Journal of Accounting and Economics 39, 295–327. This study observes a negative relation between measures of earnings quality and costs of debt and equity. The study focuses on the accrual component of earnings to infer earnings quality since this component of earnings involves more discretion in its estimation and is more prone to be manipulated by firms. 439 For example, if an executive is under pressure to meet an earnings target, rather than manage earnings through accounting judgments, the executive may elect to reduce or defer to a future E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules Moreover, the potential compliance costs related with the implementation of the clawback provision could be significant. For example, covered institutions may have to rely on the work of outside experts to estimate the amount of incentive-based compensation to be clawed back following a clawback trigger. Based on the SEC’s baseline analysis, it appears that all of the Level 1 covered institutions and most of the Level 2 covered institutions already employ clawback policies with respect to deferred compensation. The clawback policies are based on various triggers and apply to NEOs, non-NEOs and significant risk-takers. Thus, if the BDs and IAs have similar policies on clawback, and the compensation structure of private institutions is similar to that of public institutions, the implementation of the proposed clawback rule would unlikely lead to significant compliance costs. On the other hand, if the compensation practices of parent institutions are significantly different than those at their subsidiaries (e.g., BDs and IAs do not include clawback policies in their compensation packages), covered BDs and IAs could experience significant compliance costs when implementing the proposed rule. The same holds true if the compensation of BDs and IAs is generally different than that of banking institutions, which most of their parent institutions are. Additionally, since the SEC does not have data on how many covered IAs have parent institutions, it is also possible that a significant number of these IAs may be stand-alone companies and therefore could have higher costs to comply with this specific requirement of the proposed rule compared to covered IAs and BDs that are part of reporting parent institutions. The SEC has attempted to quantify such costs using data in Table 14. We note that these costs are not necessarily going to be in addition to the compliance costs discussed above, as covered institutions may hire a compensation consultant to help them with several requirements in the proposed rules. Lastly, because some BDs and IAs are subsidiaries of private parent institutions, if there is a significant difference in the compensation practices period research and development or advertising expenses. This could improve reported earnings in the short-term, but could result in a suboptimal level of investment that adversely affects performance in the long run. See Chan, L., Chen, K., Chen, T., Yu, Y. 2012. The effects of firminitiated clawback provisions on earnings quality and auditor behavior. Journal of Accounting and Economics 54, 180–196. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 of public and private covered institutions such BDs and IAs could face large compliance costs. The SEC does not have data for the use of clawback at subsidiaries of Level 1 or Level 2 parents, and thus cannot quantify the impact of the rule on those institutions. To better assess the effects of clawback on compliance costs for BDs and IAs the SEC requests detailed comments below. 6. Hedging The proposed rule would prohibit the purchase of any instrument by a Level 1 or Level 2 covered institution to hedge against any decrease in the value of a covered person’s incentive-based compensation. As discussed above, introducing a minimum mandatory deferral period for incentive-based compensation aims at increasing longterm managerial accountability, including long-term risk implications associated with covered persons’ actions. Using instruments to hedge against decreases in firm value would provide downside insurance to covered persons’ wealth, including equity holdings that are part of deferred compensation. If the value of (deferred) incentive-based compensation is protected from potential downside through a hedging transaction, this is likely to increase the covered person’s tolerance to risk. Thus, the effect of compensation deferral would likely be weakened.440 For BDs and IAs that currently initiate hedges on behalf of their covered persons, a benefit from the prohibition on hedging is that the incentives of covered persons to exert effort could be strengthened given the same compensation contract. This in turn would imply a stronger alignment between executives’ and taxpayers’ and other stakeholders’ interests for the same amount of performance-based pay. While the proposed rule intends to eliminate firm initiated hedging, a personal hedging transaction by covered persons would still be permitted (unless 440 See Bebchuk, L., Fried. J. Paying for long-term performance. University of Pennsylvania Law Review 158, 1915–1959. The paper argues that potential benefits from tying executive compensation to long-term shareholder value are weakened when executives are allowed to hedge against downside risk. See also Gao, H. 2010. Optimal compensation contracts when managers can hedge. Journal of Financial Economics 97, 218–238. This study shows that the ability to hedge against potential downside makes the executive more risk tolerant. In other words, holding the compensation arrangement constant, hedging is predicted to weaken the sensitivity of compensation to performance and also the sensitivity of compensation to risk. However, the study also shows that for executives who can engage in lowcost hedging transactions, compensation contracts tend to provide higher sensitivity of executive pay to both performance and volatility. PO 00000 Frm 00123 Fmt 4701 Sfmt 4702 37791 the institution prohibits such transactions from occurring). Thus, a covered person at BDs and IAs could potentially substitute the firm-initiated hedge with a personal hedging 441 contract and restore any changes in incentives from the prohibition of the firm-initiated hedge. To the extent that the covered person’s compensation contract is not adjusted as a response to the elimination of the hedge, the covered person would face stronger incentives to exert effort whereas her tolerance for risk-taking would decrease with the prohibition on hedging. Whether the resulting lower risk-taking tolerance is beneficial for BDs and IAs is difficult to determine. On one hand, if the covered persons’ risk-taking incentives are at an optimal level with the hedging transaction in place, then eliminating the hedge may reduce their risk-taking incentives to levels that could be detrimental for shareholder value. If this were the case, however, the institution’s compensation committees could adjust compensation structures in a manner to achieve pre-prohibition risk-taking incentives if the distortion from hedging prohibition is deemed to be detrimental to firm value; however, some provisions of the proposed rule could potentially constrain board of directors’ flexibility to make such adjustments.442 On the other hand, if covered persons had incentives to undertake undesirable risks given the downside protection provided by the hedge, then eliminating such protection could lead them to engage in risk-taking which could lead to higher firm values. Based on the SEC’s baseline analysis, it appears that most Level 1 covered institutions (70 percent) and Level 2 covered institutions (60 percent) are already using prohibition on hedging with respect to executive compensation of executives and significant risk-takers. Additionally, 70 percent of Level 1 covered institutions and 100 percent of Level 2 covered institutions already prohibit hedging with respect to executive compensation of nonemployee directors. If BDs and IAs have similar policies as their parent institutions, and the compensation structure of private institutions is similar to that of public institutions, the 441 Refer to Tables 7a and 7b for statistics regarding the complete prohibition of hedging by parent institutions of BDs and IAs. 442 For example, boards of directors or compensation committees at covered BDs and IAs would be constrained from increasing the risktaking incentives of covered persons through the additional provision of stock options, if banning hedging lowers risk-taking incentives to a suboptimal level. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37792 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules implementation of the proposed rule in its part related to the prohibition of hedging is unlikely to lead to significant compliance costs. The cost of compliance with the proposed requirement of the rule would mostly affect the few BDs and IAs whose parent institutions do not currently implement such a prohibition. On the other hand, if the compensation practices of parent institutions are significantly different than those at their subsidiaries (e.g., BDs and IAs do not prohibit hedging), covered BDs and IAs could experience significant compliance costs when implementing the proposed rule. Since the SEC does not have data on how many covered IAs have parent institutions, it is also possible that a significant number of these IAs may be stand-alone companies and therefore could have higher costs to comply with this specific requirement of the proposed rule compared to covered IAs and BDs that are part of reporting parent institutions. BDs and IAs could also incur direct economic costs such as decrease in firm value if the proposed prohibition on hedging leads to less risk-taking than is optimal. The same holds true if the compensation of BDs and IAs is generally different than that of banking institutions, which most of their parent institutions are. If BDs and IAs do not prohibit hedging and this provides incentives to their covered persons to undertake undesirable risks because of the downside protection provided by the hedge, then applying the rule provisions could lead to more appropriate risk-taking. Lastly, because some BDs and IAs are subsidiaries of private parent institutions, if there is a significant difference between the compensation practices of public and private covered institutions such BDs and IAs could face large compliance costs and direct economic costs. The SEC does not have data for a prohibition of hedging at subsidiaries of Level 1 or Level 2 private parents, and thus cannot quantify the impact of the rule on those institutions. To better assess the effects of the prohibition on hedging on compliance costs for BDs and IAs the SEC requests comments below. As an alternative, some commenters suggested disclosure of hedging transactions instead of prohibition.443 One commenter suggested instead of prohibiting the use of hedging instruments to require full disclosure of all outside transactions in financial markets by covered persons, including hedging transactions, to the extent that these transactions affect pay443 See CFP, FSR, SIFMA. VerDate Sep<11>2014 00:00 Jun 10, 2016 performance sensitivity.444 This disclosure should be made to the compensation committee of the board of directors and the appropriate regulator, and the board of directors should attest to the fact that these transactions do not distort proper risk-reward balance in the compensation arrangement. According to the commenter, sometimes covered persons may have legitimate purposes for engaging in hedging transactions such as when they are exposed excessively to the riskiness of the covered institution and need to rebalance their personal portfolio. Such an alternative, however, might not prevent covered persons from unwinding the effect of the mandatory deferral. For example, it would not be easy to disentangle hedging transactions that diminish individuals’ exposure to the riskiness of the covered institutions from transactions that reverse the effect of the deferral. Additionally, the compensation committee might not have the expertise to evaluate complex derivatives transactions. 7. Maximum Incentive-Based Compensation Opportunity The proposed rule would prohibit Level 1 and Level 2 covered institutions from awarding incentive-based compensation to senior executive officers and significant risk-takers in excess of 125 percent (for senior executive officers) or 150 percent (for significant risk-takers) of the target amount for that incentive-based compensation. Placing a cap on the amount by which the incentive-based compensation award can exceed the target would essentially limit the upside pay potential due to performance and a potential impact of such restriction could be to lower risk-taking incentives by senior executive officers and significant risk-takers. That could be the case because the cap on incentive-based compensation implies that managers would not be rewarded for performance once the cap is reached. As discussed above, high levels of upside leverage could lead to senior executive officers and significant risktakers taking inappropriate risks to maximize the potential for large amounts of incentive-based compensation. Given the positive link between risk and expected payoffs from managerial actions, a potential impact of such restriction could be to lower risktaking incentives by senior executive officers and significant risk-takers. Whether such an effect is beneficial or not for covered BDs and IAs firm value is likely to depend on many factors 444 See Jkt 238001 PO 00000 CFP. Frm 00124 Fmt 4701 Sfmt 4702 including the level of the incentivebased compensation targets set in compensation arrangements. If the proposed cap excessively lowers appropriate risk-taking incentives, then firm value could suffer. Moreover, another potential cost from the proposed restriction is that effort inducing incentives may be diminished once the cap is achieved, possibly misaligning the interests of shareholders with those of managers. On the other hand, if the cap on incentive-based compensation awards eliminates a range of payoffs that could only be achieved by actions associated with taking suboptimally high risks, then such a restriction would improve firm value. As the baseline analysis shows, the maximum incentive-based compensation opportunity for Level 1 parent institutions is on average 155 percent and that for Level 2 parent institutions is on average 190 percent. Both are significantly higher than would be permitted under the proposed rule. If BDs and IAs have similar policies as their parent institutions, and the compensation structure of private institutions is similar to that of public institutions, the implementation of the proposed rule in its part related to maximum incentive-based compensation opportunity could lead to significant compliance costs. The cost could result from changing the current practices and, as a result, potentially having to compensate senior executive officers and significant risk-takers for the decreased ability to earn compensation in excess of the target amount. If the current compensation practices with regard to maximum incentive-based compensation opportunity are optimal, it is possible than affected BDs and IAs could experience loss of human capital. On the other hand, as discussed above, if the cap on incentive-based compensation awards eliminates a range of payoffs that could only be achieved by actions associated with taking suboptimally high risks, then such a restriction would improve firm value. Since the SEC does not have data on how many covered IAs have parent institutions, it is also possible that a significant number of these IAs may be stand-alone companies and therefore could have higher costs to comply with this specific requirement of the proposed rule compared to covered IAs and BDs that are part of reporting parent institutions. Additionally, because some BDs and IAs are subsidiaries of private parent institutions, if there is a significant difference between the compensation practices of public and private covered E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 institutions such BDs and IAs could face large compliance costs when applying this rule requirement. The SEC does not have data on the use of maximum incentive-based compensation opportunity at subsidiaries of Level 1 or Level 2 private parents, and thus cannot quantify the impact of the rule on those institutions. To better assess the effects of the proposed limitations to the maximum incentive-based compensation opportunity on compliance costs for BDs and IAs the SEC requests comments below. 8. Acceleration of Payments The proposed rule would prohibit the acceleration of payment of deferred regulatory incentive-based compensation except in cases of death or disability of covered persons at Level 1 and Level 2 covered institutions. This would prevent covered institutions from undermining the effect from the mandatory deferral of incentive-based compensation by accelerating the deferred payments to covered persons. It could, however, negatively affect covered persons that decide to leave the institution in search for other employment opportunities. In such cases, these covered persons might have to forgo a significant portion of their compensation. As the analysis in the Baseline section shows, most Level 1 parent institutions (approximately 70 percent) already prohibit acceleration of payments to their executives, while very few of the Level 2 parent institutions do. The only exceptions are in cases of death or disability. Given that current practices of BDs’ and IAs’ Level 1 parent institutions already apply most of the prohibitions required by the proposed rule (except employment termination), if those BDs and IAs have similar policies as their parent institutions, and the compensation structure of private institutions is similar to that of public institutions, the implementation of the proposed with respect to the prohibition on the acceleration of payments is unlikely to lead to significant compliance costs. The cost of compliance with the requirement of the rule will mostly affect the BDs and IAs whose parent institutions are Level 2 covered institutions or Level 1 covered institutions that do not currently implement such a prohibition. On the other hand, if the compensation practices of parent institutions are significantly different than those at their subsidiaries (e.g., BDs and IAs do not prohibit acceleration of payments), covered BDs and IAs could experience significant compliance costs when implementing the proposed rule. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 Additionally, since the SEC does not have data on how many covered IAs have parent institutions, it is also possible that a significant number of these IAs may be stand-alone companies and therefore could have higher costs to comply with this specific requirement of the proposed rule compared to covered IAs and BDs that are part of reporting parent institutions. Lastly, because some BDs and IAs are subsidiaries of private parent institutions, if there is a significant difference in the compensation practices of public and private covered institutions such BDs and IAs could face large compliance costs when applying this rule requirement. The SEC does not have data for the prohibition of acceleration of payments at subsidiaries of Level 1 or Level 2 parents, and thus cannot quantify the impact of the rule on those institutions. The SEC requests comment on the effects of the prohibition on acceleration of payments may have on compliance costs for BDs and IAs. 9. Relative Performance Measures The proposed rule would prohibit the sole use of relative performance measures in incentive-based compensation arrangements at Level 1 and Level 2 covered institutions. Although relative performance measures are widely used to filter out uncontrollable events that are outside of management control and can reduce the efficiency of the compensation arrangement, a peer group could be opportunistically selected to justify compensation awards at a covered institution. To the extent that covered persons may influence peer selection, opportunism in choosing a performance benchmark may translate into covered persons selectively choosing benchmark firms in order to increase or justify increases in their compensation awards. Evidence on whether such practices take place is mixed. For example, one study examined the selection of peer firms used as benchmarks in setting compensation for a wide range of firms and showed that, on average, chosen peer firms provided higher levels of compensation to their executives. The study asserts that managers tend to choose higher paying firms as peers to justify increases in the level of their own compensation.445 The same study 445 See Faulkender, M., Yang, J. 2010. Inside the black box: The role and composition of compensation peer groups. Journal of Financial Economics 96, 257–270. The study suggests that companies appear to select highly paid peers as a benchmark for their CEO’s pay to justify higher CEO compensation. The study also suggests that such an effect is stronger when governance is weaker: In PO 00000 Frm 00125 Fmt 4701 Sfmt 4702 37793 also found that the choice of highly paid peers is more prevalent when the CEO is also the chair of the board of directors, re-enforcing the argument for opportunism in peer selection. Another study found that executives attempt to justify increases in their compensation by choosing relatively larger firms as their peers since larger firms are likely to offer higher compensation to their executives.446 However, the study also showed that boards of directors exercise conservative discretion in using information from benchmark firms when setting compensation practices. Finally, a third related study 447 suggests that firms choose peers with (relatively) highly paid CEOs when their own CEO is highly talented, a finding that is not consistent with opportunism regarding the choice of peers in compensation setting. Overall, empirical studies suggest that opportunism in the peer group selection may exist, particularly in companies where the CEO may exert influence over her compensation setting process. By restricting the sole use of relative performance measures in compensation arrangements, the proposed rule would curb the ability of covered persons to engage in such opportunistic behavior, which would benefit covered BDs and IAs. As mentioned above, the proposed rule would prohibit the sole use of relative performance measures in determining compensation at covered institutions. Constraining the use of relative performance measures in incentive-based compensation contracts has potential costs. Absolute firm performance is typically driven by multiple factors and not all of these factors are under the covered persons’ control. If incentive-based compensation is tied to measures of absolute firm performance, then at least companies where the CEO is also the chairman of the board, has longer tenure, and when directors are busier serving on multiple boards. 446 See Bizjak, J., Lemmon, M., Nguyen, T. 2011. Are all CEOs above average? An empirical analysis of compensation peer groups and pay design. Journal of Financial Economics 100, 538–555. The study suggests that companies use compensation peer groups that are larger or provide higher pay in order to inflate pay in their own company and this practice is more prevalent for companies outside of the S&P500. However, the study also shows that boards exercise discretion in adjusting compensation due to the peer group effect; pay increases only close about one-third of the gap between company CEO and peer group CEO pay. 447 See Albuquerque, A., De Franco, G., Verdi, R. 2013. Peer Choice in CEO Compensation. Journal of Financial Economics 108, 160–181. The study examines whether companies that benchmark CEO pay against highly paid peer CEOs is driven by incentives to increase CEO pay. Whereas the study suggests that benchmarking pay against highly paid peer CEOs is driven by opportunism, such practice mostly represents increased compensation for CEO talent. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37794 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules a part of incentive-based compensation will be tied to events out of covered persons’ control. This could generate uncertainty about compensation outcomes for covered persons, reducing the efficiency of the incentive-based compensation arrangement. Whereas the proposed rule would not prohibit the use of relative performance measures, if the proposed limitation regarding the use of performance measures in determining compensation awards leads to less filtering out of the uncontrollable risk component of performance, then covered institutions may increase overall pay to compensate covered persons for bearing uncontrollable risk. The SEC’s baseline analysis of current compensation practices suggests that most Level 1 and Level 2 covered institutions use a mix of absolute and relative performance measures. If BDs and IAs have similar policies as their parent institutions, and the compensation structure of private institutions is similar to that of public institutions, the SEC does not expect this rule requirement to generate significant compliance costs for covered institutions. The cost of compliance with the proposed rule would mostly affect the few BDs and IAs whose parent institutions do not currently implement such a requirement. On the other hand, if the compensation practices of parent institutions are significantly different than those at their subsidiaries (e.g., they do not use absolute performance measures, or use mostly absolute measures), covered BDs and IAs could experience significant compliance costs when implementing the proposed rule. Since the SEC does not have data on how many covered IAs have parent institutions, it is also possible that a significant number of these IAs may be stand-alone companies and therefore could have higher costs to comply with this specific requirement of the proposed rule compared to covered IAs and BDs that are part of reporting parent institutions. The same holds true if the compensation of BDs and IAs is generally different than that of banking institutions, which most of their parent institutions are. The SEC has attempted to quantify such costs based on the estimates in Table 14. The SEC also notes that these costs are not necessarily going to be in addition to the compliance costs discussed above, as covered institutions may hire a compensation consultant to help them with several requirements in the proposed rules. These costs could be lower, however, if the parent institutions of BDs and IAs already employ compensation consultants and could extend their services to meet the VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 proposed rule requirements for BDs and IAs. Lastly, because some BDs and IAs are subsidiaries of private parent institutions, if there is a significant difference in the compensation practices of public and private covered institutions such BDs and IAs could face large compliance costs. The SEC does not have data for the prohibition of the sole use of relative performance measures at subsidiaries of Level 1 or Level 2 parents, and thus cannot quantify the impact of the rule on those institutions. To better assess the effects of this prohibition on compliance costs for BDs and IAs. The SEC requests detailed comments below. For covered persons at Level 1 and Level 2 covered institutions, the proposed rule would prohibit incentivebased compensation arrangements that are based solely on the volume of transactions being generated without regard to transaction quality or compliance of the covered person with sound risk management. Such a compensation contract would provide incentives for employees to maximize the number of transactions since that outcome would lead to maximizing their compensation. A compensation contract that solely uses volume as the performance indicator is likely to provide employees with incentives for inappropriate risk-taking since employees benefit from one aspect of performance but do not bear the negative consequences of their actions— the associated costs and risks incurred to generate revenue/volume. There is limited academic literature addressing the effect of volume-driven compensation on employee incentives. A study examined the behavior of loan officers at a major commercial bank when compensation switched from a fixed salary structure to a performancebased structure where the measure of performance was set as loan origination volume.448 The study found a 31 percent increase in loan approvals, holding other factors related to the probability of loan approvals constant. The study also found that the 12-month probability of default in originating loans increased by 27.9 percent. Whereas the study did not conclude whether the bank was better or worse off due to the introduction of the compensation scheme, the authors found that interest rates charged to lower quality loans did not reflect the increased riskiness of the borrowers. Another related study 449 finds that loan officers who are incentivized based on lending volume rather than on the quality of their loan portfolio originate more loans of lower average quality. The study also finds that due to the presence of career concerns or reputational motivations, loan officers with lending volume incentives do not indiscriminately approve all applications. Whereas the study examines the effects of volume-driven compensation on employees that are not likely to be covered by the proposed rule, it confirms intuition that providing incentives for volume maximization may lead to behaviors that do not necessarily maximize firm value. It is unclear to the SEC whether volume-driven incentive-based compensation arrangements are utilized by IAs and BDs given the nature of the business conducted by IAs and BDs. Assuming that these incentive-based compensation arrangements are relevant to IAs and BDs, restricting the sole use of volume-driven compensation practices may curb incentives that reward employees of BDs and IAs on only partial outcomes of their actions; partial in the sense that costs and risks associated with those actions are not part of the performance indicators used to determine their compensation. As a consequence, to the extent that BDs and IAs contribute significantly to the overall risk profile of their parent institutions, covered persons’ incentives would likely become aligned with the interests of stakeholders, including taxpayers, since covered persons would bear both the benefits and the costs from their actions. Likewise, the prohibition on the sole use of volume-driven compensation practices is also likely to 448 See Agarwal, S., Ben-David, I. 2014. Do Loan Officers’ Incentives Lead to Lax Lending Standards? NBER Working Paper. This study examines changes in lending practices in one of the largest U.S. commercial banks when loan officers’ compensation structure was altered from fixed salary to volume-based pay. The study suggests that following the change in the compensation structure, loan origination became more aggressive as evident by higher origination rates, larger loan sizes, and higher default rates. The study estimates that 10% of the loans under the volume-based compensation structure were likely to have negative net present value. 449 See Cole, S., Kanz, M., Klapper, L. 2015. Incentivizing Calculated Risk-Taking: Evidence from an Experiment with Commercial Bank Loan Officers. Journal of Finance 70, 537–575. The study examines the effect of different incentive-based compensation arrangements on loan originators behavior in screening and approving loans in an Indian commercial bank. In general, the study finds that the structure of incentive-based arrangements for loan officers affects their decisions; the performance metric used in compensation arrangements of loan officers as well as whether pay is deferred affect loan officers screening and approval incentives and corresponding decisions. 10. Volume-Driven Incentive-Based Compensation PO 00000 Frm 00126 Fmt 4701 Sfmt 4702 E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 limit covered persons’ incentives for inappropriate risk-taking. The effect of this proposed rule on BDs and IAs cannot be unambiguously determined because of the lack of data on the current use of volume-driven compensation practices. If BDs and IAs have already instituted similar policies with respect to senior executive officers and significant risk-takers, the SEC does not expect this rule requirement to generate significant compliance costs for covered institutions. On the other hand, if covered BDs and IAs’ compensation practices with respect to senior executive officers and significant risktakers rely exclusively on volumedriven transactions, covered BDs and IAs could experience significant compliance costs when implementing the proposed rule. To better assess the effects of this prohibition on compliance costs for BDs and IAs the SEC requests comments below. 11. Risk Management The proposed rule would include specific requirements with regard to risk management functions to qualify a covered person’s incentive-based compensation arrangement at Level 1 and Level 2 covered institutions as compatible with the rule. Specifically, the proposed rule would require that a Level 1 or Level 2 covered institution have a risk management framework for its incentive-based compensation arrangement that is independent of any lines of business, includes an independent compliance program that provides for internal controls, testing, monitoring, and training, with written policies and procedures consistent with the proposed rules, and is commensurate with the size and complexity of a covered institution’s operations. Moreover, the proposed rule would require that covered persons engaged in control functions be provided with the authority to influence the risk-taking of the business areas they monitor and be compensated in accordance with the achievement of performance objectives linked to their control functions and independent of the performance of the business areas they monitor. Finally, a Level 1 or Level 2 covered institution would be required to provide independent monitoring of all incentive-based compensation plans, events related to forfeiture and downward adjustment and decisions of forfeiture and downward adjustment reviews, and compliance of the incentive-based compensation program with the covered institution’s policies and procedures. The proposed requirements may strengthen the risk management and VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 control functions of covered BDs and IAs, which could result in lower levels of inappropriate risk-taking. Academic literature suggests that stronger risk controls in bank holding companies resulted in lower risk exposure, as evident by lower tail-risk and lower fraction of non-performing loans; and better performance, as evident by better operating performance and stock return performance, during the crisis.450 This study also shows that the risk management function is stronger for larger banks, banks with larger derivative trading operations and banks whose CEOs compensation is more closely tied to stock volatility. Additionally, the study shows that stronger risk function, as measured by this study, was associated with better firm performance only during crisis years, whereas the same relation did not hold during non-crisis periods. As such, a strong and independent risk management function can curtail tail risk exposures at banks and potentially enhance value, particularly during crisis years. Another study shows that lenders with a relatively powerful risk manager, as measured by the level of the risk manager’s compensation relative to the top named executives’ level of compensation, experienced lower loan default rates. Thus, the evidence in the study seems to suggest that powerful risk executives curb risk-taking with respect to loan origination.451 It is also possible that the proposed requirements may not have an effect on the current level of risk-taking at BDs and IAs. For example, if risk-taking is driven by the culture of the institution, then governance characteristics (including risk management functions) may reflect the choice of control functions that match the inherent risktaking appetite in the institution.452 A potential downside of applying a strict risk management control function over covered BDs and IAs is that it could lead to decreased risk-taking and potential loss of value for those BDs and IAs that already employ an optimal risk management function. For such BDs and IAs, the implementation of the rule requirements with respect to risk management could result in lower than optimal risk-taking by covered persons. 450 See Ellul, A., Yerramilli, V. 2013. Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies. Journal of Finance 68, 1757– 1803. 451 See Keys, B., Mukherjee, T., Seru, A., Vig, Vikrant. 2009. Financial regulation and securitization: Evidence from subprime loans. Journal of Monetary Economics 56, 700–720. 452 See Cheng, I., Hong, H., Scheinkman, J. 2015. Yesterday’s Heroes: Compensation and Risk at Financial Firms. Journal of Finance 70, 839–879. PO 00000 Frm 00127 Fmt 4701 Sfmt 4702 37795 Based on the SEC’s baseline analysis, it appears that all Level 1 parent institutions and most Level 2 parent institutions (67 percent) of BDs already have an independent risk management and control function (e.g., a risk committee) and compensation monitoring function (e.g., a fully independent compensation committee) 453 that could apply the rule requirements. Similarly, all of the Level 1 and Level 2 parent institutions of IAs have risk committees and substantial portion (80 percent and above) have fully independent compensation committees. The SEC, however, does not have information on whether risk committees review and monitor the incentive-based compensation plans. The SEC’s analysis suggests that there are some Level 1 covered institutions (30 percent) and Level 2 covered institutions (20 percent) where CROs review compensation packages. If BDs and IAs have similar policies as their parent institutions, and the risk management structure of private institutions is similar to that of public institutions, the implementation of the proposed rule in its part related to risk management and control is unlikely to lead to significant compliance costs for the majority of covered BDs and IAs because, as mentioned in the previous paragraph, a large percentage of the parent institutions already have fully independent risk committees. Some BDs with Level 2 parent institutions and some IAs with Level 1 and Level 2 parent institutions may face high compliance costs because their parent institutions currently do not employ risk management and compensation monitoring practices similar to the one prescribed by the proposed rule. On the other hand, if the risk management practices of parent institutions are significantly different from those at their subsidiaries (e.g., BDs and IAs do not have risk management and control functions), covered BDs and IAs could experience significant compliance costs when implementing the proposed rule. Since the SEC does not have data on how many covered IAs have parent institutions, it is also possible that a significant number of these IAs may be stand-alone companies and therefore could have higher costs to comply with this specific requirement of the proposed rule compared to covered IAs and BDs that are part of reporting parent institutions. BDs and IAs could also incur direct economic costs such as decrease in firm value if the proposed 453 A risk committee is ‘‘fully independent’’ for purposes of this discussion if it consists only of directors that are not employees of the corporation. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37796 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules rule requirements regarding risk management lead to less risk-taking than is optimal. The same holds true if the risk management and controls of BDs and IAs is generally different than that of banking institutions, which most of their parent institutions are. Lastly, because some BDs and IAs are subsidiaries of private parent institutions, if there is a significant difference in the risk management practices of public and private covered institutions such BDs and IAs could face large compliance costs and direct economic costs. The SEC does not have data for the risk management and control functions at subsidiaries of Level 1 or Level 2 parents, and thus cannot quantify the impact of the rule on those institutions. To better assess the effects of these rule requirements on compliance costs for BDs and IAs the SEC requests comments below. The SEC has attempted to quantify the potential compliance costs for BDs and IAs associated with the proposed rule’s requirements regarding the existence and structure of compensation committees and risk committees. BDs and IAs that are currently not in compliance with the proposed committee requirements, either because such a committee does not exist or because the composition of such committee is not consistent with the rule requirements, may have to elect additional individuals in order to either establish the required committees or alter the structure of such committees to be in compliance with the rule’s requirements. Table 15 provides estimates of the average annual total compensation of non-employee (i.e. independent) directors for Level 1 and Level 2 parents of BDs and Level 1 and Level 2 parents of IAs covered by the proposed rule.454 Assuming that the cost estimates in the table approximate the compensation requirements for independent members of compensation and/or risk committees, the incremental compliance costs of electing an additional non-employee director to comply with this specific provision of the rule for BDs and IAs that currently do not meet the rule’s requirements could be approximately $333,086 and $309,513 annually per independent director for a Level 1 BDs and IAs, respectively, and approximately $208,009 and $194,563 annually per independent director for unconsolidated Level 2 BDs and IAs, respectively. 454 Data is taken from 2015 proxy statements. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 TABLE 15—AVERAGE TOTAL ANNUAL COMPENSATION OF A NON-EMPLOYEE DIRECTOR FOR LEVEL 1 AND LEVEL 2 COVERED INSTITUTIONS Average total annual compensation of a non-employee director BD parents: Level 1 covered institutions ............................... Level 2 covered institutions ............................... IA parents: Level 1 covered institutions ............................... Level 2 covered institutions ............................... $333,086 208,009 309,513 194,563 The SEC considers these estimates an upper bound of potential costs that BDs and IAs may incur to comply with these requirements of the proposed rule. It is possible that some BDs and IAs are able to reshuffle existing personnel in order to comply with the rule’s requirements (e.g., use existing directors to create a risk committee or fully independent compensation committee) and as such would not incur any of the costs described in the analysis. 12. Governance, Policies and Procedures For Level 1 and Level 2 covered institutions, the proposed rule would include specific corporate governance requirements to support the design and implementation of compensation arrangements that provide balanced risk-taking incentives to affected individuals. More specifically, the proposed rule would require the existence of a compensation committee composed solely of directors who are not senior executive officers, input from the corresponding risk and audit committees and risk management on the effectiveness of risk measures and adjustments used to balance incentivebased compensation arrangements, and a written assessment, submitted at least annually to the compensation committee from the management of the covered institution, regarding the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes and an independent written assessment of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution, submitted on an annual or more frequent basis by the PO 00000 Frm 00128 Fmt 4701 Sfmt 4702 internal audit or risk management function of the covered institution, developed independently of the covered institution’s management. The proposed governance requirements would benefit covered BDs and IAs by further ensuring that the design of compensation arrangements is independent of the persons receiving compensation under these arrangements, thus curbing potential conflicts of interest. It could also facilitate the optimal design of compensation arrangements by incorporating relevant information from committees whose mandate is risk oversight. For example, by having a fully independent compensation committee that designs compensation arrangements and a risk committee that reviews those compensation arrangements to make sure they are consistent with the institution’s optimal risk policy, a BD or IA may be able to devise compensation arrangements that provide a better link between pay and performance for covered persons. Based on the SEC’s baseline analysis, it appears that the majority of Level 1 and Level 2 covered parent institutions already have a fully independent compensation committee. The SEC does not have information whether BDs and IAs that are subsidiaries have compensation committees and boards of directors. In 2012, the SEC adopted rules requiring exchanges to adopt listing standards requiring a board compensation committee that satisfies independence standards that are more stringent than those in the proposed rule.455 Therefore, all covered parent institutions with listed securities on national exchanges, or any covered BDs and IAs with listed securities, should have compensation committees that would satisfy the proposed rule’s compensation committee independence requirements. Thus, this proposed requirement should place no additional burden on those IAs and BDs that have listed securities on national exchanges, or have governance structures similar to those of their listed parent institutions. For those BDs and IAs that have compensation committees, the SEC does not have information whether management of the covered BDs and IAs submits to the compensation committee on an annual or more frequent basis a written assessment of the effectiveness of the covered institution’s incentivebased compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution. 455 17 E:\FR\FM\10JNP2.SGM CFR parts 229 and 240. 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules Additionally, the SEC does not have information on whether the compensation committee obtains input from the covered institution’s risk and audit committees, or groups performing similar functions. If covered BDs and IAs have already instituted similar policies with respect to the proposed rule’s governance requirements, the SEC does not expect this proposed requirement to generate significant compliance costs for them. On the other hand, if covered BDs and IAs’ governance practices are significantly different (e.g., they do not have independent compensation committees, or the compensation committees do not obtain input from the risk and audit committees), then covered BDs and IAs could experience significant compliance costs when implementing the proposed rule. Similarly, for BDs and IAs that do not have securities listed on a national exchange or have governance structures different from those of their parent institutions with listed securities, this rule proposal may result in significant costs. Also, since the SEC does not have data on how many covered IAs have parent institutions, or whether the IAs themselves or their parents have listed securities, it is also possible that a significant number of these IAs may be stand-alone companies that do not have independent compensation committees, and therefore could have higher costs to comply with the proposed rule compared to covered IAs and BDs that are part of reporting parent institutions with independent compensation committees. To better assess the effects of the proposed rule requirement on compliance costs for BDs and IAs, the SEC requests comments below. For Level 1 and Level 2 covered BDs and IAs, the proposed rule would require the development and implementation of policies and procedures relating to its incentivebased compensation programs that would require among other things, specifying the substantive and procedural criteria for the application of the various policies such as forfeiture and clawback, identifying and describing the role of employees, committees, or groups with authority to make incentive-based compensation decisions, and description of the monitoring mechanism over incentivebased compensation arrangements. The SEC does not have information about whether covered BDs and IAs have policies and procedures in place as required by the proposed rule. If BDs and IAs have already instituted similar policies, the SEC does not expect this rule requirement to generate significant VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 compliance costs for them. On the other hand, if the covered BDs and IAs do not have such policies and procedures, or if their policies and procedures are significantly different than what the proposed rule requires, then covered BDs and IAs could experience significant compliance costs when implementing the proposed rule. To better assess the effects of these rule requirements on compliance costs for BDs and IAs the SEC requests comments below. 13. Additional Disclosure and Recordkeeping All covered institutions would be required to create annually and maintain for a period of at least 7 years records that document the structure of all incentive-based compensation arrangements and demonstrate compliance with the proposed rules. Level 1 and Level 2 covered institutions would be required to create annually and maintain for at least 7 years records that document additional information, such as identification of the senior executive officers and significant risktakers within the covered institution, the incentive-based compensation arrangements of these individuals including deferral details, and any material changes in incentive-based compensation arrangements and policies. Level 1 and Level 2 covered institutions must create and maintain such records in a manner that allows for an independent audit of incentive-based compensation arrangements, policies, and procedures. The SEC is proposing an amendment to Exchange Act Rule 17a–4(e) 456 and Investment Advisers Act Rule 204–2 457 to require that registered broker-dealers and investment advisers maintain the records required by the proposed rule for registered Level 1 and Level 2 broker-dealers and investment advisers, in accordance with the recordkeeping requirements of Exchange Act Rule 17a– 4 and Investment Advisers Act Rule 204–2, respectively. Exchange Act Rule 17a–4 and Investment Advisers Act Rule 204–2 establish the general formatting and storage requirements for records that registered broker-dealers and investment advisers are required to keep. For the sake of consistency with other broker-dealer and investment adviser records, the SEC believes that registered broker-dealers and investment advisers should also keep the records required by the proposed rule for registered Level 1 and Level 2 456 17 457 17 PO 00000 CFR 240.17a–4(e). CFR 275.204–2. Frm 00129 Fmt 4701 Sfmt 4702 37797 broker-dealers and investment advisers, in accordance with these requirements. Such recordkeeping requirements would provide information availability to the SEC in examining and confirming the design and implementation of compensation arrangements for a prolonged period of time. This may enhance compliance and facilitate oversight. The proposed requirement may increase compliance costs for covered BDs and IAs. The SEC expects that the magnitude of the compliance costs would depend on whether covered BDs and IAs are part of reporting companies or not. Most Level 1 and Level 2 BDs are subsidiaries of reporting parent institutions. Reporting covered institutions provide compensation and disclosure analysis and compensation tables for their named executive officers in their annual reports, and disclose the incentive-based compensation arrangements for named executive officers in the annual proxy statement. In addition, reporting companies have to make an assessment each year whether they need to make Item 402(s) disclosure, which, among other things includes disclosure of compensation policies and practices that present material risks to the company and the board of directors’ role in risk oversight. Thus, given that reporting covered institutions create certain records and provide certain disclosures for their annual reports and proxy statements and for internal purposes (e.g., for reports to the board of directors or the compensation committee) that are similar to those required by the proposed rule, the BDs and IAs that are subsidiaries of such parent institutions may experience lower disclosure and recordkeeping compared to BDs and IAs of non-reporting parent institutions or institutions that do not provide such disclosures. Even BDs and IAs of reporting companies, however, would have to incur costs associated with disclosure and recordkeeping of information required by the proposed rule that currently is not disclosed by their parent institutions, such as identification of significant risk-takers details on deferral of incentive-based compensation. The SEC also notes that because it does not have information on the compensation reporting and recordkeeping at the subsidiary level, the SEC may be underestimating compliance costs for BDs with reporting parent institutions. For example, even if the parent institution reports and keeps records of the incentive-based compensation arrangements, this might not be done on the same scale and detail at the subsidiary level. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37798 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules The compliance costs associated with this particular rule requirement may be higher for non-reporting covered institutions, since they may not be disclosing such information and as such may not be keeping the type of records required. However, according to 2010 Federal Banking Agency Guidance, a banking institution should provide an appropriate amount of information concerning its incentive compensation arrangements for executive and nonexecutive employees and related riskmanagement, control, and governance processes to shareholders to allow them to monitor and, where appropriate, take actions to restrain the potential for such arrangements and processes to encourage employees to take imprudent risks. Such disclosures should include information relevant to employees other than senior executives. The scope and level of the information disclosed by the institution should be tailored to the nature and complexity of the institution and its incentive-based compensation arrangements. The SEC expects the compliance costs to be lower for such covered institutions. Since the SEC does not have data on how many covered IAs have parent institutions, it is also possible that a significant number of these IAs may be stand-alone companies and therefore could have higher costs to comply with this specific requirement of the proposed rule compared to covered IAs and BDs that are part of reporting parent institutions. By requiring Level 1 and Level 2 covered institutions to create and maintain records of incentive-based compensation arrangements for covered persons, the proposed recordkeeping requirement is expected to facilitate the SEC’s ability to monitor incentive-based compensation arrangements and could potentially strengthen incentives for covered institutions to comply with the proposed rule. As a consequence, an increase in investor confidence that covered institutions are less likely to be incentivizing inappropriate actions through compensation arrangements may occur and potentially result to greater market participation and allocative efficiency, thereby potentially facilitating capital formation. As discussed above, it is difficult for the SEC to estimate compliance costs related to the specific provision. However, for covered institutions that do not currently have a similar reporting system in place, there could be significant fixed costs that could disproportionately burden smaller covered BDs and IAs and hinder competition. Overall, the SEC does not expect that the effects of the proposed VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 recordkeeping requirements on efficiency, competition and capital formation to be significant. H. Request for Comment The SEC requests comments regarding its analysis of the potential economic effects of the proposed rule. With regard to any comments, the SEC notes that such comments are of particular assistance to the SEC if accompanied by supporting data and analysis of the issues addressed in those comments. For example, the SEC is interested in receiving estimates, data, or analyses on incentive-based compensation at BDs and IAs for all aspects of the proposed rule, including thresholds, on the overall economic impact of the proposed rule, and on any other aspect of this economic analysis. The SEC also is interested in comments on the benefits and costs it has identified and any benefits and costs it may have overlooked. 1. In the SEC’s baseline analysis, the SEC uses data from publicly held covered institutions as a proxy for incentive-based compensation arrangements at privately held institutions. The SEC requests comment on the validity of the assumption that privately held institutions employ similar compensation practices to publicly held institutions. The SEC also requests data or analysis with respect to incentive-based compensation arrangements of covered persons at privately held covered institutions. 2. The SEC does not have comprehensive data on incentive-based compensation arrangements for affected individuals, other than those senior executive officers who are named executive officers (NEOs) and some significant risk-takers, for either public or privately held covered institutions. The SEC requests data or analysis related to compensation practices of all senior executive officers and significant risk-takers at covered BDs and IAs as defined in the proposed rule. 3. The SEC uses incentive-based compensation arrangements of NEOs at the parent level as a proxy for incentivebased compensation arrangements of covered persons at covered BDs and IAs that are subsidiaries. The SEC requests comment on the validity of the assumption that incentive-based compensation arrangements for senior executive officers at the parent level is similar to incentive-based compensation arrangements followed at the subsidiary level for other senior executive officers or for significant risk-takers. The SEC also requests any data or related analysis on this issue. PO 00000 Frm 00130 Fmt 4701 Sfmt 4702 4. Are the economic effects with respect to the asset thresholds ($50 billion and $250 billion) utilized to scale the proposed requirements for covered BDs and IAs adequately outlined in the analysis? The SEC also invites comment on the economic consequences of any alternative asset thresholds, as well as economic consequences of potential alternative measures. 5. The proposed consolidation approach would impose restrictions on covered persons’ incentive-based compensation arrangements in BDs and IAs that are subsidiaries of depositary institution holding companies based on the size of their parent institution. Are the economic effects from the proposed consolidation approach adequately described in the analysis? Are there specific circumstances, such as certain organizational structures, that would deem such a consolidation approach more or less effective? 6. Are there additional effects with respect to the proposed definition of significant risk-takers to be considered? Are there alternative ways to identify significant risk-takers and what would be the economic consequences of alternative ways to identify significant risk-takers? 7. Are the economic effects on the proposed minimum deferral periods and the proposed minimum deferral percentage amounts adequately described in the analysis? What would be the economic effects of any alternative? The SEC also requests literature or evidence regarding the length and amount of deferral of incentive-based compensation that would lead to incentive-based compensation arrangements that best address the underlying risks at covered institutions. 8. Are the economic effects from the proposed vesting schedule for deferred incentive-based compensation adequately described in the analysis? What would be the economic effects from any alternatives? 9. Are there additional economic effects to be considered from the proposed prohibition of increasing a senior executive officer or significant risk-taker’s unvested deferred incentivebased compensation? What would be the economic effects of any alternatives? 10. The proposed rule would require deferred qualifying incentive-based compensation to be composed of substantial amounts of both deferred cash and equity-like instruments for covered persons. Are the economic effects of the proposed rule adequately described in the analysis? Would explicitly specifying the mix between E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules cash and equity-like instruments to be included in the deferral amount be preferred? What would be the economic effects of such an alternative? Are there additional alternatives to be considered? 11. For senior executive officers and significant risk-takers at Level 1 and Level 2 covered institutions, the total amount of options that may be used to meet the minimum deferral amount requirements is limited to no more than 15 percent of the amount of total incentive-based compensation awarded for a given performance period. Indirectly, this policy choice would place a cap on the amount of options that covered BDs and IAs may provide to affected persons as part of their incentive-based compensation arrangement. Are the economic effects of the provision adequately described in the analysis? What would be the economic effects from any alternatives? 12. Are the triggers for forfeiture or downward adjustment review effective for both senior executive officers and significant risk-takers? Are some of the triggers more effective for significant risk-takers while others are more effective for senior executive officers? What other triggers would be effective for forfeiture or downward adjustment review? 13. Are the economic effects from the 125 percent (150 percent) limit on the amount by which incentive-based compensation may exceed the target amount for senior executive officers (significant risk-takers) at covered BDs and IAs adequately described in the analysis? Are there alternatives to be considered? What would be the economic effect of such alternatives? 14. Are the economic effects regarding the prohibition of the sole use of industry peer performance benchmarks for incentive-based compensation performance measurement adequately described in the analysis? The SEC also requests data on relative performance measures used by covered BDs and IAs and/or related analysis that may further inform this policy choice. 15. The SEC requests any relevant data or analysis regarding the potential effect of the proposed rule on the ability of covered BDs and IAs to attract and retain managerial talent. 16. In general, are there alternative courses of action to be considered that would enhance accountability and limit the potential for inappropriate risktaking by covered persons at BDs and IAs? What would be the economic effects of such alternatives? Are there specific circumstances, such as certain types of shareholders and other stakeholders, that would make these alternative approaches more or less VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 effective? For example, should such alternative approaches distinguish between the effects on short-term shareholders and the effects on longterm shareholders? 17. In recent years, several foreign regulators have implemented regulations concerning incentive-based compensation similar to those in the proposed rule. The SEC requests data or analysis regarding the economic effects of those regulations and whether they are similar to or different from the likely economic effects of the proposed rule. J. Small Business Regulatory Enforcement Fairness Act For purposes of the Small Business Regulatory Enforcement Fairness Act of 1996 (‘‘SBREFA’’) 458 the SEC must advise the OMB whether the proposed regulation constitutes a ‘‘major’’ rule. Under SBREFA, a rule is considered ‘‘major’’ where, if adopted, it results or is likely to result in: (1) An annual effect on the economy of $100 million or more; (2) a major increase in costs or prices for consumers or individual industries; or (3) significant adverse effect on competition, investment or innovation. The SEC requests comment on the potential impact of the proposed amendment on the economy on an annual basis. Commenters are requested to provide empirical data and other factual support for their views to the extent possible. List of Subjects 12 CFR Part 42 Banks, banking, Compensation, National banks, Reporting and recordkeeping requirements. 12 CFR Part 236 Banks, Bank holding companies, Compensation, Foreign banking organizations, Reporting and recordkeeping requirements, Savings and loan holding companies. 12 CFR Part 372 Banks, banking, Compensation, Foreign banking. 37799 Reporting and recordkeeping requirements. 17 CFR Part 240 Reporting and recordkeeping requirements, Securities. 17 CFR Part 275 Reporting and recordkeeping requirements, Securities. 17 CFR Part 303 Incentive-based compensation arrangements, Reporting and recordkeeping requirements, Securities. Department of the Treasury: Office of the Comptroller of the Currency 12 CFR Chapter I Authority and Issuance For the reasons set forth in the joint preamble, the OCC proposes to amend 12 CFR chapter I of the Code of Federal Regulations as follows: ■ 1. Add part 42 to read as follows: PART 42—INCENTIVE-BASED COMPENSATION ARRANGEMENTS Sec. 42.1 Authority, scope, and initial applicability. 42.2 Definitions. 42.3 Applicability. 42.4 Requirements and prohibitions applicable to all covered institutions. 42.5 Additional disclosure and recordkeeping requirements for Level 1 and Level 2 covered institutions. 42.6 Reservation of authority for Level 3 covered institutions. 42.7 Deferral, forfeiture and downward adjustment, and clawback requirements for Level 1 and Level 2 covered institutions. 42.8 Additional prohibitions for Level 1 and Level 2 covered institutions. 42.9 Risk management and controls requirements for Level 1 and Level 2 covered institutions. 42.10 Governance requirements for Level 1 and Level 2 covered institutions. 42.11 Policies and procedures requirements for Level 1 and Level 2 covered institutions. 42.12 Indirect actions. 42.13 Enforcement. 12 CFR Parts 741 and 751 Authority: 12 U.S.C. 1 et seq. 1, 93a, 1462a, 1463, 1464, 1818, 1831p–1, and 5641. Compensation, Credit unions, Reporting and recording requirements. § 42.1 Authority, scope, and initial applicability. 12 CFR Part 1232 Administrative practice and procedure, Banks, Compensation, Confidential business information, Government-sponsored enterprises, 458 Public Law 104–121, Title II, 110 Stat. 857 (1996) (codified in various sections of 5 U.S.C. and 15 U.S.C. and as a note to 5 U.S.C. 601). PO 00000 Frm 00131 Fmt 4701 Sfmt 4702 (a) Authority. This part is issued pursuant to section 956 of the DoddFrank Wall Street Reform and Consumer Protection Act (12 U.S.C. 5641), sections 8 and 39 of the Federal Deposit Insurance Act (12 U.S.C. 1818 and 1831p–1), sections 3, 4, and 5 of the Home Owners’ Loan Act (12 U.S.C. 1462a, 1463, and 1464), and section E:\FR\FM\10JNP2.SGM 10JNP2 37800 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules 5239A of the Revised Statutes (12 U.S.C. 93a). (b) Scope. This part applies to a covered institution with average total consolidated assets greater than or equal to $1 billion that offers incentive-based compensation to covered persons. (c) Initial applicability—(1) Compliance date. A covered institution must meet the requirements of this part no later than [Date of the beginning of the first calendar quarter that begins at least 540 days after a final rule is published in the Federal Register]. Whether a covered institution is a Level 1, Level 2, or Level 3 covered institution at that time will be determined based on average total consolidated assets as of [Date of the beginning of the first calendar quarter that begins after a final rule is published in the Federal Register]. (2) Grandfathered plans. A covered institution is not required to comply with the requirements of this part with respect to any incentive-based compensation plan with a performance period that begins before [Compliance Date as described in § 42.1(c)(1)]. (d) Preservation of authority. Nothing in this part in any way limits the authority of the OCC under other provisions of applicable law and regulations. mstockstill on DSK3G9T082PROD with PROPOSALS2 § 42.2 Definitions. For purposes of this part only, the following definitions apply unless otherwise specified: (a) Affiliate means any company that controls, is controlled by, or is under common control with another company. (b) Average total consolidated assets means the average of the total consolidated assets of a national bank; a Federal savings association; a Federal branch or agency of a foreign bank; a subsidiary of a national bank, Federal savings association, or Federal branch or agency; or a depository institution holding company, as reported on the national bank’s, Federal savings association’s, Federal branch or agency’s, subsidiary’s, or depository institution holding company’s regulatory reports, for the four most recent consecutive quarters. If a national bank, Federal savings association, Federal branch or agency, subsidiary, or depository institution holding company has not filed a regulatory report for each of the four most recent consecutive quarters, the national bank, Federal savings association, Federal branch or agency, subsidiary, or depository institution holding company’s average total consolidated assets means the average of its total consolidated assets, as reported on its regulatory reports, for VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 the most recent quarter or consecutive quarters, as applicable. Average total consolidated assets are measured on the as-of date of the most recent regulatory report used in the calculation of the average. (c) To award incentive-based compensation means to make a final determination, conveyed to a covered person, of the amount of incentivebased compensation payable to the covered person for performance over a performance period. (d) Board of directors means the governing body of a covered institution that oversees the activities of the covered institution, often referred to as the board of directors or board of managers. For a Federal branch or agency of a foreign bank, ‘‘board of directors’’ refers to the relevant oversight body for the Federal branch or agency, consistent with its overall corporate and management structure. (e) Clawback means a mechanism by which a covered institution can recover vested incentive-based compensation from a covered person. (f) Compensation, fees, or benefits means all direct and indirect payments, both cash and non-cash, awarded to, granted to, or earned by or for the benefit of, any covered person in exchange for services rendered to a covered institution. (g) Control means that any company has control over a bank or over any company if— (1) The company directly or indirectly or acting through one or more other persons owns, controls, or has power to vote 25 percent or more of any class of voting securities of the bank or company; (2) The company controls in any manner the election of a majority of the directors or trustees of the bank or company; or (3) The OCC determines, after notice and opportunity for hearing, that the company directly or indirectly exercises a controlling influence over the management or policies of the bank or company. (h) Control function means a compliance, risk management, internal audit, legal, human resources, accounting, financial reporting, or finance role responsible for identifying, measuring, monitoring, or controlling risk-taking. (i) Covered institution means: (1) A national bank, Federal savings association, or Federal branch or agency of a foreign bank with average total consolidated assets greater than or equal to $1 billion; and PO 00000 Frm 00132 Fmt 4701 Sfmt 4702 (2) A subsidiary of a national bank, Federal savings association, or Federal branch or agency of a foreign bank that: (i) Is not a broker, dealer, person providing insurance, investment company, or investment adviser; and (ii) Has average total consolidated assets greater than or equal to $1 billion. (j) Covered person means any executive officer, employee, director, or principal shareholder who receives incentive-based compensation at a covered institution. (k) Deferral means the delay of vesting of incentive-based compensation beyond the date on which the incentivebased compensation is awarded. (l) Deferral period means the period of time between the date a performance period ends and the last date on which the incentive-based compensation awarded for such performance period vests. (m) Depository institution holding company means a top-tier depository institution holding company, where ‘‘depository institution holding company’’ has the same meaning as in section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813). (n) Director of a covered institution means a member of the board of directors. (o) Downward adjustment means a reduction of the amount of a covered person’s incentive-based compensation not yet awarded for any performance period that has already begun, including amounts payable under long-term incentive plans, in accordance with a forfeiture and downward adjustment review under § 42.7(b). (p) Equity-like instrument means: (1) Equity in the covered institution or of any affiliate of the covered institution; or (2) A form of compensation: (i) Payable at least in part based on the price of the shares or other equity instruments of the covered institution or of any affiliate of the covered institution; or (ii) That requires, or may require, settlement in the shares of the covered institution or of any affiliate of the covered institution. (q) Forfeiture means a reduction of the amount of deferred incentive-based compensation awarded to a covered person that has not vested. (r) Incentive-based compensation means any variable compensation, fees, or benefits that serve as an incentive or reward for performance. (s) Incentive-based compensation arrangement means an agreement between a covered institution and a covered person, under which the covered institution provides incentive- E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules based compensation to the covered person, including incentive-based compensation delivered through one or more incentive-based compensation plans. (t) Incentive-based compensation plan means a document setting forth terms and conditions governing the opportunity for and the payment of incentive-based compensation payments to one or more covered persons. (u) Incentive-based compensation program means a covered institution’s framework for incentive-based compensation that governs incentivebased compensation practices and establishes related controls. (v) Level 1 covered institution means: (1) A covered institution that is a subsidiary of a depository institution holding company with average total consolidated assets greater than or equal to $250 billion; (2) A covered institution with average total consolidated assets greater than or equal to $250 billion that is not a subsidiary of a covered institution or of a depository institution holding company; and (3) A covered institution that is a subsidiary of a covered institution with average total consolidated assets greater than or equal to $250 billion. (w) Level 2 covered institution means: (1) A covered institution that is a subsidiary of a depository institution holding company with average total consolidated assets greater than or equal to $50 billion but less than $250 billion; (2) A covered institution with average total consolidated assets greater than or equal to $50 billion but less than $250 billion that is not a subsidiary of a covered institution or of a depository institution holding company; and (3) A covered institution that is a subsidiary of a covered institution with average total consolidated assets greater than or equal to $50 billion but less than $250 billion. (x) Level 3 covered institution means: (1) A covered institution with average total consolidated assets greater than or equal to $1 billion but less than $50 billion; and (2) A covered institution that is a subsidiary of a covered institution with average total consolidated assets greater than or equal to $1 billion but less than $50 billion. (y) Long-term incentive plan means a plan to provide incentive-based compensation that is based on a performance period of at least three years. (z) Option means an instrument through which a covered institution provides a covered person the right, but not the obligation, to buy a specified VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 number of shares representing an ownership stake in a company at a predetermined price within a set time period or on a date certain, or any similar instrument, such as a stock appreciation right. (aa) Performance period means the period during which the performance of a covered person is assessed for purposes of determining incentivebased compensation. (bb) Principal shareholder means a natural person who, directly or indirectly, or acting through or in concert with one or more persons, owns, controls, or has the power to vote 10 percent or more of any class of voting securities of a covered institution. (cc) Qualifying incentive-based compensation means the amount of incentive-based compensation awarded to a covered person for a particular performance period, excluding amounts awarded to the covered person for that particular performance period under a long-term incentive plan. (dd) [Reserved]. (ee) Regulatory report means: (1) For a national bank or Federal savings association, the consolidated Reports of Condition and Income (‘‘Call Report’’); (2) For a Federal branch or agency of a foreign bank, the Reports of Assets and Liabilities of U.S. Branches and Agencies of Foreign Banks—FFIEC 002; (3) For a depository institution holding company— (i) The Consolidated Financial Statements for Bank Holding Companies (‘‘FR Y–9C’’); (ii) In the case of a savings and loan holding company that is not required to file an FR Y–9C, the Quarterly Savings and Loan Holding Company Report (‘‘FR 2320’’), if the savings and loan holding company reports consolidated assets on the FR 2320, as applicable; or (iii) In the case of a savings and loan holding company that does not file an FRY–9C or report consolidated assets on the FR2320, a report submitted to the Board of Governors of the Federal Reserve System pursuant to 12 CFR 236.2(ee); and (4) For a covered institution that is a subsidiary of a national bank, Federal savings association, or Federal branch or agency of a foreign bank, a report of the subsidiary’s total consolidated assets prepared by the subsidiary, national bank, Federal savings association, or Federal branch or agency in a form that is acceptable to the OCC. (ff) Section 956 affiliate means an affiliate that is an institution described in § 42.2(i), 12 CFR 236.2(i), 12 CFR 372.2(i), 12 CFR 741.2(i), 12 CFR 1232.2(i), or 17 CFR 303.2(i). PO 00000 Frm 00133 Fmt 4701 Sfmt 4702 37801 (gg) Senior executive officer means a covered person who holds the title or, without regard to title, salary, or compensation, performs the function of one or more of the following positions at a covered institution for any period of time in the relevant performance period: President, chief executive officer, executive chairman, chief operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer, chief compliance officer, chief audit executive, chief credit officer, chief accounting officer, or head of a major business line or control function. (hh) Significant risk-taker means: (1) Any covered person at a Level 1 or Level 2 covered institution, other than a senior executive officer, who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period of which at least one-third is incentive-based compensation and is— (i) A covered person of a Level 1 covered institution who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period that placed the covered person among the highest 5 percent in annual base salary and incentive-based compensation among all covered persons (excluding senior executive officers) of the Level 1 covered institution together with all individuals who receive incentive-based compensation at any section 956 affiliate of the Level 1 covered institution; (ii) A covered person of a Level 2 covered institution who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period that placed the covered person among the highest 2 percent in annual base salary and incentive-based compensation among all covered persons (excluding senior executive officers) of the Level 2 covered institution together with all individuals who receive incentive-based compensation at any section 956 affiliate of the Level 2 covered institution; or (iii) A covered person of a covered institution who may commit or expose 0.5 percent or more of the common equity tier 1 capital, or in the case of a registered securities broker or dealer, 0.5 percent or more of the tentative net capital, of the covered institution or of any section 956 affiliate of the covered E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37802 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules institution, whether or not the individual is a covered person of that specific legal entity; and (2) Any covered person at a Level 1 or Level 2 covered institution, other than a senior executive officer, who is designated as a ‘‘significant risk-taker’’ by the OCC because of that person’s ability to expose a covered institution to risks that could lead to material financial loss in relation to the covered institution’s size, capital, or overall risk tolerance, in accordance with procedures established by the OCC, or by the covered institution. (3) For purposes of this part, an individual who is an employee, director, senior executive officer, or principal shareholder of an affiliate of a Level 1 or Level 2 covered institution, where such affiliate has less than $1 billion in total consolidated assets, and who otherwise would meet the requirements for being a significant risktaker under paragraph (hh)(1)(iii) of this section, shall be considered to be a significant risk-taker with respect to the Level 1 or Level 2 covered institution for which the individual may commit or expose 0.5 percent or more of common equity tier 1 capital or tentative net capital. The Level 1 or Level 2 covered institution for which the individual commits or exposes 0.5 percent or more of common equity tier 1 capital or tentative net capital shall ensure that the individual’s incentive compensation arrangement complies with the requirements of this part. (4) If the OCC determines, in accordance with procedures established by the OCC, that a Level 1 covered institution’s activities, complexity of operations, risk profile, and compensation practices are similar to those of a Level 2 covered institution, the Level 1 covered institution may apply paragraph (hh)(1)(i) of this section to covered persons of the Level 1 covered institution by substituting ‘‘2 percent’’ for ‘‘5 percent’’. (ii) Subsidiary means any company that is owned or controlled directly or indirectly by another company (jj) Vesting of incentive-based compensation means the transfer of ownership of the incentive-based compensation to the covered person to whom the incentive-based compensation was awarded, such that the covered person’s right to the incentive-based compensation is no longer contingent on the occurrence of any event. § 42.3 Applicability. (a) When average total consolidated assets increase—(1) In general—(A) Covered institution subsidiaries of VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 depository institution holding companies. A national bank or Federal savings association that is a subsidiary of a depository institution holding company shall become a Level 1, Level 2, or Level 3 covered institution when the depository institution holding company’s average total consolidated assets increase to an amount that equals or exceeds $250 billion, $50 billion, or $1 billion, respectively. (B) Covered institutions that are not subsidiaries of a depository institution holding company. A national bank, Federal savings association, or Federal branch or agency of a foreign bank that is not a subsidiary of a national bank, Federal savings association, Federal branch or agency, or depository institution holding company shall become a Level 1, Level 2, or Level 3 covered institution when the national bank, Federal savings association, or Federal branch or agency’s average total consolidated assets increase to an amount that equals or exceeds $250 billion, $50 billion, or $1 billion, respectively. (C) Subsidiaries of covered institutions. A subsidiary of a national bank, Federal savings association, or Federal branch or agency of a foreign bank that is not a broker, dealer, person providing insurance, investment company, or investment adviser shall become a Level 1, Level 2, or Level 3 covered institution when the national bank, Federal savings association, or Federal branch or agency becomes a Level 1, Level 2, or Level 3 covered institution, respectively, pursuant to paragraph (a)(1)(A) or (B) of this section. (2) Compliance date. A national bank, Federal savings association, Federal branch or agency of a foreign bank, or a subsidiary thereof, that becomes a Level 1, Level 2, or Level 3 covered institution pursuant to paragraph (a)(1) of this section shall comply with the requirements of this part for a Level 1, Level 2, or Level 3 covered institution, respectively, not later than the first day of the first calendar quarter that begins not later than 540 days after the date on which the national bank, Federal savings association, Federal branch or agency, or subsidiary becomes a Level 1, Level 2, or Level 3 covered institution, respectively. Until that day, the Level 1, Level 2, or Level 3 covered institution will remain subject to the requirements of this part, if any, that applied to the institution on the day before the date on which it became a Level 1, Level 2, or Level 3 covered institution. (3) Grandfathered plans. A national bank, Federal savings association, Federal branch or agency of a foreign bank, or a subsidiary thereof, that PO 00000 Frm 00134 Fmt 4701 Sfmt 4702 becomes a Level 1, Level 2, or Level 3 covered institution under paragraph (a)(1) of this section is not required to comply with requirements of this part applicable to a Level 1, Level 2, or Level 3 covered institution, respectively, with respect to any incentive-based compensation plan with a performance period that begins before the date described in paragraph (a)(2) of this section. Any such incentive-based compensation plan shall remain subject to the requirements under this part, if any, that applied to the national bank, Federal savings association, Federal branch or agency of a foreign bank, or subsidiary at the beginning of the performance period. (b) When total consolidated assets decrease—(1) Covered institutions that are subsidiaries of depository institution holding companies. A Level 1, Level 2, or Level 3 covered institution that is a subsidiary of a depository institution holding company will remain subject to the requirements applicable to such covered institution at that level under this part unless and until the total consolidated assets of the depository institution holding company, as reported on the depository institution holding company’s regulatory reports, fall below $250 billion, $50 billion, or $1 billion, respectively, for each of four consecutive quarters. (2) Covered institutions that are not subsidiaries of depository institution holding companies. A Level 1, Level 2, or Level 3 covered institution that is a not subsidiary of a depository institution holding company will remain subject to the requirements applicable to such covered institution at that level under this part unless and until the total consolidated assets of the covered institution, as reported on the covered institution’s regulatory reports, fall below $250 billion, $50 billion, or $1 billion, respectively, for each of four consecutive quarters. (3) Subsidiaries of covered institutions. A Level 1, Level 2, or Level 3 covered institution that is a subsidiary of a national bank, Federal savings association, or Federal branch or agency of a foreign bank that is a covered institution will remain subject to the requirements applicable to such national bank, Federal savings association, or Federal branch or agency at that level under this part unless and until the total consolidated assets of the national bank, Federal savings association, Federal branch or agency, or depository institution holding company of the national bank, Federal savings association, or Federal branch or agency, as reported on its regulatory reports, fall below $250 billion, $50 E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules billion, or $1 billion, respectively, for each of four consecutive quarters. (4) Calculations. The calculations under this paragraph (b) of this section will be effective on the as-of date of the fourth consecutive regulatory report. (c) Compliance of covered institutions that are subsidiaries of covered institutions. A covered institution that is a subsidiary of another covered institution may meet any requirement of this part if the parent covered institution complies with that requirement in a way that causes the relevant portion of the incentive-based compensation program of the subsidiary covered institution to comply with that requirement. mstockstill on DSK3G9T082PROD with PROPOSALS2 § 42.4 Requirements and prohibitions applicable to all covered institutions. (a) In general. A covered institution must not establish or maintain any type of incentive-based compensation arrangement, or any feature of any such arrangement, that encourages inappropriate risks by the covered institution: (1) By providing a covered person with excessive compensation, fees, or benefits; or (2) That could lead to material financial loss to the covered institution. (b) Excessive compensation. Compensation, fees, and benefits are considered excessive for purposes of paragraph (a)(1) of this section when amounts paid are unreasonable or disproportionate to the value of the services performed by a covered person, taking into consideration all relevant factors, including, but not limited to: (1) The combined value of all compensation, fees, or benefits provided to the covered person; (2) The compensation history of the covered person and other individuals with comparable expertise at the covered institution; (3) The financial condition of the covered institution; (4) Compensation practices at comparable institutions, based upon such factors as asset size, geographic location, and the complexity of the covered institution’s operations and assets; (5) For post-employment benefits, the projected total cost and benefit to the covered institution; and (6) Any connection between the covered person and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the covered institution. (c) Material financial loss. An incentive-based compensation arrangement at a covered institution encourages inappropriate risks that VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 could lead to material financial loss to the covered institution, unless the arrangement: (1) Appropriately balances risk and reward; (2) Is compatible with effective risk management and controls; and (3) Is supported by effective governance. (d) Performance measures. An incentive-based compensation arrangement will not be considered to appropriately balance risk and reward for purposes of paragraph (c)(1) of this section unless: (1) The arrangement includes financial and non-financial measures of performance, including considerations of risk-taking, that are relevant to a covered person’s role within a covered institution and to the type of business in which the covered person is engaged and that are appropriately weighted to reflect risk-taking; (2) The arrangement is designed to allow non-financial measures of performance to override financial measures of performance when appropriate in determining incentivebased compensation; and (3) Any amounts to be awarded under the arrangement are subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance. (e) Board of directors. A covered institution’s board of directors, or a committee thereof, must: (1) Conduct oversight of the covered institution’s incentive-based compensation program; (2) Approve incentive-based compensation arrangements for senior executive officers, including the amounts of all awards and, at the time of vesting, payouts under such arrangements; and (3) Approve any material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers. (f) Disclosure and recordkeeping requirements. A covered institution must create annually and maintain for a period of at least seven years records that document the structure of all its incentive-based compensation arrangements and demonstrate compliance with this part. A covered institution must disclose the records to the OCC upon request. At a minimum, the records must include copies of all incentive-based compensation plans, a record of who is subject to each plan, and a description of how the incentivebased compensation program is PO 00000 Frm 00135 Fmt 4701 Sfmt 4702 37803 compatible with effective risk management and controls. (g) Rule of construction. A covered institution is not required to report the actual amount of compensation, fees, or benefits of individual covered persons as part of the disclosure and recordkeeping requirements under this part. § 42.5 Additional disclosure and recordkeeping requirements for Level 1 and Level 2 covered institutions. (a) A Level 1 or Level 2 covered institution must create annually and maintain for a period of at least seven years records that document: (1) The covered institution’s senior executive officers and significant risktakers, listed by legal entity, job function, organizational hierarchy, and line of business; (2) The incentive-based compensation arrangements for senior executive officers and significant risk-takers, including information on percentage of incentive-based compensation deferred and form of award; (3) Any forfeiture and downward adjustment or clawback reviews and decisions for senior executive officers and significant risk-takers; and (4) Any material changes to the covered institution’s incentive-based compensation arrangements and policies. (b) A Level 1 or Level 2 covered institution must create and maintain records in a manner that allows for an independent audit of incentive-based compensation arrangements, policies, and procedures, including, those required under § 42.11. (c) A Level 1 or Level 2 covered institution must provide the records described in paragraph (a) of this section to the OCC in such form and with such frequency as requested by the OCC. § 42.6 Reservation of authority for Level 3 covered institutions. (a) In general. The OCC may require a Level 3 covered institution with average total consolidated assets greater than or equal to $10 billion and less than $50 billion to comply with some or all of the provisions of §§ 42.5 and 42.7 through 42.11 if the OCC determines that the Level 3 covered institution’s complexity of operations or compensation practices are consistent with those of a Level 1 or Level 2 covered institution. (b) Factors considered. Any exercise of authority under this section will be in writing by the OCC in accordance with procedures established by the OCC and will consider the activities, E:\FR\FM\10JNP2.SGM 10JNP2 37804 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules (i) Minimum required deferral amount. (A) A Level 1 covered institution must defer at least 60 percent of a senior executive officer’s incentivebased compensation awarded under a § 42.7 Deferral, forfeiture and downward long-term incentive plan for each adjustment, and clawback requirements for performance period. Level 1 and Level 2 covered institutions. (B) A Level 1 covered institution must An incentive-based compensation defer at least 50 percent of a significant arrangement at a Level 1 or Level 2 risk-taker’s incentive-based covered institution will not be considered to appropriately balance risk compensation awarded under a longand reward, for purposes of § 42.4(c)(1), term incentive plan for each performance period. unless the following requirements are (C) A Level 2 covered institution must met. defer at least 50 percent of a senior (a) Deferral. (1) Qualifying incentivebased compensation must be deferred as executive officer’s incentive-based compensation awarded under a longfollows: term incentive plan for each (i) Minimum required deferral performance period. amount. (A) A Level 1 covered (D) A Level 2 covered institution must institution must defer at least 60 percent of a senior executive officer’s qualifying defer at least 40 percent of a significant risk-taker’s incentive-based incentive-based compensation awarded compensation awarded under a longfor each performance period. (B) A Level 1 covered institution must term incentive plan for each defer at least 50 percent of a significant performance period. risk-taker’s qualifying incentive-based (ii) Minimum required deferral period. compensation awarded for each (A) For a senior executive officer or performance period. significant risk-taker of a Level 1 (C) A Level 2 covered institution must covered institution, the deferral period defer at least 50 percent of a senior for deferred long-term incentive plan executive officer’s qualifying incentiveamounts must be at least 2 years. based compensation awarded for each (B) For a senior executive officer or performance period. significant risk-taker of a Level 2 (D) A Level 2 covered institution must covered institution, the deferral period defer at least 40 percent of a significant for deferred long-term incentive plan risk-taker’s qualifying incentive-based amounts must be at least 1 year. compensation awarded for each (iii) Vesting of amounts during performance period. deferral period—(A) Pro rata vesting. (ii) Minimum required deferral period. During a deferral period, deferred long(A) For a senior executive officer or term incentive plan amounts may not significant risk-taker of a Level 1 vest faster than on a pro rata annual covered institution, the deferral period basis beginning no earlier than the first for deferred qualifying incentive-based anniversary of the end of the compensation must be at least 4 years. performance period for which the (B) For a senior executive officer or amounts were awarded. significant risk-taker of a Level 2 (B) Acceleration of vesting. A Level 1 covered institution, the deferral period or Level 2 covered institution must not for deferred qualifying incentive-based accelerate the vesting of a covered compensation must be at least 3 years. person’s deferred long-term incentive (iii) Vesting of amounts during plan amounts that is required to be deferral period—(A) Pro rata vesting. deferred under this part, except in the During a deferral period, deferred case of death or disability of such qualifying incentive-based covered person. compensation may not vest faster than (3) Adjustments of deferred qualifying on a pro rata annual basis beginning no incentive-based compensation and earlier than the first anniversary of the end of the performance period for which deferred long-term incentive plan compensation amounts. A Level 1 or the amounts were awarded. Level 2 covered institution may not (B) Acceleration of vesting. A Level 1 increase deferred qualifying incentiveor Level 2 covered institution must not based compensation or deferred longaccelerate the vesting of a covered term incentive plan amounts for a senior person’s deferred qualifying incentiveexecutive officer or significant risk-taker based compensation that is required to during the deferral period. For purposes be deferred under this part, except in of this paragraph, an increase in value the case of death or disability of such attributable solely to a change in share covered person. value, a change in interest rates, or the (2) Incentive-based compensation payment of interest according to terms awarded under a long-term incentive set out at the time of the award is not plan must be deferred as follows: mstockstill on DSK3G9T082PROD with PROPOSALS2 complexity of operations, risk profile, and compensation practices of the Level 3 covered institution, in addition to any other relevant factors. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 PO 00000 Frm 00136 Fmt 4701 Sfmt 4702 considered an increase in incentivebased compensation amounts. (4) Composition of deferred qualifying incentive-based compensation and deferred long-term incentive plan compensation for Level 1 and Level 2 covered institutions—(i) Cash and equity-like instruments. For a senior executive officer or significant risk-taker of a Level 1 or Level 2 covered institution that issues equity or is an affiliate of a covered institution that issues equity, any deferred qualifying incentive-based compensation or deferred long-term incentive plan amounts must include substantial portions of both deferred cash and equity-like instruments throughout the deferral period. (ii) Options. If a senior executive officer or significant risk-taker of a Level 1 or Level 2 covered institution receives incentive-based compensation for a performance period in the form of options, the total amount of such options that may be used to meet the minimum deferral amount requirements of paragraph (a)(1)(i) or (a)(2)(i) of this section is limited to no more than 15 percent of the amount of total incentivebased compensation awarded to the senior executive officer or significant risk-taker for that performance period. (b) Forfeiture and downward adjustment—(1) Compensation at risk— (i) A Level 1 or Level 2 covered institution must place at risk of forfeiture all unvested deferred incentive-based compensation of any senior executive officer or significant risk-taker, including unvested deferred amounts awarded under long-term incentive plans. (ii) A Level 1 or Level 2 covered institution must place at risk of downward adjustment all of a senior executive officer’s or significant risktaker’s incentive-based compensation amounts not yet awarded for the current performance period, including amounts payable under long-term incentive plans. (2) Events triggering forfeiture and downward adjustment review. At a minimum, a Level 1 or Level 2 covered institution must consider forfeiture and downward adjustment of incentivebased compensation of senior executive officers and significant risk-takers described in paragraph (b)(3) of this section due to any of the following adverse outcomes at the covered institution: (i) Poor financial performance attributable to a significant deviation from the risk parameters set forth in the covered institution’s policies and procedures; E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules (ii) Inappropriate risk taking, regardless of the impact on financial performance; (iii) Material risk management or control failures; (iv) Non-compliance with statutory, regulatory, or supervisory standards that results in: (A) Enforcement or legal action against the covered institution brought by a federal or state regulator or agency; or (B) A requirement that the covered institution report a restatement of a financial statement to correct a material error; and (v) Other aspects of conduct or poor performance as defined by the covered institution. (3) Senior executive officers and significant risk-takers affected by forfeiture and downward adjustment. A Level 1 or Level 2 covered institution must consider forfeiture and downward adjustment for a senior executive officer or significant risk-taker with direct responsibility, or responsibility due to the senior executive officer’s or significant risk-taker’s role or position in the covered institution’s organizational structure, for the events related to the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section. (4) Determining forfeiture and downward adjustment amounts. A Level 1 or Level 2 covered institution must consider, at a minimum, the following factors when determining the amount or portion of a senior executive officer’s or significant risk-taker’s incentive-based compensation that should be forfeited or adjusted downward: (i) The intent of the senior executive officer or significant risk-taker to operate outside the risk governance framework approved by the covered institution’s board of directors or to depart from the covered institution’s policies and procedures; (ii) The senior executive officer’s or significant risk-taker’s level of participation in, awareness of, and responsibility for, the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section; (iii) Any actions the senior executive officer or significant risk-taker took or could have taken to prevent the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section; (iv) The financial and reputational impact of the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section to the covered institution, the line or sub-line of business, and VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 individuals involved, as applicable, including the magnitude of any financial loss and the cost of known or potential subsequent fines, settlements, and litigation; (v) The causes of the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section, including any decisionmaking by other individuals; and (vi) Any other relevant information, including past behavior and past risk outcomes attributable to the senior executive officer or significant risktaker. (c) Clawback. A Level 1 or Level 2 covered institution must include clawback provisions in incentive-based compensation arrangements for senior executive officers and significant risktakers that, at a minimum, allow the covered institution to recover incentivebased compensation from a current or former senior executive officer or significant risk-taker for seven years following the date on which such compensation vests, if the covered institution determines that the senior executive officer or significant risk-taker engaged in: (1) Misconduct that resulted in significant financial or reputational harm to the covered institution; (2) Fraud; or (3) Intentional misrepresentation of information used to determine the senior executive officer or significant risk-taker’s incentive-based compensation. § 42.8 Additional prohibitions for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will be considered to provide incentives that appropriately balance risk and reward for purposes of § 42.4(c)(1) only if such institution complies with the following prohibitions. (a) Hedging. A Level 1 or Level 2 covered institution must not purchase a hedging instrument or similar instrument on behalf of a covered person to hedge or offset any decrease in the value of the covered person’s incentive-based compensation. (b) Maximum incentive-based compensation opportunity. A Level 1 or Level 2 covered institution must not award incentive-based compensation to: (1) A senior executive officer in excess of 125 percent of the target amount for that incentive-based compensation; or (2) A significant risk-taker in excess of 150 percent of the target amount for that incentive-based compensation. (c) Relative performance measures. A Level 1 or Level 2 covered institution PO 00000 Frm 00137 Fmt 4701 Sfmt 4702 37805 must not use incentive-based compensation performance measures that are based solely on industry peer performance comparisons. (d) Volume driven incentive-based compensation. A Level 1 or Level 2 covered institution must not provide incentive-based compensation to a covered person that is based solely on transaction revenue or volume without regard to transaction quality or compliance of the covered person with sound risk management. § 42.9 Risk management and controls requirements for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will be considered to be compatible with effective risk management and controls for purposes of § 42.4(c)(2) only if such institution meets the following requirements. (a) A Level 1 or Level 2 covered institution must have a risk management framework for its incentive-based compensation program that: (1) Is independent of any lines of business; (2) Includes an independent compliance program that provides for internal controls, testing, monitoring, and training with written policies and procedures consistent with § 42.11; and (3) Is commensurate with the size and complexity of the covered institution’s operations. (b) A Level 1 or Level 2 covered institution must: (1) Provide individuals engaged in control functions with the authority to influence the risk-taking of the business areas they monitor; and (2) Ensure that covered persons engaged in control functions are compensated in accordance with the achievement of performance objectives linked to their control functions and independent of the performance of those business areas. (c) A Level 1 or Level 2 covered institution must provide for the independent monitoring of: (1) All incentive-based compensation plans in order to identify whether those plans provide incentives that appropriately balance risk and reward; (2) Events related to forfeiture and downward adjustment reviews and decisions of forfeiture and downward adjustment reviews in order to determine consistency with § 42.7(b); and (3) Compliance of the incentive-based compensation program with the covered institution’s policies and procedures. E:\FR\FM\10JNP2.SGM 10JNP2 37806 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules § 42.10 Governance requirements for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will not be considered to be supported by effective governance for purposes of § 42.4(c)(3), unless: (a) The covered institution establishes a compensation committee composed solely of directors who are not senior executive officers to assist the board of directors in carrying out its responsibilities under § 42.4(e); and (b) The compensation committee established pursuant to paragraph (a) of this section obtains: (1) Input from the risk and audit committees of the covered institution’s board of directors, or groups performing similar functions, and risk management function on the effectiveness of risk measures and adjustments used to balance risk and reward in incentivebased compensation arrangements; (2) A written assessment of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution, submitted on an annual or more frequent basis by the management of the covered institution and developed with input from the risk and audit committees of its board of directors, or groups performing similar functions, and from the covered institution’s risk management and audit functions; and (3) An independent written assessment of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution, submitted on an annual or more frequent basis by the internal audit or risk management function of the covered institution, developed independently of the covered institution’s management. mstockstill on DSK3G9T082PROD with PROPOSALS2 § 42.11 Policies and procedures requirements for Level 1 and Level 2 covered institutions. 00:00 Jun 10, 2016 Jkt 238001 § 42.12 Indirect actions. A covered institution must not indirectly, or through or by any other person, do anything that would be unlawful for such covered institution to do directly under this part. § 42.13 A Level 1 or Level 2 covered institution must develop and implement policies and procedures for its incentive-based compensation program that, at a minimum: (a) Are consistent with the prohibitions and requirements of this part; (b) Specify the substantive and procedural criteria for the application of forfeiture and clawback, including the process for determining the amount of VerDate Sep<11>2014 incentive-based compensation to be clawed back; (c) Require that the covered institution maintain documentation of final forfeiture, downward adjustment, and clawback decisions; (d) Specify the substantive and procedural criteria for the acceleration of payments of deferred incentive-based compensation to a covered person, consistent with § 42.7(a)(1)(iii)(B) and (a)(2)(iii)(B)); (e) Identify and describe the role of any employees, committees, or groups authorized to make incentive-based compensation decisions, including when discretion is authorized; (f) Describe how discretion is expected to be exercised to appropriately balance risk and reward; (g) Require that the covered institution maintain documentation of the establishment, implementation, modification, and monitoring of incentive-based compensation arrangements, sufficient to support the covered institution’s decisions; (h) Describe how incentive-based compensation arrangements will be monitored; (i) Specify the substantive and procedural requirements of the independent compliance program consistent with § 42.9(a)(2); and (j) Ensure appropriate roles for risk management, risk oversight, and other control function personnel in the covered institution’s processes for: (1) Designing incentive-based compensation arrangements and determining awards, deferral amounts, deferral periods, forfeiture, downward adjustment, clawback, and vesting; and (2) Assessing the effectiveness of incentive-based compensation arrangements in restraining inappropriate risk-taking. Enforcement. The provisions of this part shall be enforced under section 505 of the Gramm-Leach-Bliley Act and, for purposes of such section, a violation of this part shall be treated as a violation of subtitle A of title V of such Act. Federal Reserve Board 12 CFR Chapter II Authority and Issuance For the reasons set forth in the joint preamble, the Board proposes to amend 12 CFR chapter II as follows: PO 00000 Frm 00138 Fmt 4701 Sfmt 4702 ■ 2. Add part 236 to read as follows: PART 236—INCENTIVE-BASED COMPENSATION ARRANGEMENTS (REGULATION JJ) Sec. 236.1 Authority, scope, and initial applicability. 236.2 Definitions. 236.3 Applicability. 236.4 Requirements and prohibitions applicable to all covered institutions. 236.5 Additional disclosure and recordkeeping requirements for Level 1 and Level 2 covered institutions. 236.6 Reservation of authority for Level 3 covered institutions. 236.7 Deferral, forfeiture and downward adjustment, and clawback requirements for Level 1 and Level 2 covered institutions. 236.8 Additional prohibitions for Level 1 and Level 2 covered institutions. 236.9 Risk management and controls requirements for Level 1 and Level 2 covered institutions. 236.10 Governance requirements for Level 1 and Level 2 covered institutions. 236.11 Policies and procedures requirements for Level 1 and Level 2 covered institutions. 236.12 Indirect actions. 236.13 Enforcement. Authority: 12 U.S.C. 24, 321–338a, 1462a, 1467a, 1818, 1844(b), 3108, and 5641. § 236.1 Authority, scope, and initial applicability. (a) Authority. This part is issued pursuant to section 956 of the DoddFrank Wall Street Reform and Consumer Protection Act (12 U.S.C. 5641), section 5136 of the Revised Statutes (12 U.S.C. 24), the Federal Reserve Act (12 U.S.C. 321–338a), section 8 of the Federal Deposit Insurance Act (12 U.S.C. 1818), section 5 of the Bank Holding Company Act of 1956 (12 U.S.C. 1844(b)), sections 3 and 10 of the Home Owners’ Loan Act of 1933 (12 U.S.C. 1462a and 1467a), and section 13 of the International Banking Act of 1978 (12 U.S.C. 3108). (b) Scope. This part applies to a covered institution with average total consolidated assets greater than or equal to $1 billion that offers incentive-based compensation to covered persons. (c) Initial applicability—(1) Compliance date. A covered institution must meet the requirements of this part no later than [Date of the beginning of the first calendar quarter that begins at least 540 days after a final rule is published in the Federal Register]. Whether a covered institution is a Level 1, Level 2, or Level 3 covered institution at that time will be determined based on average total consolidated assets as of [Date of the beginning of the first calendar quarter that begins after a final E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules rule is published in the Federal Register]. (2) Grandfathered plans. A covered institution is not required to comply with the requirements of this part with respect to any incentive-based compensation plan with a performance period that begins before [Compliance Date as described in § 236.1(c)(1)]. (d) Preservation of authority. Nothing in this part in any way limits the authority of the Board under other provisions of applicable law and regulations. mstockstill on DSK3G9T082PROD with PROPOSALS2 § 236.2 Definitions. For purposes of this part only, the following definitions apply unless otherwise specified: (a) Affiliate means any company that controls, is controlled by, or is under common control with another company. (b) Average total consolidated assets means the average of a regulated institution’s total consolidated assets, as reported on the regulated institution’s regulatory reports, for the four most recent consecutive quarters. If a regulated institution has not filed a regulatory report for each of the four most recent consecutive quarters, the regulated institution’s average total consolidated assets means the average of its total consolidated assets, as reported on its regulatory reports, for the most recent quarter or consecutive quarters, as applicable. Average total consolidated assets are measured on the as-of date of the most recent regulatory report used in the calculation of the average. (c) To award incentive-based compensation means to make a final determination, conveyed to a covered person, of the amount of incentivebased compensation payable to the covered person for performance over a performance period. (d) Board of directors means the governing body of a covered institution that oversees the activities of the covered institution, often referred to as the board of directors or board of managers. For a foreign banking organization, ‘‘board of directors’’ refers to the relevant oversight body for the firm’s U.S. branch, agency or operations, consistent with the foreign banking organization’s overall corporate and management structure. (e) Clawback means a mechanism by which a covered institution can recover vested incentive-based compensation from a covered person. (f) Compensation, fees, or benefits means all direct and indirect payments, both cash and non-cash, awarded to, granted to, or earned by or for the benefit of, any covered person in VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 exchange for services rendered to a covered institution. (g) Control means that any company has control over a bank or over any company if— (1) The company directly or indirectly or acting through one or more other persons owns, controls, or has power to vote 25 percent or more of any class of voting securities of the bank or company; (2) The company controls in any manner the election of a majority of the directors or trustees of the bank or company; or (3) The Board determines, after notice and opportunity for hearing, that the company directly or indirectly exercises a controlling influence over the management or policies of the bank or company. (h) Control function means a compliance, risk management, internal audit, legal, human resources, accounting, financial reporting, or finance role responsible for identifying, measuring, monitoring, or controlling risk-taking. (i) Covered institution means a regulated institution with average total consolidated assets greater than or equal to $1 billion. (j) Covered person means any executive officer, employee, director, or principal shareholder who receives incentive-based compensation at a covered institution. (k) Deferral means the delay of vesting of incentive-based compensation beyond the date on which the incentivebased compensation is awarded. (l) Deferral period means the period of time between the date a performance period ends and the last date on which the incentive-based compensation awarded for such performance period vests. (m) [Reserved]. (n) Director of a covered institution means a member of the board of directors. (o) Downward adjustment means a reduction of the amount of a covered person’s incentive-based compensation not yet awarded for any performance period that has already begun, including amounts payable under long-term incentive plans, in accordance with a forfeiture and downward adjustment review under § 236.7(b). (p) Equity-like instrument means: (1) Equity in the covered institution or of any affiliate of the covered institution; or (2) A form of compensation: (i) Payable at least in part based on the price of the shares or other equity instruments of the covered institution or of any affiliate of the covered institution; or PO 00000 Frm 00139 Fmt 4701 Sfmt 4702 37807 (ii) That requires, or may require, settlement in the shares of the covered institution or of any affiliate of the covered institution. (q) Forfeiture means a reduction of the amount of deferred incentive-based compensation awarded to a covered person that has not vested. (r) Incentive-based compensation means any variable compensation, fees, or benefits that serve as an incentive or reward for performance. (s) Incentive-based compensation arrangement means an agreement between a covered institution and a covered person, under which the covered institution provides incentivebased compensation to the covered person, including incentive-based compensation delivered through one or more incentive-based compensation plans. (t) Incentive-based compensation plan means a document setting forth terms and conditions governing the opportunity for and the payment of incentive-based compensation payments to one or more covered persons. (u) Incentive-based compensation program means a covered institution’s framework for incentive-based compensation that governs incentivebased compensation practices and establishes related controls. (v) Level 1 covered institution means a covered institution with average total consolidated assets greater than or equal to $250 billion and any subsidiary of a Level 1 covered institution that would itself be a covered institution. (w) Level 2 covered institution means a covered institution with average total consolidated assets greater than or equal to $50 billion that is not a Level 1 covered institution and any subsidiary of a Level 2 covered institution that would itself be a covered institution. (x) Level 3 covered institution means a covered institution with average total consolidated assets greater than or equal to $1 billion that is not a Level 1 covered institution or Level 2 covered institution. (y) Long-term incentive plan means a plan to provide incentive-based compensation that is based on a performance period of at least three years. (z) Option means an instrument through which a covered institution provides a covered person the right, but not the obligation, to buy a specified number of shares representing an ownership stake in a company at a predetermined price within a set time period or on a date certain, or any similar instrument, such as a stock appreciation right. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37808 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules (aa) Performance period means the period during which the performance of a covered person is assessed for purposes of determining incentivebased compensation. (bb) Principal shareholder means a natural person who, directly or indirectly, or acting through or in concert with one or more persons, owns, controls, or has the power to vote 10 percent or more of any class of voting securities of a covered institution. (cc) Qualifying incentive-based compensation means the amount of incentive-based compensation awarded to a covered person for a particular performance period, excluding amounts awarded to the covered person for that particular performance period under a long-term incentive plan. (dd) Regulated institution means: (1) A state member bank, as defined in 12 CFR 208.2(g); (2) A bank holding company, as defined in 12 CFR 225.2(c), that is not a foreign banking organization, as defined in 12 CFR 211.21(o), and a subsidiary of such a bank holding company that is not a depository institution, broker-dealer, or investment adviser; (3) A savings and loan holding company, as defined in 12 CFR 238.2(m), and a subsidiary of a savings and loan holding company that is not a depository institution, broker-dealer, or investment adviser; (4) An organization operating under section 25 or 25A of the Federal Reserve Act (‘‘Edge or Agreement Corporation’’); (5) A state-licensed uninsured branch or agency of a foreign bank, as defined in section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813); and (6) The U.S. operations of a foreign banking organization, as defined in 12 CFR 211.21(o), excluding any Federal branch or agency and any state insured branch of the foreign banking organization, and a U.S. subsidiary of such foreign banking organization that is not a depository institution, brokerdealer, or investment adviser. (ee) Regulatory report means: (1) For a state member bank, Consolidated Reports of Condition and Income (‘‘Call Report’’); (2) For a bank holding company that is not a foreign banking organization, Consolidated Financial Statements for Bank Holding Companies (‘‘FR Y–9C’’); (3) For a savings and loan holding company, FR Y–9C; if a savings and loan holding company is not required to file an FR Y–9C, Quarterly Savings and Loan Holding Company Report (‘‘FR 2320’’), if the savings and loan holding company reports consolidated assets on the FR 2320; VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 (4) For a savings and loan holding company that does not file a regulatory report within the meaning of § 236.2(ee)(3), a report of average total consolidated assets filed with the Board on a quarterly basis. (5) For an Edge or Agreement Corporation, Consolidated Report of Condition and Income for Edge and Agreement Corporations (‘‘FR 2886b’’); (6) For a state-licensed uninsured branch or agency of a foreign bank, Reports of Assets and Liabilities of U.S. Branches and Agencies of Foreign Banks—FFIEC 002; (7) For the U.S. operations of a foreign banking organization, a report of average total consolidated U.S. assets filed with the Board on a quarterly basis; and (8) For a regulated institution that is a subsidiary of a bank holding company, savings and loan holding company, or a foreign banking organization, a report of the subsidiary’s total consolidated assets prepared by the bank holding company, savings and loan holding company, or subsidiary in a form that is acceptable to the Board. (ff) Section 956 affiliate means an affiliate that is an institution described in § 236.2(i), 12 CFR 42.2(i), 12 CFR 372.2(i), 12 CFR 741.2(i), 12 CFR 1232.2(i), or 17 CFR 303.2(i). (gg) Senior executive officer means a covered person who holds the title or, without regard to title, salary, or compensation, performs the function of one or more of the following positions at a covered institution for any period of time in the relevant performance period: President, chief executive officer, executive chairman, chief operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer, chief compliance officer, chief audit executive, chief credit officer, chief accounting officer, or head of a major business line or control function. (hh) Significant risk-taker means: (1) Any covered person at a Level 1 or Level 2 covered institution, other than a senior executive officer, who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period of which at least one-third is incentive-based compensation and is— (i) A covered person of a Level 1 covered institution who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period that placed the covered person among the highest 5 percent in annual base salary and incentive-based PO 00000 Frm 00140 Fmt 4701 Sfmt 4702 compensation among all covered persons (excluding senior executive officers) of the Level 1 covered institution together with all individuals who receive incentive-based compensation at any section 956 affiliate of the Level 1 covered institution; (ii) A covered person of a Level 2 covered institution who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period that placed the covered person among the highest 2 percent in annual base salary and incentive-based compensation among all covered persons (excluding senior executive officers) of the Level 2 covered institution together with all individuals who receive incentive-based compensation at any section 956 affiliate of the Level 2 covered institution; or (iii) A covered person of a covered institution who may commit or expose 0.5 percent or more of the common equity tier 1 capital, or in the case of a registered securities broker or dealer, 0.5 percent or more of the tentative net capital, of the covered institution or of any section 956 affiliate of the covered institution, whether or not the individual is a covered person of that specific legal entity; and (2) Any covered person at a Level 1 or Level 2 covered institution, other than a senior executive officer, who is designated as a ‘‘significant risk-taker’’ by the Board because of that person’s ability to expose a covered institution to risks that could lead to material financial loss in relation to the covered institution’s size, capital, or overall risk tolerance, in accordance with procedures established by the Board, or by the covered institution. (3) For purposes of this part, an individual who is an employee, director, senior executive officer, or principal shareholder of an affiliate of a Level 1 or Level 2 covered institution, where such affiliate has less than $1 billion in total consolidated assets, and who otherwise would meet the requirements for being a significant risktaker under paragraph (hh)(1)(iii) of this section, shall be considered to be a significant risk-taker with respect to the Level 1 or Level 2 covered institution for which the individual may commit or expose 0.5 percent or more of common equity tier 1 capital or tentative net capital. The Level 1 or Level 2 covered institution for which the individual commits or exposes 0.5 percent or more of common equity tier 1 capital or tentative net capital shall ensure that E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules the individual’s incentive compensation arrangement complies with the requirements of this part. (4) If the Board determines, in accordance with procedures established by the Board, that a Level 1 covered institution’s activities, complexity of operations, risk profile, and compensation practices are similar to those of a Level 2 covered institution, the Level 1 covered institution may apply paragraph (hh)(1)(i) of this section to covered persons of the Level 1 covered institution by substituting ‘‘2 percent’’ for ‘‘5 percent’’. (ii) Subsidiary means any company that is owned or controlled directly or indirectly by another company; provided that the following are not subsidiaries for purposes of this part: (1) Any merchant banking investment that is owned or controlled pursuant to 12 U.S.C. 1843(k)(4)(H) and subpart J of the Board’s Regulation Y (12 CFR part 225); and (2) Any company with respect to which the covered institution acquired ownership or control in the ordinary course of collecting a debt previously contracted in good faith. (jj) Vesting of incentive-based compensation means the transfer of ownership of the incentive-based compensation to the covered person to whom the incentive-based compensation was awarded, such that the covered person’s right to the incentive-based compensation is no longer contingent on the occurrence of any event. mstockstill on DSK3G9T082PROD with PROPOSALS2 § 236.3 Applicability. (a) When average total consolidated assets increase—(1) In general. A regulated institution shall become a Level 1, Level 2, or Level 3 covered institution when its average total consolidated assets or the average total consolidated assets of any affiliate of the regulated institution equals or exceeds $250 billion, $50 billion, or $1 billion, respectively. (2) Compliance date. A regulated institution that becomes a Level 1, Level 2, or Level 3 covered institution pursuant to paragraph (a)(1) of this section shall comply with the requirements of this part for a Level 1, Level 2, or Level 3 covered institution, respectively, not later than the first day of the first calendar quarter that begins at least 540 days after the date on which the regulated institution becomes a Level 1, Level 2, or Level 3 covered institution, respectively. Until that day, the Level 1, Level 2, or Level 3 covered institution will remain subject to the requirements of this part, if any, that applied to the regulated institution on VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 the day before the date on which it became a Level 1, Level 2, or Level 3 covered institution. (3) Grandfathered plans. A regulated institution that becomes a Level 1, Level 2, or Level 3 covered institution under paragraph (a)(1) of this section is not required to comply with requirements of this part applicable to a Level 1, Level 2, or Level 3 covered institution, respectively, with respect to any incentive-based compensation plan with a performance period that begins before the date described in paragraph (a)(2) of this section. Any such incentive-based compensation plan shall remain subject to the requirements under this part, if any, that applied to the regulated institution at the beginning of the performance period. (b) When total consolidated assets decrease. A Level 1, Level 2, or Level 3 covered institution will remain subject to the requirements applicable to such covered institution under this part unless and until the total consolidated assets of such covered institution, or the total consolidated assets of another Level 1, Level 2, or Level 3 covered institution of which the first covered institution is a subsidiary, as reported on the covered institution’s regulatory reports, fall below $250 billion, $50 billion, or $1 billion, respectively, for each of four consecutive quarters. The calculation will be effective on the asof date of the fourth consecutive regulatory report. (c) Compliance of covered institutions that are subsidiaries of covered institutions. A covered institution that is a subsidiary of another covered institution may meet any requirement of this part if the parent covered institution complies with that requirement in such a way that causes the relevant portion of the incentivebased compensation program of the subsidiary covered institution to comply with that requirement. § 236.4 Requirements and prohibitions applicable to all covered institutions. (a) In general. A covered institution must not establish or maintain any type of incentive-based compensation arrangement, or any feature of any such arrangement, that encourages inappropriate risks by the covered institution: (1) By providing a covered person with excessive compensation, fees, or benefits; or (2) That could lead to material financial loss to the covered institution. (b) Excessive compensation. Compensation, fees, and benefits are considered excessive for purposes of paragraph (a)(1) of this section when PO 00000 Frm 00141 Fmt 4701 Sfmt 4702 37809 amounts paid are unreasonable or disproportionate to the value of the services performed by a covered person, taking into consideration all relevant factors, including, but not limited to: (1) The combined value of all compensation, fees, or benefits provided to the covered person; (2) The compensation history of the covered person and other individuals with comparable expertise at the covered institution; (3) The financial condition of the covered institution; (4) Compensation practices at comparable institutions, based upon such factors as asset size, geographic location, and the complexity of the covered institution’s operations and assets; (5) For post-employment benefits, the projected total cost and benefit to the covered institution; and (6) Any connection between the covered person and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the covered institution. (c) Material financial loss. An incentive-based compensation arrangement at a covered institution encourages inappropriate risks that could lead to material financial loss to the covered institution, unless the arrangement: (1) Appropriately balances risk and reward; (2) Is compatible with effective risk management and controls; and (3) Is supported by effective governance. (d) Performance measures. An incentive-based compensation arrangement will not be considered to appropriately balance risk and reward for purposes of paragraph (c)(1) of this section unless: (1) The arrangement includes financial and non-financial measures of performance, including considerations of risk-taking, that are relevant to a covered person’s role within a covered institution and to the type of business in which the covered person is engaged and that are appropriately weighted to reflect risk-taking; (2) The arrangement is designed to allow non-financial measures of performance to override financial measures of performance when appropriate in determining incentivebased compensation; and (3) Any amounts to be awarded under the arrangement are subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance. E:\FR\FM\10JNP2.SGM 10JNP2 37810 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules (e) Board of directors. A covered institution’s board of directors, or a committee thereof, must: (1) Conduct oversight of the covered institution’s incentive-based compensation program; (2) Approve incentive-based compensation arrangements for senior executive officers, including the amounts of all awards and, at the time of vesting, payouts under such arrangements; and (3) Approve any material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers. (f) Disclosure and recordkeeping requirements. A covered institution must create annually and maintain for a period of at least seven years records that document the structure of all its incentive-based compensation arrangements and demonstrate compliance with this part. A covered institution must disclose the records to the Board upon request. At a minimum, the records must include copies of all incentive-based compensation plans, a record of who is subject to each plan, and a description of how the incentivebased compensation program is compatible with effective risk management and controls. (g) Rule of construction. A covered institution is not required to report the actual amount of compensation, fees, or benefits of individual covered persons as part of the disclosure and recordkeeping requirements under this part. mstockstill on DSK3G9T082PROD with PROPOSALS2 § 236.5 Additional disclosure and recordkeeping requirements for Level 1 and Level 2 covered institutions. (a) A Level 1 or Level 2 covered institution must create annually and maintain for a period of at least seven years records that document: (1) The covered institution’s senior executive officers and significant risktakers, listed by legal entity, job function, organizational hierarchy, and line of business; (2) The incentive-based compensation arrangements for senior executive officers and significant risk-takers, including information on percentage of incentive-based compensation deferred and form of award; (3) Any forfeiture and downward adjustment or clawback reviews and decisions for senior executive officers and significant risk-takers; and (4) Any material changes to the covered institution’s incentive-based compensation arrangements and policies. (b) A Level 1 or Level 2 covered institution must create and maintain VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 records in a manner that allows for an independent audit of incentive-based compensation arrangements, policies, and procedures, including, those required under § 236.11. (c) A Level 1 or Level 2 covered institution must provide the records described in paragraph (a) of this section to the Board in such form and with such frequency as requested by the Board. § 236.6 Reservation of authority for Level 3 covered institutions. (a) In general. The Board may require a Level 3 covered institution with average total consolidated assets greater than or equal to $10 billion and less than $50 billion to comply with some or all of the provisions of §§ 236.5 and 236.7 through 236.11 if the Board determines that the Level 3 covered institution’s complexity of operations or compensation practices are consistent with those of a Level 1 or Level 2 covered institution. (b) Factors considered. Any exercise of authority under this section will be in writing by the Board in accordance with procedures established by the Board and will consider the activities, complexity of operations, risk profile, and compensation practices of the Level 3 covered institution, in addition to any other relevant factors. § 236.7 Deferral, forfeiture and downward adjustment, and clawback requirements for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will not be considered to appropriately balance risk and reward, for purposes of § 236.4(c)(1), unless the following requirements are met. (a) Deferral. (1) Qualifying incentivebased compensation must be deferred as follows: (i) Minimum required deferral amount. (A) A Level 1 covered institution must defer at least 60 percent of a senior executive officer’s qualifying incentive-based compensation awarded for each performance period. (B) A Level 1 covered institution must defer at least 50 percent of a significant risk-taker’s qualifying incentive-based compensation awarded for each performance period. (C) A Level 2 covered institution must defer at least 50 percent of a senior executive officer’s qualifying incentivebased compensation awarded for each performance period. (D) A Level 2 covered institution must defer at least 40 percent of a significant risk-taker’s qualifying incentive-based compensation awarded for each performance period. PO 00000 Frm 00142 Fmt 4701 Sfmt 4702 (ii) Minimum required deferral period. (A) For a senior executive officer or significant risk-taker of a Level 1 covered institution, the deferral period for deferred qualifying incentive-based compensation must be at least 4 years. (B) For a senior executive officer or significant risk-taker of a Level 2 covered institution, the deferral period for deferred qualifying incentive-based compensation must be at least 3 years. (iii) Vesting of amounts during deferral period—(A) Pro rata vesting. During a deferral period, deferred qualifying incentive-based compensation may not vest faster than on a pro rata annual basis beginning no earlier than the first anniversary of the end of the performance period for which the amounts were awarded. (B) Acceleration of vesting. A Level 1 or Level 2 covered institution must not accelerate the vesting of a covered person’s deferred qualifying incentivebased compensation that is required to be deferred under this part, except in the case of death or disability of such covered person. (2) Incentive-based compensation awarded under a long-term incentive plan must be deferred as follows: (i) Minimum required deferral amount. (A) A Level 1 covered institution must defer at least 60 percent of a senior executive officer’s incentivebased compensation awarded under a long-term incentive plan for each performance period. (B) A Level 1 covered institution must defer at least 50 percent of a significant risk-taker’s incentive-based compensation awarded under a longterm incentive plan for each performance period. (C) A Level 2 covered institution must defer at least 50 percent of a senior executive officer’s incentive-based compensation awarded under a longterm incentive plan for each performance period. (D) A Level 2 covered institution must defer at least 40 percent of a significant risk-taker’s incentive-based compensation awarded under a longterm incentive plan for each performance period. (ii) Minimum required deferral period. (A) For a senior executive officer or significant risk-taker of a Level 1 covered institution, the deferral period for deferred long-term incentive plan amounts must be at least 2 years. (B) For a senior executive officer or significant risk-taker of a Level 2 covered institution, the deferral period for deferred long-term incentive plan amounts must be at least 1 year. (iii) Vesting of amounts during deferral period—(A) Pro rata vesting. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules During a deferral period, deferred longterm incentive plan amounts may not vest faster than on a pro rata annual basis beginning no earlier than the first anniversary of the end of the performance period for which the amounts were awarded. (B) Acceleration of vesting. A Level 1 or Level 2 covered institution must not accelerate the vesting of a covered person’s deferred long-term incentive plan amounts that is required to be deferred under this part, except in the case of death or disability of such covered person. (3) Adjustments of deferred qualifying incentive-based compensation and deferred long-term incentive plan compensation amounts. A Level 1 or Level 2 covered institution may not increase deferred qualifying incentivebased compensation or deferred longterm incentive plan amounts for a senior executive officer or significant risk-taker during the deferral period. For purposes of this paragraph, an increase in value attributable solely to a change in share value, a change in interest rates, or the payment of interest according to terms set out at the time of the award is not considered an increase in incentivebased compensation amounts. (4) Composition of deferred qualifying incentive-based compensation and deferred long-term incentive plan compensation for Level 1 and Level 2 covered institutions—(i) Cash and equity-like instruments. For a senior executive officer or significant risk-taker of a Level 1 or Level 2 covered institution that issues equity or is an affiliate of a covered institution that issues equity, any deferred qualifying incentive-based compensation or deferred long-term incentive plan amounts must include substantial portions of both deferred cash and equity-like instruments throughout the deferral period. (ii) Options. If a senior executive officer or significant risk-taker of a Level 1 or Level 2 covered institution receives incentive-based compensation for a performance period in the form of options, the total amount of such options that may be used to meet the minimum deferral amount requirements of paragraph (a)(1)(i) or (a)(2)(i) of this section is limited to no more than 15 percent of the amount of total incentivebased compensation awarded to the senior executive officer or significant risk-taker for that performance period. (b) Forfeiture and downward adjustment—(1) Compensation at risk. (i) A Level 1 or Level 2 covered institution must place at risk of forfeiture all unvested deferred incentive-based compensation of any VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 senior executive officer or significant risk-taker, including unvested deferred amounts awarded under long-term incentive plans. (ii) A Level 1 or Level 2 covered institution must place at risk of downward adjustment all of a senior executive officer’s or significant risktaker’s incentive-based compensation amounts not yet awarded for the current performance period, including amounts payable under long-term incentive plans. (2) Events triggering forfeiture and downward adjustment review. At a minimum, a Level 1 or Level 2 covered institution must consider forfeiture and downward adjustment of incentivebased compensation of senior executive officers and significant risk-takers described in paragraph (b)(3) of this section due to any of the following adverse outcomes at the covered institution: (i) Poor financial performance attributable to a significant deviation from the risk parameters set forth in the covered institution’s policies and procedures; (ii) Inappropriate risk taking, regardless of the impact on financial performance; (iii) Material risk management or control failures; (iv) Non-compliance with statutory, regulatory, or supervisory standards that results in: (A) Enforcement or legal action against the covered institution brought by a federal or state regulator or agency; or (B) A requirement that the covered institution report a restatement of a financial statement to correct a material error; and (v) Other aspects of conduct or poor performance as defined by the covered institution. (3) Senior executive officers and significant risk-takers affected by forfeiture and downward adjustment. A Level 1 or Level 2 covered institution must consider forfeiture and downward adjustment for a senior executive officer or significant risk-taker with direct responsibility, or responsibility due to the senior executive officer’s or significant risk-taker’s role or position in the covered institution’s organizational structure, for the events related to the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section. (4) Determining forfeiture and downward adjustment amounts. A Level 1 or Level 2 covered institution must consider, at a minimum, the following factors when determining the amount or portion of a senior executive officer’s or PO 00000 Frm 00143 Fmt 4701 Sfmt 4702 37811 significant risk-taker’s incentive-based compensation that should be forfeited or adjusted downward: (i) The intent of the senior executive officer or significant risk-taker to operate outside the risk governance framework approved by the covered institution’s board of directors or to depart from the covered institution’s policies and procedures; (ii) The senior executive officer’s or significant risk-taker’s level of participation in, awareness of, and responsibility for, the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section; (iii) Any actions the senior executive officer or significant risk-taker took or could have taken to prevent the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section; (iv) The financial and reputational impact of the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section to the covered institution, the line or sub-line of business, and individuals involved, as applicable, including the magnitude of any financial loss and the cost of known or potential subsequent fines, settlements, and litigation; (v) The causes of the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section, including any decisionmaking by other individuals; and (vi) Any other relevant information, including past behavior and past risk outcomes attributable to the senior executive officer or significant risktaker. (c) Clawback. A Level 1 or Level 2 covered institution must include clawback provisions in incentive-based compensation arrangements for senior executive officers and significant risktakers that, at a minimum, allow the covered institution to recover incentivebased compensation from a current or former senior executive officer or significant risk-taker for seven years following the date on which such compensation vests, if the covered institution determines that the senior executive officer or significant risk-taker engaged in: (1) Misconduct that resulted in significant financial or reputational harm to the covered institution; (2) Fraud; or (3) Intentional misrepresentation of information used to determine the senior executive officer or significant risk-taker’s incentive-based compensation. E:\FR\FM\10JNP2.SGM 10JNP2 37812 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules § 236.8 Additional prohibitions for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will be considered to provide incentives that appropriately balance risk and reward for purposes of § 236.4(c)(1) only if such institution complies with the following prohibitions. (a) Hedging. A Level 1 or Level 2 covered institution must not purchase a hedging instrument or similar instrument on behalf of a covered person to hedge or offset any decrease in the value of the covered person’s incentive-based compensation. (b) Maximum incentive-based compensation opportunity. A Level 1 or Level 2 covered institution must not award incentive-based compensation to: (1) A senior executive officer in excess of 125 percent of the target amount for that incentive-based compensation; or (2) A significant risk-taker in excess of 150 percent of the target amount for that incentive-based compensation. (c) Relative performance measures. A Level 1 or Level 2 covered institution must not use incentive-based compensation performance measures that are based solely on industry peer performance comparisons. (d) Volume driven incentive-based compensation. A Level 1 or Level 2 covered institution must not provide incentive-based compensation to a covered person that is based solely on transaction revenue or volume without regard to transaction quality or compliance of the covered person with sound risk management. mstockstill on DSK3G9T082PROD with PROPOSALS2 § 236.9 Risk management and controls requirements for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will be considered to be compatible with effective risk management and controls for purposes of § 236.4(c)(2) only if such institution meets the following requirements. (a) A Level 1 or Level 2 covered institution must have a risk management framework for its incentive-based compensation program that: (1) Is independent of any lines of business; (2) Includes an independent compliance program that provides for internal controls, testing, monitoring, and training with written policies and procedures consistent with § 236.11; and (3) Is commensurate with the size and complexity of the covered institution’s operations. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 (b) A Level 1 or Level 2 covered institution must: (1) Provide individuals engaged in control functions with the authority to influence the risk-taking of the business areas they monitor; and (2) Ensure that covered persons engaged in control functions are compensated in accordance with the achievement of performance objectives linked to their control functions and independent of the performance of those business areas. (c) A Level 1 or Level 2 covered institution must provide for the independent monitoring of: (1) All incentive-based compensation plans in order to identify whether those plans provide incentives that appropriately balance risk and reward; (2) Events related to forfeiture and downward adjustment reviews and decisions of forfeiture and downward adjustment reviews in order to determine consistency with § 236.7(b); and (3) Compliance of the incentive-based compensation program with the covered institution’s policies and procedures. § 236.10 Governance requirements for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will not be considered to be supported by effective governance for purposes of § 236.4(c)(3), unless: (a) The covered institution establishes a compensation committee composed solely of directors who are not senior executive officers to assist the board of directors in carrying out its responsibilities under § 236.4(e); and (b) The compensation committee established pursuant to paragraph (a) of this section obtains: (1) Input from the risk and audit committees of the covered institution’s board of directors, or groups performing similar functions, and risk management function on the effectiveness of risk measures and adjustments used to balance risk and reward in incentivebased compensation arrangements; (2) A written assessment of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution, submitted on an annual or more frequent basis by the management of the covered institution and developed with input from the risk and audit committees of its board of directors, or groups performing similar functions, PO 00000 Frm 00144 Fmt 4701 Sfmt 4702 and from the covered institution’s risk management and audit functions; and (3) An independent written assessment of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution, submitted on an annual or more frequent basis by the internal audit or risk management function of the covered institution, developed independently of the covered institution’s management. § 236.11 Policies and procedures requirements for Level 1 and Level 2 covered institutions. A Level 1 or Level 2 covered institution must develop and implement policies and procedures for its incentive-based compensation program that, at a minimum: (a) Are consistent with the prohibitions and requirements of this part; (b) Specify the substantive and procedural criteria for the application of forfeiture and clawback, including the process for determining the amount of incentive-based compensation to be clawed back; (c) Require that the covered institution maintain documentation of final forfeiture, downward adjustment, and clawback decisions; (d) Specify the substantive and procedural criteria for the acceleration of payments of deferred incentive-based compensation to a covered person, consistent with § 236.7(a)(1)(iii)(B) and (a)(2)(iii)(B)); (e) Identify and describe the role of any employees, committees, or groups authorized to make incentive-based compensation decisions, including when discretion is authorized; (f) Describe how discretion is expected to be exercised to appropriately balance risk and reward; (g) Require that the covered institution maintain documentation of the establishment, implementation, modification, and monitoring of incentive-based compensation arrangements, sufficient to support the covered institution’s decisions; (h) Describe how incentive-based compensation arrangements will be monitored; (i) Specify the substantive and procedural requirements of the independent compliance program consistent with § 236.9(a)(2); and (j) Ensure appropriate roles for risk management, risk oversight, and other control function personnel in the covered institution’s processes for: E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules (1) Designing incentive-based compensation arrangements and determining awards, deferral amounts, deferral periods, forfeiture, downward adjustment, clawback, and vesting; and (2) Assessing the effectiveness of incentive-based compensation arrangements in restraining inappropriate risk-taking. § 236.12 Indirect actions. A covered institution must not indirectly, or through or by any other person, do anything that would be unlawful for such covered institution to do directly under this part. § 236.13 Enforcement. The provisions of this part shall be enforced under section 505 of the Gramm-Leach-Bliley Act and, for purposes of such section, a violation of this part shall be treated as a violation of subtitle A of title V of such Act. Federal Deposit Insurance Corporation 12 CFR Chapter III Authority and Issuance For the reasons set forth in the joint preamble, the Federal Deposit Insurance Corporation proposes to amend chapter III of title 12 of the Code of Federal Regulations as follows: ■ 3. Add part 372 to read as follows: mstockstill on DSK3G9T082PROD with PROPOSALS2 PART 372—INCENTIVE-BASED COMPENSATION ARRANGEMENTS Sec. 372.1 Authority, scope, and initial applicability. 372.2 Definitions. 372.3 Applicability. 372.4 Requirements and prohibitions applicable to all covered institutions. 372.5 Additional disclosure and recordkeeping requirements for Level 1 and Level 2 covered institutions. 372.6 Reservation of authority for Level 3 covered institutions. 372.7 Deferral, forfeiture and downward adjustment, and clawback requirements for Level 1 and Level 2 covered institutions. 372.8 Additional prohibitions for Level 1 and Level 2 covered institutions. 372.9 Risk management and controls requirements for Level 1 and Level 2 covered institutions. 372.10 Governance requirements for Level 1 and Level 2 covered institutions. 372.11 Policies and procedures requirements for Level 1 and Level 2 covered institutions. 372.12 Indirect actions. 372.13 Enforcement. Authority: 12 U.S.C. 5641, 12 U.S.C. 1818, 12 U.S.C. 1819 Tenth, 12 U.S.C. 1831p–1. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 § 372.1 Authority, scope, and initial applicability. (a) Authority. This part is issued pursuant to section 956 of the DoddFrank Wall Street Reform and Consumer Protection Act (12 U.S.C. 5641), and sections 8 (12 U.S.C. 1818), 9 (12 U.S.C. 1819 Tenth), and 39 (12 U.S.C. 1831p– 1) of the Federal Deposit Insurance Act. (b) Scope. This part applies to a covered institution with average total consolidated assets greater than or equal to $1 billion that offers incentive-based compensation to covered persons. (c) Initial applicability—(1) Compliance date. A covered institution must meet the requirements of this part no later than [Date of the beginning of the first calendar quarter that begins at least 540 days after a final rule is published in the Federal Register]. Whether a covered institution is a Level 1, Level 2, or Level 3 covered institution at that time will be determined based on average total consolidated assets as of [Date of the beginning of the first calendar quarter that begins after a final rule is published in the Federal Register]. (2) Grandfathered plans. A covered institution is not required to comply with the requirements of this part with respect to any incentive-based compensation plan with a performance period that begins before [Compliance Date as described in § 372.1(c)(1)]. (d) Preservation of authority. Nothing in this part in any way limits the authority of the Corporation under other provisions of applicable law and regulations. § 372.2 Definitions. For purposes of this part only, the following definitions apply unless otherwise specified: (a) Affiliate means any company that controls, is controlled by, or is under common control with another company. (b) Average total consolidated assets means the average of the total consolidated assets of a state nonmember bank; state savings association; state insured branch of a foreign bank; a subsidiary of a state nonmember bank, state savings association, or state insured branch of a foreign bank; or a depository institution holding company, as reported on the state nonmember bank’s, state savings association’s, state insured branch of a foreign bank’s, subsidiary’s, or depository institution holding company’s regulatory reports, for the four most recent consecutive quarters. If a state nonmember bank, state savings association, state insured branch of a foreign bank, subsidiary, or depository institution holding company has not PO 00000 Frm 00145 Fmt 4701 Sfmt 4702 37813 filed a regulatory report for each of the four most recent consecutive quarters, the state nonmember bank, state savings association, state insured branch of a foreign bank, subsidiary, or depository institution holding company’s average total consolidated assets means the average of its total consolidated assets, as reported on its regulatory reports, for the most recent quarter or consecutive quarters, as applicable. Average total consolidated assets are measured on the as-of date of the most recent regulatory report used in the calculation of the average. (c) To award incentive-based compensation means to make a final determination, conveyed to a covered person, of the amount of incentivebased compensation payable to the covered person for performance over a performance period. (d) Board of directors means the governing body of a covered institution that oversees the activities of the covered institution, often referred to as the board of directors or board of managers. For a state insured branch of a foreign bank, ‘‘board of directors’’ refers to the relevant oversight body for the state insured branch consistent with the foreign bank’s overall corporate and management structure. (e) Clawback means a mechanism by which a covered institution can recover vested incentive-based compensation from a covered person. (f) Compensation, fees, or benefits means all direct and indirect payments, both cash and non-cash, awarded to, granted to, or earned by or for the benefit of, any covered person in exchange for services rendered to a covered institution. (g) Control means that any company has control over a bank or over any company if— (1) The company directly or indirectly or acting through one or more other persons owns, controls, or has power to vote 25 percent or more of any class of voting securities of the bank or company; (2) The company controls in any manner the election of a majority of the directors or trustees of the bank or company; or (3) The Corporation determines, after notice and opportunity for hearing, that the company directly or indirectly exercises a controlling influence over the management or policies of the bank or company. (h) Control function means a compliance, risk management, internal audit, legal, human resources, accounting, financial reporting, or finance role responsible for identifying, E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37814 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules measuring, monitoring, or controlling risk-taking. (i) Covered institution means (1) A state nonmember bank, state savings association, or a state insured branch of a foreign bank, as such terms are defined in section 3 of the Federal Deposit Insurance Act, 12 U.S.C. 1813, with average total consolidated assets greater than or equal to $1 billion; and (2) A subsidiary of a state nonmember bank, state savings association, or a state insured branch of a foreign bank, as such terms are defined in section 3 of the Federal Deposit Insurance Act, 12 U.S.C. 1813, that: (i) Is not a broker, dealer, person providing insurance, investment company, or investment adviser; and (ii) Has average total consolidated assets greater than or equal to $1 billion. (j) Covered person means any executive officer, employee, director, or principal shareholder who receives incentive-based compensation at a covered institution. (k) Deferral means the delay of vesting of incentive-based compensation beyond the date on which the incentivebased compensation is awarded. (l) Deferral period means the period of time between the date a performance period ends and the last date on which the incentive-based compensation awarded for such performance period vests. (m) Depository institution holding company means a top-tier depository institution holding company, where ‘‘depository institution holding company’’ has the same meaning as in section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813). (n) Director of a covered institution means a member of the board of directors. (o) Downward adjustment means a reduction of the amount of a covered person’s incentive-based compensation not yet awarded for any performance period that has already begun, including amounts payable under long-term incentive plans, in accordance with a forfeiture and downward adjustment review under § 372.7(b). (p) Equity-like instrument means: (1) Equity in the covered institution or of any affiliate of the covered institution; or (2) A form of compensation: (i) Payable at least in part based on the price of the shares or other equity instruments of the covered institution or of any affiliate of the covered institution; or (ii) That requires, or may require, settlement in the shares of the covered institution or of any affiliate of the covered institution. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 (q) Forfeiture means a reduction of the amount of deferred incentive-based compensation awarded to a covered person that has not vested. (r) Incentive-based compensation means any variable compensation, fees, or benefits that serve as an incentive or reward for performance. (s) Incentive-based compensation arrangement means an agreement between a covered institution and a covered person, under which the covered institution provides incentivebased compensation to the covered person, including incentive-based compensation delivered through one or more incentive-based compensation plans. (t) Incentive-based compensation plan means a document setting forth terms and conditions governing the opportunity for and the payment of incentive-based compensation payments to one or more covered persons. (u) Incentive-based compensation program means a covered institution’s framework for incentive-based compensation that governs incentivebased compensation practices and establishes related controls. (v) Level 1 covered institution means (1) A covered institution that is a subsidiary of a depository institution holding company with average total consolidated assets greater than or equal to $250 billion; (2) A covered institution with average total consolidated assets greater than or equal to $250 billion that is not a subsidiary of a covered institution or of a depository institution holding company; and (3) A covered institution that is a subsidiary of a covered institution with average total consolidated assets greater than or equal to $250 billion. (w) Level 2 covered institution means (1) A covered institution that is a subsidiary of a depository institution holding company with average total consolidated assets greater than or equal to $50 billion but less than $250 billion; (2) A covered institution with average total consolidated assets greater than or equal to $50 billion but less than $250 billion that is not a subsidiary of a covered institution or of a depository institution holding company; and (3) A covered institution that is a subsidiary of a covered institution with average total consolidated assets greater than or equal to $50 billion but less than $250 billion. (x) Level 3 covered institution means (1) A covered institution that is a subsidiary of a depository institution holding company with average total consolidated assets greater than or equal to $1 billion but less than $50 billion; PO 00000 Frm 00146 Fmt 4701 Sfmt 4702 (2) A covered institution with average total consolidated assets greater than or equal to $1 billion but less than $50 billion that is not a subsidiary of a covered institution or of a depository institution holding company; and (3) A covered institution that is a subsidiary of a covered institution with average total consolidated assets greater than or equal to $1 billion but less than $50 billion. (y) Long-term incentive plan means a plan to provide incentive-based compensation that is based on a performance period of at least three years. (z) Option means an instrument through which a covered institution provides a covered person the right, but not the obligation, to buy a specified number of shares representing an ownership stake in a company at a predetermined price within a set time period or on a date certain, or any similar instrument, such as a stock appreciation right. (aa) Performance period means the period during which the performance of a covered person is assessed for purposes of determining incentivebased compensation. (bb) Principal shareholder means a natural person who, directly or indirectly, or acting through or in concert with one or more persons, owns, controls, or has the power to vote 10 percent or more of any class of voting securities of a covered institution. (cc) Qualifying incentive-based compensation means the amount of incentive-based compensation awarded to a covered person for a particular performance period, excluding amounts awarded to the covered person for that particular performance period under a long-term incentive plan. (dd) [Reserved]. (ee) Regulatory report means (1) For a state nonmember bank and state savings association, Consolidated Reports of Condition and Income; (2) For an state insured branch of a foreign bank, the Reports of Assets and Liabilities of U.S. Branches and Agencies of Foreign Banks—FFIEC 002; and (3) For a depository institution holding company: (i) The Consolidated Financial Statements for Bank Holding Companies (‘‘FR Y–9C’’); (ii) In the case of a savings and loan holding company that is not required to file an FR Y–9C, the Quarterly Savings and Loan Holding Company Report (‘‘FR 2320’’), if the savings and loan holding company reports consolidated assets on the FR 2320, as applicable; and E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules (iii) In the case of a savings and loan holding company that does not file an FRY–9C or report consolidated assets on the FR2320, a report submitted to the Board of Governors of the Federal Reserve System pursuant to 12 CFR 236.2(ee). (ff) Section 956 affiliate means an affiliate that is an institution described in § 372.2(i), 12 CFR 42.2(i), 12 CFR 236.2(i), 12 CFR 741.2(i), 12 CFR 1232.2(i), or 17 CFR 303.2(i). (gg) Senior executive officer means a covered person who holds the title or, without regard to title, salary, or compensation, performs the function of one or more of the following positions at a covered institution for any period of time in the relevant performance period: President, chief executive officer, executive chairman, chief operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer, chief compliance officer, chief audit executive, chief credit officer, chief accounting officer, or head of a major business line or control function. (hh) Significant risk-taker means: (1) Any covered person at a Level 1 or Level 2 covered institution, other than a senior executive officer, who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period of which at least one-third is incentive-based compensation and is— (i) A covered person of a Level 1 covered institution who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period that placed the covered person among the highest 5 percent in annual base salary and incentive-based compensation among all covered persons (excluding senior executive officers) of the Level 1 covered institution together with all individuals who receive incentive-based compensation at any section 956 affiliate of the Level 1 covered institution; (ii) A covered person of a Level 2 covered institution who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period that placed the covered person among the highest 2 percent in annual base salary and incentive-based compensation among all covered persons (excluding senior executive officers) of the Level 2 covered institution together with all individuals VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 who receive incentive-based compensation at any section 956 affiliate of the Level 2 covered institution; or (iii) A covered person of a covered institution who may commit or expose 0.5 percent or more of the common equity tier 1 capital, or in the case of a registered securities broker or dealer, 0.5 percent or more of the tentative net capital, of the covered institution or of any section 956 affiliate of the covered institution, whether or not the individual is a covered person of that specific legal entity; and (2) Any covered person at a Level 1 or Level 2 covered institution, other than a senior executive officer, who is designated as a ‘‘significant risk-taker’’ by the Corporation because of that person’s ability to expose a covered institution to risks that could lead to material financial loss in relation to the covered institution’s size, capital, or overall risk tolerance, in accordance with procedures established by the Corporation, or by the covered institution. (3) For purposes of this part, an individual who is an employee, director, senior executive officer, or principal shareholder of an affiliate of a Level 1 or Level 2 covered institution, where such affiliate has less than $1 billion in total consolidated assets, and who otherwise would meet the requirements for being a significant risktaker under paragraph (hh)(1)(iii) of this section, shall be considered to be a significant risk-taker with respect to the Level 1 or Level 2 covered institution for which the individual may commit or expose 0.5 percent or more of common equity tier 1 capital or tentative net capital. The Level 1 or Level 2 covered institution for which the individual commits or exposes 0.5 percent or more of common equity tier 1 capital or tentative net capital shall ensure that the individual’s incentive compensation arrangement complies with the requirements of this part. (4) If the Corporation determines, in accordance with procedures established by the Corporation, that a Level 1 covered institution’s activities, complexity of operations, risk profile, and compensation practices are similar to those of a Level 2 covered institution, the Level 1 covered institution may apply paragraph (hh)(1)(i) of this section to covered persons of the Level 1 covered institution by substituting ‘‘2 percent’’ for ‘‘5 percent’’. (ii) Subsidiary means any company that is owned or controlled directly or indirectly by another company. (jj) Vesting of incentive-based compensation means the transfer of PO 00000 Frm 00147 Fmt 4701 Sfmt 4702 37815 ownership of the incentive-based compensation to the covered person to whom the incentive-based compensation was awarded, such that the covered person’s right to the incentive-based compensation is no longer contingent on the occurrence of any event. § 372.3 Applicability. (a) When average total consolidated assets increase—(1) In general—(i) Covered institution subsidiaries of depository institution holding companies. A state nonmember bank or state savings association that is a subsidiary of a depository institution holding company shall become a Level 1, Level 2, or Level 3 covered institution when the depository institution holding company’s average total consolidated assets increase to an amount that equals or exceeds $250 billion, $50 billion, or $1 billion, respectively. (ii) Covered institutions that are not subsidiaries of a depository institution holding company. A state nonmember bank, state savings association, or state insured branch of a foreign bank that is not a subsidiary of a state nonmember bank, state savings association, or state insured branch of a foreign bank, or depository institution holding company shall become a Level 1, Level 2, or Level 3 covered institution when such state nonmember bank, state savings association, or state insured branch of a foreign bank’s average total consolidated assets increase to an amount that equals or exceeds $250 billion, $50 billion, or $1 billion, respectively. (iii) Subsidiaries of covered institutions. A subsidiary of a state nonmember bank, state savings association, or state insured branch of a foreign bank, as described under § 372.2(i)(2), shall become a Level 1, Level 2, or Level 3 covered institution when the state nonmember bank, state savings association, or state insured branch of a foreign bank becomes a Level 1, Level 2, or Level 3 covered institution, respectively, under paragraph (a)(1)(i) or (ii) of this section. (2) Compliance date. A state nonmember bank, state savings association, state insured branch of a foreign bank, or subsidiary thereof, that becomes a Level 1, Level 2, or Level 3 covered institution pursuant to paragraph (a)(1) of this section shall comply with the requirements of this part for a Level 1, Level 2, or Level 3 covered institution, respectively, not later than the first day of the first calendar quarter that begins at least 540 days after the date on which such state nonmember bank, state savings association, state insured branch of a E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37816 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules foreign bank, or subsidiary thereof becomes a Level 1, Level 2, or Level 3 covered institution, respectively. Until that day, the Level 1, Level 2, or Level 3 covered institution will remain subject to the requirements of this part, if any, that applied to the institution on the day before the date on which it became a Level 1, Level 2, or Level 3 covered institution. (3) Grandfathered plans. A state nonmember bank, state savings association, state insured branch of a foreign bank, or subsidiary thereof, that becomes a Level 1, Level 2, or Level 3 covered institution under paragraph (a)(1) of this section is not required to comply with requirements of this part applicable to a Level 1, Level 2, or Level 3 covered institution, respectively, with respect to any incentive-based compensation plan with a performance period that begins before the date described in paragraph (a)(2) of this section. Any such incentive-based compensation plan shall remain subject to the requirements under this part, if any, that applied to such state nonmember bank, state savings association, state insured branch of a foreign bank, or subsidiary thereof at the beginning of the performance period. (b) When total consolidated assets decrease—(1) Covered institutions that are subsidiaries of depository institution holding companies. A Level 1, Level 2, or Level 3 covered institution that is a subsidiary of a depository institution holding company will remain subject to the requirements applicable to such covered institution at that level under this part unless and until the total consolidated assets of the depository institution holding company, as reported on the depository institution holding company’s regulatory reports, fall below $250 billion, $50 billion, or $1 billion, respectively, for each of four consecutive quarters. (2) Covered institutions that are not subsidiaries of depository institution holding companies. A Level 1, Level 2, or Level 3 covered institution that is not a subsidiary of a depository institution holding company will remain subject to the requirements applicable to such covered institution at that level under this part unless and until the total consolidated assets of the covered institution, as reported on the covered institution’s regulatory reports, fall below $250 billion, $50 billion, or $1 billion, respectively, for each of four consecutive quarters. (3) Subsidiaries of covered institutions. A Level 1, Level 2, or Level 3 covered institution that is a subsidiary of a state nonmember bank, state savings association, or state insured branch of a VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 foreign bank that is a covered institution will remain subject to the requirements applicable to such state nonmember bank, state savings association, or state insured branch of a foreign bank at that level under this part unless and until the total consolidated assets of the state nonmember bank, state savings association, state insured branch of a foreign bank, or depository holding company of the state nonmember bank or state savings association, as reported on its regulatory reports, fall below $250 billion, $50 billion, or $1 billion, respectively, for each of four consecutive quarters. (4) The calculations under this paragraph (b) of this section will be effective on the as-of date of the fourth consecutive regulatory report. (c) Compliance of covered institutions that are subsidiaries of covered institutions. A covered institution that is a subsidiary of another covered institution may meet any requirement of this part if the parent covered institution complies with that requirement in a way that causes the relevant portion of the incentive-based compensation program of the subsidiary covered institution to comply with that requirement. § 372.4 Requirements and prohibitions applicable to all covered institutions. (a) In general. A covered institution must not establish or maintain any type of incentive-based compensation arrangement, or any feature of any such arrangement, that encourages inappropriate risks by the covered institution: (1) By providing a covered person with excessive compensation, fees, or benefits; or (2) That could lead to material financial loss to the covered institution. (b) Excessive compensation. Compensation, fees, and benefits are considered excessive for purposes of paragraph (a)(1) of this section when amounts paid are unreasonable or disproportionate to the value of the services performed by a covered person, taking into consideration all relevant factors, including, but not limited to: (1) The combined value of all compensation, fees, or benefits provided to the covered person; (2) The compensation history of the covered person and other individuals with comparable expertise at the covered institution; (3) The financial condition of the covered institution; (4) Compensation practices at comparable institutions, based upon such factors as asset size, geographic location, and the complexity of the PO 00000 Frm 00148 Fmt 4701 Sfmt 4702 covered institution’s operations and assets; (5) For post-employment benefits, the projected total cost and benefit to the covered institution; and (6) Any connection between the covered person and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the covered institution. (c) Material financial loss. An incentive-based compensation arrangement at a covered institution encourages inappropriate risks that could lead to material financial loss to the covered institution, unless the arrangement: (1) Appropriately balances risk and reward; (2) Is compatible with effective risk management and controls; and (3) Is supported by effective governance. (d) Performance measures. An incentive-based compensation arrangement will not be considered to appropriately balance risk and reward for purposes of paragraph (c)(1) of this section unless: (1) The arrangement includes financial and non-financial measures of performance, including considerations of risk-taking, that are relevant to a covered person’s role within a covered institution and to the type of business in which the covered person is engaged and that are appropriately weighted to reflect risk-taking; (2) The arrangement is designed to allow non-financial measures of performance to override financial measures of performance when appropriate in determining incentivebased compensation; and (3) Any amounts to be awarded under the arrangement are subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance. (e) Board of directors. A covered institution’s board of directors, or a committee thereof, must: (1) Conduct oversight of the covered institution’s incentive-based compensation program; (2) Approve incentive-based compensation arrangements for senior executive officers, including the amounts of all awards and, at the time of vesting, payouts under such arrangements; and (3) Approve any material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers. (f) Disclosure and recordkeeping requirements. A covered institution E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules must create annually and maintain for a period of at least seven years records that document the structure of all its incentive-based compensation arrangements and demonstrate compliance with this part. A covered institution must disclose the records to the Corporation upon request. At a minimum, the records must include copies of all incentive-based compensation plans, a record of who is subject to each plan, and a description of how the incentive-based compensation program is compatible with effective risk management and controls. (g) Rule of construction. A covered institution is not required to report the actual amount of compensation, fees, or benefits of individual covered persons as part of the disclosure and recordkeeping requirements under this part. mstockstill on DSK3G9T082PROD with PROPOSALS2 § 372.5 Additional disclosure and recordkeeping requirements for Level 1 and Level 2 covered institutions. (a) A Level 1 or Level 2 covered institution must create annually and maintain for a period of at least seven years records that document: (1) The covered institution’s senior executive officers and significant risktakers, listed by legal entity, job function, organizational hierarchy, and line of business; (2) The incentive-based compensation arrangements for senior executive officers and significant risk-takers, including information on percentage of incentive-based compensation deferred and form of award; (3) Any forfeiture and downward adjustment or clawback reviews and decisions for senior executive officers and significant risk-takers; and (4) Any material changes to the covered institution’s incentive-based compensation arrangements and policies. (b) A Level 1 or Level 2 covered institution must create and maintain records in a manner that allows for an independent audit of incentive-based compensation arrangements, policies, and procedures, including, those required under § 372.11. (c) A Level 1 or Level 2 covered institution must provide the records described in paragraph (a) of this section to the Corporation in such form and with such frequency as requested by the Corporation. § 372.6 Reservation of authority for Level 3 covered institutions. (a) In general. The Corporation may require a Level 3 covered institution with average total consolidated assets VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 37817 compensation may not vest faster than on a pro rata annual basis beginning no earlier than the first anniversary of the end of the performance period for which the amounts were awarded. (B) Acceleration of vesting. A Level 1 or Level 2 covered institution must not accelerate the vesting of a covered person’s deferred qualifying incentivebased compensation that is required to be deferred under this part, except in the case of death or disability of such covered person. (2) Incentive-based compensation awarded under a long-term incentive plan must be deferred as follows: (i) Minimum required deferral amount. (A) A Level 1 covered institution must defer at least 60 percent § 372.7 Deferral, forfeiture and downward of a senior executive officer’s incentiveadjustment, and clawback requirements for based compensation awarded under a Level 1 and Level 2 covered institutions. long-term incentive plan for each An incentive-based compensation performance period. arrangement at a Level 1 or Level 2 (B) A Level 1 covered institution must covered institution will not be defer at least 50 percent of a significant considered to appropriately balance risk risk-taker’s incentive-based and reward, for purposes of compensation awarded under a long§ 372.4(c)(1), unless the following term incentive plan for each requirements are met. performance period. (a) Deferral. (1) Qualifying incentive(C) A Level 2 covered institution must based compensation must be deferred as defer at least 50 percent of a senior follows: executive officer’s incentive-based (i) Minimum required deferral compensation awarded under a longamount. term incentive plan for each (A) A Level 1 covered institution must performance period. defer at least 60 percent of a senior (D) A Level 2 covered institution must executive officer’s qualifying incentivedefer at least 40 percent of a significant based compensation awarded for each risk-taker’s incentive-based performance period. compensation awarded under a long(B) A Level 1 covered institution must term incentive plan for each defer at least 50 percent of a significant performance period. risk-taker’s qualifying incentive-based (ii) Minimum required deferral period. compensation awarded for each (A) For a senior executive officer or performance period. significant risk-taker of a Level 1 (C) A Level 2 covered institution must covered institution, the deferral period defer at least 50 percent of a senior for deferred long-term incentive plan executive officer’s qualifying incentiveamounts must be at least 2 years. based compensation awarded for each (B) For a senior executive officer or performance period. significant risk-taker of a Level 2 (D) A Level 2 covered institution must covered institution, the deferral period defer at least 40 percent of a significant for deferred long-term incentive plan risk-taker’s qualifying incentive-based amounts must be at least 1 year. (iii) Vesting of amounts during compensation awarded for each deferral period—(A) Pro rata vesting. performance period. (ii) Minimum required deferral period. During a deferral period, deferred long(A) For a senior executive officer or term incentive plan amounts may not significant risk-taker of a Level 1 vest faster than on a pro rata annual covered institution, the deferral period basis beginning no earlier than the first for deferred qualifying incentive-based anniversary of the end of the compensation must be at least 4 years. performance period for which the (B) For a senior executive officer or amounts were awarded. (B) Acceleration of vesting. A Level 1 significant risk-taker of a Level 2 or Level 2 covered institution must not covered institution, the deferral period accelerate the vesting of a covered for deferred qualifying incentive-based person’s deferred long-term incentive compensation must be at least 3 years. plan amounts that is required to be (iii) Vesting of amounts during deferred under this part, except in the deferral period—(A) Pro rata vesting. case of death or disability of such During a deferral period, deferred covered person. qualifying incentive-based greater than or equal to $10 billion and less than $50 billion to comply with some or all of the provisions of §§ 372.5 and 372.7 through 372.11 if the Corporation determines that the Level 3 covered institution’s complexity of operations or compensation practices are consistent with those of a Level 1 or Level 2 covered institution. (b) Factors considered. Any exercise of authority under this section will be in writing by the Corporation in accordance with procedures established by the Corporation and will consider the activities, complexity of operations, risk profile, and compensation practices of the Level 3 covered institution, in addition to any other relevant factors. PO 00000 Frm 00149 Fmt 4701 Sfmt 4702 E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37818 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules (3) Adjustments of deferred qualifying incentive-based compensation and deferred long-term incentive plan compensation amounts. A Level 1 or Level 2 covered institution may not increase deferred qualifying incentivebased compensation or deferred longterm incentive plan amounts for a senior executive officer or significant risk-taker during the deferral period. For purposes of this paragraph, an increase in value attributable solely to a change in share value, a change in interest rates, or the payment of interest according to terms set out at the time of the award is not considered an increase in incentivebased compensation amounts. (4) Composition of deferred qualifying incentive-based compensation and deferred long-term incentive plan compensation for Level 1 and Level 2 covered institutions—(i) Cash and equity-like instruments. For a senior executive officer or significant risk-taker of a Level 1 or Level 2 covered institution that issues equity or is an affiliate of a covered institution that issues equity, any deferred qualifying incentive-based compensation or deferred long-term incentive plan amounts must include substantial portions of both deferred cash and equity-like instruments throughout the deferral period. (ii) Options. If a senior executive officer or significant risk-taker of a Level 1 or Level 2 covered institution receives incentive-based compensation for a performance period in the form of options, the total amount of such options that may be used to meet the minimum deferral amount requirements of paragraph (a)(1)(i) or (a)(2)(i) of this section is limited to no more than 15 percent of the amount of total incentivebased compensation awarded to the senior executive officer or significant risk-taker for that performance period. (b) Forfeiture and downward adjustment—(1) Compensation at risk. (i) A Level 1 or Level 2 covered institution must place at risk of forfeiture all unvested deferred incentive-based compensation of any senior executive officer or significant risk-taker, including unvested deferred amounts awarded under long-term incentive plans. (ii) A Level 1 or Level 2 covered institution must place at risk of downward adjustment all of a senior executive officer’s or significant risktaker’s incentive-based compensation amounts not yet awarded for the current performance period, including amounts payable under long-term incentive plans. (2) Events triggering forfeiture and downward adjustment review. At a VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 minimum, a Level 1 or Level 2 covered institution must consider forfeiture and downward adjustment of incentivebased compensation of senior executive officers and significant risk-takers described in paragraph (b)(3) of this section due to any of the following adverse outcomes at the covered institution: (i) Poor financial performance attributable to a significant deviation from the risk parameters set forth in the covered institution’s policies and procedures; (ii) Inappropriate risk taking, regardless of the impact on financial performance; (iii) Material risk management or control failures; (iv) Non-compliance with statutory, regulatory, or supervisory standards that results in: (A) Enforcement or legal action against the covered institution brought by a federal or state regulator or agency; or (B) A requirement that the covered institution report a restatement of a financial statement to correct a material error; and (v) Other aspects of conduct or poor performance as defined by the covered institution. (3) Senior executive officers and significant risk-takers affected by forfeiture and downward adjustment. A Level 1 or Level 2 covered institution must consider forfeiture and downward adjustment for a senior executive officer or significant risk-taker with direct responsibility, or responsibility due to the senior executive officer’s or significant risk-taker’s role or position in the covered institution’s organizational structure, for the events related to the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section. (4) Determining forfeiture and downward adjustment amounts. A Level 1 or Level 2 covered institution must consider, at a minimum, the following factors when determining the amount or portion of a senior executive officer’s or significant risk-taker’s incentive-based compensation that should be forfeited or adjusted downward: (i) The intent of the senior executive officer or significant risk-taker to operate outside the risk governance framework approved by the covered institution’s board of directors or to depart from the covered institution’s policies and procedures; (ii) The senior executive officer’s or significant risk-taker’s level of participation in, awareness of, and responsibility for, the events triggering the forfeiture and downward adjustment PO 00000 Frm 00150 Fmt 4701 Sfmt 4702 review set forth in paragraph (b)(2) of this section; (iii) Any actions the senior executive officer or significant risk-taker took or could have taken to prevent the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section; (iv) The financial and reputational impact of the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section to the covered institution, the line or sub-line of business, and individuals involved, as applicable, including the magnitude of any financial loss and the cost of known or potential subsequent fines, settlements, and litigation; (v) The causes of the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section, including any decisionmaking by other individuals; and (vi) Any other relevant information, including past behavior and past risk outcomes attributable to the senior executive officer or significant risktaker. (c) Clawback. A Level 1 or Level 2 covered institution must include clawback provisions in incentive-based compensation arrangements for senior executive officers and significant risktakers that, at a minimum, allow the covered institution to recover incentivebased compensation from a current or former senior executive officer or significant risk-taker for seven years following the date on which such compensation vests, if the covered institution determines that the senior executive officer or significant risk-taker engaged in: (1) Misconduct that resulted in significant financial or reputational harm to the covered institution; (2) Fraud; or (3) Intentional misrepresentation of information used to determine the senior executive officer or significant risk-taker’s incentive-based compensation. § 372.8 Additional prohibitions for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will be considered to provide incentives that appropriately balance risk and reward for purposes of § 372.4(c)(1) only if such institution complies with the following prohibitions. (a) Hedging. A Level 1 or Level 2 covered institution must not purchase a hedging instrument or similar instrument on behalf of a covered person to hedge or offset any decrease E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules in the value of the covered person’s incentive-based compensation. (b) Maximum incentive-based compensation opportunity. A Level 1 or Level 2 covered institution must not award incentive-based compensation to: (1) A senior executive officer in excess of 125 percent of the target amount for that incentive-based compensation; or (2) A significant risk-taker in excess of 150 percent of the target amount for that incentive-based compensation. (c) Relative performance measures. A Level 1 or Level 2 covered institution must not use incentive-based compensation performance measures that are based solely on industry peer performance comparisons. (d) Volume driven incentive-based compensation. A Level 1 or Level 2 covered institution must not provide incentive-based compensation to a covered person that is based solely on transaction revenue or volume without regard to transaction quality or compliance of the covered person with sound risk management. mstockstill on DSK3G9T082PROD with PROPOSALS2 § 372.9 Risk management and controls requirements for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will be considered to be compatible with effective risk management and controls for purposes of § 372.4(c)(2) only if such institution meets the following requirements. (a) A Level 1 or Level 2 covered institution must have a risk management framework for its incentive-based compensation program that: (1) Is independent of any lines of business; (2) Includes an independent compliance program that provides for internal controls, testing, monitoring, and training with written policies and procedures consistent with § 372.11; and (3) Is commensurate with the size and complexity of the covered institution’s operations. (b) A Level 1 or Level 2 covered institution must: (1) Provide individuals engaged in control functions with the authority to influence the risk-taking of the business areas they monitor; and (2) Ensure that covered persons engaged in control functions are compensated in accordance with the achievement of performance objectives linked to their control functions and independent of the performance of those business areas. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 (c) A Level 1 or Level 2 covered institution must provide for the independent monitoring of: (1) All incentive-based compensation plans in order to identify whether those plans provide incentives that appropriately balance risk and reward; (2) Events related to forfeiture and downward adjustment reviews and decisions of forfeiture and downward adjustment reviews in order to determine consistency with § 372.7(b); and (3) Compliance of the incentive-based compensation program with the covered institution’s policies and procedures. § 372.10 Governance requirements for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will not be considered to be supported by effective governance for purposes of § 372.4(c)(3), unless: (a) The covered institution establishes a compensation committee composed solely of directors who are not senior executive officers to assist the board of directors in carrying out its responsibilities under § 372.4(e); and (b) The compensation committee established pursuant to paragraph (a) of this section obtains: (1) Input from the risk and audit committees of the covered institution’s board of directors, or groups performing similar functions, and risk management function on the effectiveness of risk measures and adjustments used to balance risk and reward in incentivebased compensation arrangements; (2) A written assessment of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution, submitted on an annual or more frequent basis by the management of the covered institution and developed with input from the risk and audit committees of its board of directors, or groups performing similar functions, and from the covered institution’s risk management and audit functions; and (3) An independent written assessment of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution, submitted on an annual or more frequent basis by the internal audit or risk management function of the covered institution, PO 00000 Frm 00151 Fmt 4701 Sfmt 4702 37819 developed independently of the covered institution’s management. § 372.11 Policies and procedures requirements for Level 1 and Level 2 covered institutions. A Level 1 or Level 2 covered institution must develop and implement policies and procedures for its incentive-based compensation program that, at a minimum: (a) Are consistent with the prohibitions and requirements of this part; (b) Specify the substantive and procedural criteria for the application of forfeiture and clawback, including the process for determining the amount of incentive-based compensation to be clawed back; (c) Require that the covered institution maintain documentation of final forfeiture, downward adjustment, and clawback decisions; (d) Specify the substantive and procedural criteria for the acceleration of payments of deferred incentive-based compensation to a covered person, consistent with § 372.7(a)(1)(iii)(B) and (a)(2)(iii)(B)); (e) Identify and describe the role of any employees, committees, or groups authorized to make incentive-based compensation decisions, including when discretion is authorized; (f) Describe how discretion is expected to be exercised to appropriately balance risk and reward; (g) Require that the covered institution maintain documentation of the establishment, implementation, modification, and monitoring of incentive-based compensation arrangements, sufficient to support the covered institution’s decisions; (h) Describe how incentive-based compensation arrangements will be monitored; (i) Specify the substantive and procedural requirements of the independent compliance program consistent with § 372.9(a)(2); and (j) Ensure appropriate roles for risk management, risk oversight, and other control function personnel in the covered institution’s processes for: (1) Designing incentive-based compensation arrangements and determining awards, deferral amounts, deferral periods, forfeiture, downward adjustment, clawback, and vesting; and (2) Assessing the effectiveness of incentive-based compensation arrangements in restraining inappropriate risk-taking. § 372.12 Indirect actions. A covered institution must not indirectly, or through or by any other E:\FR\FM\10JNP2.SGM 10JNP2 37820 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules person, do anything that would be unlawful for such covered institution to do directly under this part. § 372.13 Enforcement. The provisions of this part shall be enforced under section 505 of the Gramm-Leach-Bliley Act and, for purposes of such section, a violation of this part shall be treated as a violation of subtitle A of title V of such Act. National Credit Union Administration 12 CFR Chapter VII Authority and Issuance For the reasons stated in the joint preamble, the National Credit Union Administration proposes to amend chapter VII of title 12 of the Code of Federal Regulations as follows: PART 741—REQUIREMENTS FOR INSURANCE 4. The authority citation for part 741 continues to read as follows: ■ Authority: 12 U.S.C. 1757, 1766, 1781– 1790, and 1790d; 31 U.S.C. 3717. ■ 5. Add § 741.226 to read as follows: § 741.226 Incentive-based compensation arrangements. Any credit union which is insured pursuant to Title II of the Act must adhere to the requirements stated in part 751 of this chapter. ■ 6. Add part 751 to subchapter A to read as follows. mstockstill on DSK3G9T082PROD with PROPOSALS2 PART 751—INCENTIVE-BASED COMPENSATION ARRANGEMENTS Sec. 751.1 Authority, scope, and initial applicability. 751.2 Definitions. 751.3 Applicability. 751.4 Requirements and prohibitions applicable to all credit unions subject to this part. 751.5 Additional disclosure and recordkeeping requirements for Level 1 and Level 2 credit unions. 751.6 Reservation of authority for Level 3 credit unions. 751.7 Deferral, forfeiture and downward adjustment, and clawback requirements for Level 1 and Level 2 credit unions. 751.8 Additional prohibitions for Level 1 and Level 2 credit unions. 751.9 Risk management and controls requirements for Level 1 and Level 2 credit unions. 751.10 Governance requirements for Level 1 and Level 2 credit unions. 751.11 Policies and procedures requirements for Level 1 and Level 2 credit unions. 751.12 Indirect actions. 751.13 Enforcement. 751.14 Credit unions in conservatorship or liquidation. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 Authority: 12 U.S.C. 1751 et seq. and 5641. § 751.1 Authority, scope, and initial applicability. (a) Authority. This part is issued pursuant to section 956 of the DoddFrank Wall Street Reform and Consumer Protection Act (12 U.S.C. 5641) and the Federal Credit Union Act (12 U.S.C. 1751 et seq.) (b) Scope. This part applies to any federally insured credit union, or any credit union eligible to make application to become an insured credit union under 12 U.S.C. 1781, with average total consolidated assets greater than or equal to $1 billion that offers incentive-based compensation to covered persons. (c) Initial applicability—(1) Compliance date. A credit union must meet the requirements of this part no later than [Date of the beginning of the first calendar quarter that begins at least 540 days after a final rule is published in the Federal Register]. Whether a credit union is a Level 1, Level 2, or Level 3 credit union at that time will be determined based on average total consolidated assets as of [Date of the beginning of the first calendar quarter that begins after a final rule is published in the Federal Register]. (2) Grandfathered plans. A credit union is not required to comply with the requirements of this part with respect to any incentive-based compensation plan with a performance period that begins before [Compliance Date as described in paragraph (c)(1) of this section]. (d) Preservation of authority. Nothing in this part in any way limits the authority of NCUA under other provisions of applicable law and regulations. § 751.2 Definitions. For purposes of this part only, the following definitions apply unless otherwise specified: (a) [Reserved]. (b) Average total consolidated assets means the average of a credit union’s total consolidated assets, as reported on the credit union’s regulatory reports, for the four most recent consecutive quarters. If a credit union has not filed a regulatory report for each of the four most recent consecutive quarters, the credit union’s average total consolidated assets means the average of its total consolidated assets, as reported on its regulatory reports, for the most recent quarter or consecutive quarters, as applicable. Average total consolidated assets are measured on the as-of date of the most recent regulatory report used in the calculation of the average. PO 00000 Frm 00152 Fmt 4701 Sfmt 4702 (c) To award incentive-based compensation means to make a final determination, conveyed to a covered person, of the amount of incentivebased compensation payable to the covered person for performance over a performance period. (d) Board of directors means the governing body of a credit union that oversees the activities of the credit union. (e) Clawback means a mechanism by which a credit union can recover vested incentive-based compensation from a covered person. (f) Compensation, fees, or benefits means all direct and indirect payments, both cash and non-cash, awarded to, granted to, or earned by or for the benefit of, any covered person in exchange for services rendered to a credit union. (g) [Reserved]. (h) Control function means a compliance, risk management, internal audit, legal, human resources, accounting, financial reporting, or finance role responsible for identifying, measuring, monitoring, or controlling risk-taking. (i) [Reserved]. (j) Covered person means any executive officer, employee, or director who receives incentive-based compensation at a credit union. (k) Deferral means the delay of vesting of incentive-based compensation beyond the date on which the incentivebased compensation is awarded. (l) Deferral period means the period of time between the date a performance period ends and the last date on which the incentive-based compensation awarded for such performance period vests. (m) [Reserved]. (n) Director of a credit union means a member of the board of directors. (o) Downward adjustment means a reduction of the amount of a covered person’s incentive-based compensation not yet awarded for any performance period that has already begun, including amounts payable under long-term incentive plans, in accordance with a forfeiture and downward adjustment review under § 751.7(b). (p) [Reserved]. (q) Forfeiture means a reduction of the amount of deferred incentive-based compensation awarded to a covered person that has not vested. (r) Incentive-based compensation means any variable compensation, fees, or benefits that serve as an incentive or reward for performance. (s) Incentive-based compensation arrangement means an agreement between a credit union and a covered E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules person, under which the credit union provides incentive-based compensation to the covered person, including incentive-based compensation delivered through one or more incentive-based compensation plans. (t) Incentive-based compensation plan means a document setting forth terms and conditions governing the opportunity for and the payment of incentive-based compensation payments to one or more covered persons. (u) Incentive-based compensation program means a credit union’s framework for incentive-based compensation that governs incentivebased compensation practices and establishes related controls. (v) Level 1 credit union means a credit union with average total consolidated assets greater than or equal to $250 billion. (w) Level 2 credit union means a credit union with average total consolidated assets greater than or equal to $50 billion that is not a Level 1 credit union. (x) Level 3 credit union means a credit union with average total consolidated assets greater than or equal to $1 billion that is not a Level 1 credit union or Level 2 credit union. (y) Long-term incentive plan means a plan to provide incentive-based compensation that is based on a performance period of at least three years. (z) [Reserved]. (aa) Performance period means the period during which the performance of a covered person is assessed for purposes of determining incentivebased compensation. (bb) [Reserved]. (cc) Qualifying incentive-based compensation means the amount of incentive-based compensation awarded to a covered person for a particular performance period, excluding amounts awarded to the covered person for that particular performance period under a long-term incentive plan. (dd) [Reserved]. (ee) Regulatory report means NCUA form 5300 or 5310 call report. (ff) [Reserved]. (gg) Senior executive officer means a covered person who holds the title or, without regard to title, salary, or compensation, performs the function of one or more of the following positions at a credit union for any period of time in the relevant performance period: President, chief executive officer, executive chairman, chief operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer, chief compliance officer, chief audit VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 executive, chief credit officer, chief accounting officer, or head of a major business line or control function. (hh) Significant risk-taker means: (1) Any covered person at a Level 1 or Level 2 credit union, other than a senior executive officer, who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period of which at least one-third is incentivebased compensation and is— (i) A covered person of a Level 1 credit union who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period that placed the covered person among the highest 5 percent in annual base salary and incentive-based compensation among all covered persons (excluding senior executive officers) of the Level 1 credit union; (ii) A covered person of a Level 2 credit union who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period that placed the covered person among the highest 2 percent in annual base salary and incentive-based compensation among all covered persons (excluding senior executive officers) of the Level 2 credit union; or (iii) A covered person of a credit union who may commit or expose 0.5 percent or more of the net worth or total capital of the credit union; and (2) Any covered person at a Level 1 or Level 2 credit union, other than a senior executive officer, who is designated as a ‘‘significant risk-taker’’ by NCUA because of that person’s ability to expose a credit union to risks that could lead to material financial loss in relation to the credit union’s size, capital, or overall risk tolerance, in accordance with procedures established by NCUA, or by the credit union. (3) [Reserved] (4) If NCUA determines, in accordance with procedures established by NCUA, that a Level 1 credit union’s activities, complexity of operations, risk profile, and compensation practices are similar to those of a Level 2 credit union, the Level 1 credit union may apply paragraph (hh)(1)(i) of this section to covered persons of the Level 1 credit union by substituting ‘‘2 percent’’ for ‘‘5 percent’’. (ii) [Reserved] (jj) Vesting of incentive-based compensation means the transfer of ownership of the incentive-based compensation to the covered person to PO 00000 Frm 00153 Fmt 4701 Sfmt 4702 37821 whom the incentive-based compensation was awarded, such that the covered person’s right to the incentive-based compensation is no longer contingent on the occurrence of any event. 751.3 Applicability. (a) When average total consolidated assets increase—(1) In general. A credit union shall become a Level 1, Level 2, or Level 3 credit union when its average total consolidated assets increase to an amount that equals or exceeds $250 billion, $50 billion, or $1 billion, respectively. (2) Compliance date. A credit union that becomes a Level 1, Level 2, or Level 3 credit union pursuant to paragraph (a)(1) of this section shall comply with the requirements of this part for a Level 1, Level 2, or Level 3 credit union, respectively, not later than the first day of the first calendar quarter that begins at least 540 days after the date on which the credit union becomes a Level 1, Level 2, or Level 3 credit union, respectively. Until that day, the Level 1, Level 2, or Level 3 credit union will remain subject to the requirements of this part, if any, that applied to the credit union on the day before the date on which it became a Level 1, Level 2, or Level 3 credit union. (3) Grandfathered plans. A credit union that becomes a Level 1, Level 2, or Level 3 credit union under paragraph (a)(1) of this section is not required to comply with requirements of this part applicable to a Level 1, Level 2, or Level 3 credit union, respectively, with respect to any incentive-based compensation plan with a performance period that begins before the date described in paragraph (a)(2) of this section. (b) When total consolidated assets decrease. A Level 1, Level 2, or Level 3 credit union will remain subject to the requirements applicable to such credit union under this part unless and until the total consolidated assets of the credit union, as reported on the credit union’s regulatory reports, fall below $250 billion, $50 billion, or $1 billion, respectively, for each of four consecutive quarters. The calculation will be effective on the as-of date of the fourth consecutive regulatory report. 751.4 Requirements and prohibitions applicable to all credit unions subject to this part. (a) In general. A credit union must not establish or maintain any type of incentive-based compensation arrangement, or any feature of any such arrangement, that encourages inappropriate risks by the credit union: E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37822 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules (1) By providing a covered person with excessive compensation, fees, or benefits; or (2) That could lead to material financial loss to the credit union. (b) Excessive compensation. Compensation, fees, and benefits are considered excessive for purposes of paragraph (a)(1) of this section when amounts paid are unreasonable or disproportionate to the value of the services performed by a covered person, taking into consideration all relevant factors, including, but not limited to: (1) The combined value of all compensation, fees, or benefits provided to the covered person; (2) The compensation history of the covered person and other individuals with comparable expertise at the credit union; (3) The financial condition of the credit union; (4) Compensation practices at comparable credit unions, based upon such factors as asset size, geographic location, and the complexity of the credit union’s operations and assets; (5) For post-employment benefits, the projected total cost and benefit to the credit union; and (6) Any connection between the covered person and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the credit union. (c) Material financial loss. An incentive-based compensation arrangement at a credit union encourages inappropriate risks that could lead to material financial loss to the credit union, unless the arrangement: (1) Appropriately balances risk and reward; (2) Is compatible with effective risk management and controls; and (3) Is supported by effective governance. (d) Performance measures. An incentive-based compensation arrangement will not be considered to appropriately balance risk and reward for purposes of paragraph (c)(1) of this section unless: (1) The arrangement includes financial and non-financial measures of performance, including considerations of risk-taking, that are relevant to a covered person’s role within a credit union and to the type of business in which the covered person is engaged and that are appropriately weighted to reflect risk-taking; (2) The arrangement is designed to allow non-financial measures of performance to override financial measures of performance when VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 appropriate in determining incentivebased compensation; and (3) Any amounts to be awarded under the arrangement are subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance. (e) Board of directors. A credit union’s board of directors, or a committee thereof, must: (1) Conduct oversight of the credit union’s incentive-based compensation program; (2) Approve incentive-based compensation arrangements for senior executive officers, including the amounts of all awards and, at the time of vesting, payouts under such arrangements; and (3) Approve any material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers. (f) Disclosure and recordkeeping requirements. A credit union must create annually and maintain for a period of at least seven years records that document the structure of all its incentive-based compensation arrangements and demonstrate compliance with this part. A credit union must disclose the records to NCUA upon request. At a minimum, the records must include copies of all incentive-based compensation plans, a record of who is subject to each plan, and a description of how the incentivebased compensation program is compatible with effective risk management and controls. (g) Rule of construction. A credit union is not required to report the actual amount of compensation, fees, or benefits of individual covered persons as part of the disclosure and recordkeeping requirements under this part. § 751.5 Additional disclosure and recordkeeping requirements for Level 1 and Level 2 credit unions. (a) A Level 1 or Level 2 credit union must create annually and maintain for a period of at least seven years records that document: (1) The credit union’s senior executive officers and significant risktakers, listed by legal entity, job function, organizational hierarchy, and line of business; (2) The incentive-based compensation arrangements for senior executive officers and significant risk-takers, including information on percentage of incentive-based compensation deferred and form of award; (3) Any forfeiture and downward adjustment or clawback reviews and PO 00000 Frm 00154 Fmt 4701 Sfmt 4702 decisions for senior executive officers and significant risk-takers; and (4) Any material changes to the credit union’s incentive-based compensation arrangements and policies. (b) A Level 1 or Level 2 credit union must create and maintain records in a manner that allows for an independent audit of incentive-based compensation arrangements, policies, and procedures, including, those required under § 751.11. (c) A Level 1 or Level 2 credit union must provide the records described in paragraph (a) of this section to NCUA in such form and with such frequency as requested by NCUA. § 751.6 Reservation of authority for Level 3 credit unions. (a) In general. NCUA may require a Level 3 credit union with average total consolidated assets greater than or equal to $10 billion and less than $50 billion to comply with some or all of the provisions of §§ 751.5 and 751.7 through 751.11 if NCUA determines that the Level 3 credit union’s complexity of operations or compensation practices are consistent with those of a Level 1 or Level 2 credit union. (b) Factors considered. Any exercise of authority under this section will be in writing by the NCUA Board in accordance with procedures established by the NCUA Board and will consider the activities, complexity of operations, risk profile, and compensation practices of the Level 3 credit union, in addition to any other relevant factors. § 751.7 Deferral, forfeiture and downward adjustment, and clawback requirements for Level 1 and Level 2 credit unions. An incentive-based compensation arrangement at a Level 1 or Level 2 credit union will not be considered to appropriately balance risk and reward, for purposes of § 751.4(c)(1), unless the following requirements are met. (a) Deferral. (1) Qualifying incentivebased compensation must be deferred as follows: (i) Minimum required deferral amount. (A) A Level 1 credit union must defer at least 60 percent of a senior executive officer’s qualifying incentivebased compensation awarded for each performance period. (B) A Level 1 credit union must defer at least 50 percent of a significant risktaker’s qualifying incentive-based compensation awarded for each performance period. (C) A Level 2 credit union must defer at least 50 percent of a senior executive officer’s qualifying incentive-based compensation awarded for each performance period. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules (D) A Level 2 credit union must defer at least 40 percent of a significant risktaker’s qualifying incentive-based compensation awarded for each performance period. (ii) Minimum required deferral period. (A) For a senior executive officer or significant risk-taker of a Level 1 credit union, the deferral period for deferred qualifying incentive-based compensation must be at least 4 years. (B) For a senior executive officer or significant risk-taker of a Level 2 credit union, the deferral period for deferred qualifying incentive-based compensation must be at least 3 years. (iii) Vesting of amounts during deferral period—(A) Pro rata vesting. During a deferral period, deferred qualifying incentive-based compensation may not vest faster than on a pro rata annual basis beginning no earlier than the first anniversary of the end of the performance period for which the amounts were awarded. (B) Acceleration of vesting. A Level 1 or Level 2 credit union must not accelerate the vesting of a covered person’s deferred qualifying incentivebased compensation that is required to be deferred under this part, except in the case of: (1) Death or disability of such covered person; or (2) The payment of income taxes that become due on deferred amounts before the covered person is vested in the deferred amount. For purposes of this paragraph, any accelerated vesting must be deducted from the scheduled deferred amounts proportionally to the deferral schedule. (2) Incentive-based compensation awarded under a long-term incentive plan must be deferred as follows: (i) Minimum required deferral amount. (A) A Level 1 credit union must defer at least 60 percent of a senior executive officer’s incentive-based compensation awarded under a longterm incentive plan for each performance period. (B) A Level 1 credit union must defer at least 50 percent of a significant risktaker’s incentive-based compensation awarded under a long-term incentive plan for each performance period. (C) A Level 2 credit union must defer at least 50 percent of a senior executive officer’s incentive-based compensation awarded under a long-term incentive plan for each performance period. (D) A Level 2 credit union must defer at least 40 percent of a significant risktaker’s incentive-based compensation awarded under a long-term incentive plan for each performance period. (ii) Minimum required deferral period. (A) For a senior executive officer or VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 significant risk-taker of a Level 1 credit union, the deferral period for deferred long-term incentive plan amounts must be at least 2 years. (B) For a senior executive officer or significant risk-taker of a Level 2 credit union, the deferral period for deferred long-term incentive plan amounts must be at least 1 year. (iii) Vesting of amounts during deferral period—(A) Pro rata vesting. During a deferral period, deferred longterm incentive plan amounts may not vest faster than on a pro rata annual basis beginning no earlier than the first anniversary of the end of the performance period for which the amounts were awarded. (B) Acceleration of vesting. A Level 1 or Level 2 credit union must not accelerate the vesting of a covered person’s deferred long-term incentive plan amounts that is required to be deferred under this part, except in the case of: (1) Death or disability of such covered person; or (2) The payment of income taxes that become due on deferred amounts before the covered person is vested in the deferred amount. For purposes of this paragraph, any accelerated vesting must be deducted from the scheduled deferred amounts proportionally to the deferral schedule. (3) Adjustments of deferred qualifying incentive-based compensation and deferred long-term incentive plan compensation amounts. A Level 1 or Level 2 credit union may not increase deferred qualifying incentive-based compensation or deferred long-term incentive plan amounts for a senior executive officer or significant risk-taker during the deferral period. For purposes of this paragraph, an increase in value attributable solely to a change in share value, a change in interest rates, or the payment of interest according to terms set out at the time of the award is not considered an increase in incentivebased compensation amounts. (4) [Reserved]. (b) Forfeiture and downward adjustment—(1) Compensation at risk. (i) A Level 1 or Level 2 credit union must place at risk of forfeiture all unvested deferred incentive-based compensation of any senior executive officer or significant risk-taker, including unvested deferred amounts awarded under long-term incentive plans. (ii) A Level 1 or Level 2 credit union must place at risk of downward adjustment all of a senior executive officer’s or significant risk-taker’s incentive-based compensation amounts not yet awarded for the current PO 00000 Frm 00155 Fmt 4701 Sfmt 4702 37823 performance period, including amounts payable under long-term incentive plans. (2) Events triggering forfeiture and downward adjustment review. At a minimum, a Level 1 or Level 2 credit union must consider forfeiture and downward adjustment of incentivebased compensation of senior executive officers and significant risk-takers described in paragraph (b)(3) of this section due to any of the following adverse outcomes at the credit union: (i) Poor financial performance attributable to a significant deviation from the risk parameters set forth in the credit union’s policies and procedures; (ii) Inappropriate risk taking, regardless of the impact on financial performance; (iii) Material risk management or control failures; (iv) Non-compliance with statutory, regulatory, or supervisory standards that results in: (A) Enforcement or legal action against the credit union brought by a federal or state regulator or agency; or (B) A requirement that the credit union report a restatement of a financial statement to correct a material error; and (v) Other aspects of conduct or poor performance as defined by the credit union. (3) Senior executive officers and significant risk-takers affected by forfeiture and downward adjustment. A Level 1 or Level 2 credit union must consider forfeiture and downward adjustment for a senior executive officer or significant risk-taker with direct responsibility, or responsibility due to the senior executive officer’s or significant risk-taker’s role or position in the credit union’s organizational structure, for the events related to the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section. (4) Determining forfeiture and downward adjustment amounts. A Level 1 or Level 2 credit union must consider, at a minimum, the following factors when determining the amount or portion of a senior executive officer’s or significant risk-taker’s incentive-based compensation that should be forfeited or adjusted downward: (i) The intent of the senior executive officer or significant risk-taker to operate outside the risk governance framework approved by the credit union’s board of directors or to depart from the credit union’s policies and procedures; (ii) The senior executive officer’s or significant risk-taker’s level of participation in, awareness of, and responsibility for, the events triggering E:\FR\FM\10JNP2.SGM 10JNP2 37824 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section; (iii) Any actions the senior executive officer or significant risk-taker took or could have taken to prevent the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section; (iv) The financial and reputational impact of the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section to the credit union, the line or sub-line of business, and individuals involved, as applicable, including the magnitude of any financial loss and the cost of known or potential subsequent fines, settlements, and litigation; (v) The causes of the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section, including any decisionmaking by other individuals; and (vi) Any other relevant information, including past behavior and past risk outcomes attributable to the senior executive officer or significant risktaker. (c) Clawback. A Level 1 or Level 2 credit union must include clawback provisions in incentive-based compensation arrangements for senior executive officers and significant risktakers that, at a minimum, allow the credit union to recover incentive-based compensation from a current or former senior executive officer or significant risk-taker for seven years following the date on which such compensation vests, if the credit union determines that the senior executive officer or significant risk-taker engaged in: (1) Misconduct that resulted in significant financial or reputational harm to the credit union; (2) Fraud; or (3) Intentional misrepresentation of information used to determine the senior executive officer or significant risk-taker’s incentive-based compensation. mstockstill on DSK3G9T082PROD with PROPOSALS2 § 751.8 Additional prohibitions for Level 1 and Level 2 credit unions. An incentive-based compensation arrangement at a Level 1 or Level 2 credit union will be considered to provide incentives that appropriately balance risk and reward for purposes of § 751.4(c)(1) only if such credit union complies with the following prohibitions. (a) Hedging. A Level 1 or Level 2 credit union must not purchase a hedging instrument or similar instrument on behalf of a covered person to hedge or offset any decrease VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 in the value of the covered person’s incentive-based compensation. (b) Maximum incentive-based compensation opportunity. A Level 1 or Level 2 credit union must not award incentive-based compensation to: (1) A senior executive officer in excess of 125 percent of the target amount for that incentive-based compensation; or (2) A significant risk-taker in excess of 150 percent of the target amount for that incentive-based compensation. (c) Relative performance measures. A Level 1 or Level 2 credit union must not use incentive-based compensation performance measures that are based solely on industry peer performance comparisons. (d) Volume driven incentive-based compensation. A Level 1 or Level 2 credit union must not provide incentive-based compensation to a covered person that is based solely on transaction revenue or volume without regard to transaction quality or compliance of the covered person with sound risk management. § 751.9 Risk management and controls requirements for Level 1 and Level 2 credit unions. An incentive-based compensation arrangement at a Level 1 or Level 2 credit union will be considered to be compatible with effective risk management and controls for purposes of § 751.4(c)(2) only if such credit union meets the following requirements. (a) A Level 1 or Level 2 credit union must have a risk management framework for its incentive-based compensation program that: (1) Is independent of any lines of business; (2) Includes an independent compliance program that provides for internal controls, testing, monitoring, and training with written policies and procedures consistent with § 751.11; and (3) Is commensurate with the size and complexity of the credit union’s operations. (b) A Level 1 or Level 2 credit union must: (1) Provide individuals engaged in control functions with the authority to influence the risk-taking of the business areas they monitor; and (2) Ensure that covered persons engaged in control functions are compensated in accordance with the achievement of performance objectives linked to their control functions and independent of the performance of those business areas. (c) A Level 1 or Level 2 credit union must provide for the independent monitoring of: PO 00000 Frm 00156 Fmt 4701 Sfmt 4702 (1) All incentive-based compensation plans in order to identify whether those plans provide incentives that appropriately balance risk and reward; (2) Events related to forfeiture and downward adjustment reviews and decisions of forfeiture and downward adjustment reviews in order to determine consistency with § 751.7(b); and (3) Compliance of the incentive-based compensation program with the credit union’s policies and procedures. § 751.10 Governance requirements for Level 1 and Level 2 credit unions. An incentive-based compensation arrangement at a Level 1 or Level 2 credit union will not be considered to be supported by effective governance for purposes of § 751.4(c)(3), unless: (a) The credit union establishes a compensation committee composed solely of directors who are not senior executive officers to assist the board of directors in carrying out its responsibilities under § 751.4(e); and (b) The compensation committee established pursuant to paragraph (a) of this section obtains: (1) Input from the risk and audit committees of the credit union’s board of directors, or groups performing similar functions, and risk management function on the effectiveness of risk measures and adjustments used to balance risk and reward in incentivebased compensation arrangements; (2) A written assessment of the effectiveness of the credit union’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the credit union, submitted on an annual or more frequent basis by the management of the credit union and developed with input from the risk and audit committees of its board of directors, or groups performing similar functions, and from the credit union’s risk management and audit functions; and (3) An independent written assessment of the effectiveness of the credit union’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the credit union, submitted on an annual or more frequent basis by the internal audit or risk management function of the credit union, developed independently of the credit union’s management. E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 § 751.11 Policies and procedures requirements for Level 1 and Level 2 credit unions. A Level 1 or Level 2 credit union must develop and implement policies and procedures for its incentive-based compensation program that, at a minimum: (a) Are consistent with the prohibitions and requirements of this part; (b) Specify the substantive and procedural criteria for the application of forfeiture and clawback, including the process for determining the amount of incentive-based compensation to be clawed back; (c) Require that the credit union maintain documentation of final forfeiture, downward adjustment, and clawback decisions; (d) Specify the substantive and procedural criteria for the acceleration of payments of deferred incentive-based compensation to a covered person, consistent with § 751.7(a)(1)(iii)(B) and (a)(2)(iii)(B)); (e) Identify and describe the role of any employees, committees, or groups authorized to make incentive-based compensation decisions, including when discretion is authorized; (f) Describe how discretion is expected to be exercised to appropriately balance risk and reward; (g) Require that the credit union maintain documentation of the establishment, implementation, modification, and monitoring of incentive-based compensation arrangements, sufficient to support the credit union’s decisions; (h) Describe how incentive-based compensation arrangements will be monitored; (i) Specify the substantive and procedural requirements of the independent compliance program consistent with § 751.9(a)(2); and (j) Ensure appropriate roles for risk management, risk oversight, and other control function personnel in the credit union’s processes for: (1) Designing incentive-based compensation arrangements and determining awards, deferral amounts, deferral periods, forfeiture, downward adjustment, clawback, and vesting; and (2) Assessing the effectiveness of incentive-based compensation arrangements in restraining inappropriate risk-taking. § 751.12 Indirect actions. A credit union must not indirectly, or through or by any other person, do anything that would be unlawful for such credit union to do directly under this part. The term ‘‘any other person’’ VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 includes a credit union service organization described in 12 U.S.C. 1757(7)(I) or established under similar state law. § 751.13 Enforcement. The provisions of this part shall be enforced under section 505 of the Gramm-Leach-Bliley Act and, for purposes of such section, a violation of this part shall be treated as a violation of subtitle A of title V of such Act. § 751.14 Credit unions in conservatorship or liquidation. (a) Scope. This section applies to federally insured credit unions for which any one or more of the following parties are acting as conservator or liquidating agent: (1) The National Credit Union Administration Board; (2) The appropriate state supervisory authority; or (3) Any party designated by the National Credit Union Administration Board or by the appropriate state supervisory authority. (b) Compensation requirements. For a credit union subject to this section, the requirements of this part do not apply. Instead, the conservator or liquidating agent, in its discretion and according to the circumstances deemed relevant in the judgment of the conservator or liquidating agent, will determine the requirements that best fulfill the requirements and purposes of 12 U.S.C. 5641. The conservator or liquidating agent may determine appropriate transition terms and provisions in the event that the credit union ceases to be within the scope of this section. Federal Housing Finance Agency Authority and Issuance Accordingly, for the reasons stated in the joint preamble, under the authority of 12 U.S.C. 4526 and 5641, FHFA proposes to amend chapter XII of title 12 of the Code of Federal Regulation as follows: ■ 7. Add part 1232 to subchapter B to read as follows: PART 1232—INCENTIVE-BASED COMPENSATION ARRANGEMENTS Sec. 1232.1 Authority, scope, and initial applicability. 1232.2 Definitions. 1232.3 Applicability. 1232.4 Requirements and prohibitions applicable to all covered institutions. 1232.5 Additional disclosure and recordkeeping requirements for Level 1 and Level 2 covered institutions. 1232.6 Reservation of authority for Level 3 covered institutions. PO 00000 Frm 00157 Fmt 4701 Sfmt 4702 37825 1232.7 Deferral, forfeiture and downward adjustment, and clawback requirements for Level 1 and Level 2 covered institutions. 1232.8 Additional prohibitions for Level 1 and Level 2 covered institutions. 1232.9 Risk management and controls requirements for Level 1 and Level 2 covered institutions. 1232.10 Governance requirements for Level 1 and Level 2 covered institutions. 1232.11 Policies and procedures requirements for Level 1 and Level 2 covered institutions. 1232.12 Indirect actions. 1232.13 Enforcement. 1232.14 Covered institutions in conservatorship or receivership. Authority: 12 U.S.C. 4511(b), 4513, 4514, 4518, 4526, ch. 46 subch. III, and 5641. § 1232.1 Authority, scope, and initial applicability. (a) Authority. This part is issued pursuant to section 956 of the DoddFrank Wall Street Reform and Consumer Protection Act (12 U.S.C. 5641) and sections 1311, 1313, 1314, 1318, and 1319G and Subtitle C of the Safety and Soundness Act (12 U.S.C. 4511(b), 4513, 4514, 4518, 4526, and ch. 46 subch. III). (b) Scope. This part applies to a covered institution with average total consolidated assets greater than or equal to $1 billion that offers incentive-based compensation to covered persons. (c) Initial applicability—(1) Compliance date. A covered institution must meet the requirements of this part no later than [Date of the beginning of the first calendar quarter that begins at least 540 days after a final rule is published in the Federal Register]. Whether a covered institution other than a Federal Home Loan Bank is a Level 1, Level 2, or Level 3 covered institution at that time will be determined based on average total consolidated assets as of [Date of the beginning of the first calendar quarter that begins after a final rule is published in the Federal Register]. (2) Grandfathered plans. A covered institution is not required to comply with the requirements of this part with respect to any incentive-based compensation plan with a performance period that begins before [Compliance Date as described in paragraph (c)(1) of this section]. (d) Preservation of authority. Nothing in this part in any way limits the authority of the Federal Housing Finance Agency under other provisions of applicable law and regulations. § 1232.2 Definitions. For purposes of this part only, the following definitions apply unless otherwise specified: (a) [Reserved]. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37826 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules (b) Average total consolidated assets means the average of a regulated institution’s total consolidated assets, as reported on the regulated institution’s regulatory reports, for the four most recent consecutive quarters. If a regulated institution has not filed a regulatory report for each of the four most recent consecutive quarters, the regulated institution’s average total consolidated assets means the average of its total consolidated assets, as reported on its regulatory reports, for the most recent quarter or consecutive quarters, as applicable. Average total consolidated assets are measured on the as-of date of the most recent regulatory report used in the calculation of the average. (c) To award incentive-based compensation means to make a final determination, conveyed to a covered person, of the amount of incentivebased compensation payable to the covered person for performance over a performance period. (d) Board of directors means the governing body of a covered institution that oversees the activities of the covered institution, often referred to as the board of directors or board of managers. (e) Clawback means a mechanism by which a covered institution can recover vested incentive-based compensation from a covered person. (f) Compensation, fees, or benefits means all direct and indirect payments, both cash and non-cash, awarded to, granted to, or earned by or for the benefit of, any covered person in exchange for services rendered to a covered institution. (g) [Reserved]. (h) Control function means a compliance, risk management, internal audit, legal, human resources, accounting, financial reporting, or finance role responsible for identifying, measuring, monitoring, or controlling risk-taking. (i) Covered institution means a regulated institution with average total consolidated assets greater than or equal to $1 billion. (j) Covered person means any executive officer, employee, director, or principal shareholder who receives incentive-based compensation at a covered institution. (k) Deferral means the delay of vesting of incentive-based compensation beyond the date on which the incentivebased compensation is awarded. (l) Deferral period means the period of time between the date a performance period ends and the last date on which the incentive-based compensation VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 awarded for such performance period vests. (m) [Reserved]. (n) Director of a covered institution means a member of the board of directors. (o) Downward adjustment means a reduction of the amount of a covered person’s incentive-based compensation not yet awarded for any performance period that has already begun, including amounts payable under long-term incentive plans, in accordance with a forfeiture and downward adjustment review under § 1232.7(b). (p) Equity-like instrument means: (1) Equity in the covered institution or of any affiliate of the covered institution; or (2) A form of compensation: (i) Payable at least in part based on the price of the shares or other equity instruments of the covered institution or of any affiliate of the covered institution; or (ii) That requires, or may require, settlement in the shares of the covered institution or of any affiliate of the covered institution. (q) Forfeiture means a reduction of the amount of deferred incentive-based compensation awarded to a covered person that has not vested. (r) Incentive-based compensation means any variable compensation, fees, or benefits that serve as an incentive or reward for performance. (s) Incentive-based compensation arrangement means an agreement between a covered institution and a covered person, under which the covered institution provides incentivebased compensation to the covered person, including incentive-based compensation delivered through one or more incentive-based compensation plans. (t) Incentive-based compensation plan means a document setting forth terms and conditions governing the opportunity for and the payment of incentive-based compensation payments to one or more covered persons. (u) Incentive-based compensation program means a covered institution’s framework for incentive-based compensation that governs incentivebased compensation practices and establishes related controls. (v) Level 1 covered institution means a covered institution with average total consolidated assets greater than or equal to $250 billion that is not a Federal Home Loan Bank. (w) Level 2 covered institution means a covered institution with average total consolidated assets greater than or equal to $50 billion that is not a Level 1 covered institution and any Federal PO 00000 Frm 00158 Fmt 4701 Sfmt 4702 Home Loan Bank that is a covered institution. (x) Level 3 covered institution means a covered institution with average total consolidated assets greater than or equal to $1 billion that is not a Level 1 covered institution or Level 2 covered institution. (y) Long-term incentive plan means a plan to provide incentive-based compensation that is based on a performance period of at least three years. (z) Option means an instrument through which a covered institution provides a covered person the right, but not the obligation, to buy a specified number of shares representing an ownership stake in a company at a predetermined price within a set time period or on a date certain, or any similar instrument, such as a stock appreciation right. (aa) Performance period means the period during which the performance of a covered person is assessed for purposes of determining incentivebased compensation. (bb) Principal shareholder means a natural person who, directly or indirectly, or acting through or in concert with one or more persons, owns, controls, or has the power to vote 10 percent or more of any class of voting securities of a covered institution. (cc) Qualifying incentive-based compensation means the amount of incentive-based compensation awarded to a covered person for a particular performance period, excluding amounts awarded to the covered person for that particular performance period under a long-term incentive plan. (dd) Regulated institution means an Enterprise, as defined in 12 U.S.C. 4502(10), and a Federal Home Loan Bank. (ee) Regulatory report means the Call Report Statement of Condition. (ff) [Reserved]. (gg) Senior executive officer means a covered person who holds the title or, without regard to title, salary, or compensation, performs the function of one or more of the following positions at a covered institution for any period of time in the relevant performance period: President, chief executive officer, executive chairman, chief operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer, chief compliance officer, chief audit executive, chief credit officer, chief accounting officer, or head of a major business line or control function. (hh) Significant risk-taker means: (1) Any covered person at a Level 1 or Level 2 covered institution, other E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules than a senior executive officer, who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period of which at least one-third is incentive-based compensation and is— (i) A covered person of a Level 1 covered institution who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period that placed the covered person among the highest 5 percent in annual base salary and incentive-based compensation among all covered persons (excluding senior executive officers) of the Level 1 covered institution; (ii) A covered person of a Level 2 covered institution who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period that placed the covered person among the highest 2 percent in annual base salary and incentive-based compensation among all covered persons (excluding senior executive officers) of the Level 2 covered institution; or (iii) A covered person of a covered institution who may commit or expose 0.5 percent or more of the regulatory capital, in the case of a Federal Home Loan Bank, or the minimum capital, in the case of an Enterprise, of the covered institution; and (2) Any covered person at a Level 1 or Level 2 covered institution, other than a senior executive officer, who is designated as a ‘‘significant risk-taker’’ by the Federal Housing Finance Agency because of that person’s ability to expose a covered institution to risks that could lead to material financial loss in relation to the covered institution’s size, capital, or overall risk tolerance, in accordance with procedures established by the Federal Housing Finance Agency, or by the covered institution. (3) [Reserved]. (4) If the Federal Housing Finance Agency determines, in accordance with procedures established by the Federal Housing Finance Agency, that a Level 1 covered institution’s activities, complexity of operations, risk profile, and compensation practices are similar to those of a Level 2 covered institution, the Level 1 covered institution may apply paragraph (hh)(1)(i) of this section to covered persons of the Level 1 covered institution by substituting ‘‘2 percent’’ for ‘‘5 percent’’. (ii) [Reserved]. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 (jj) Vesting of incentive-based compensation means the transfer of ownership of the incentive-based compensation to the covered person to whom the incentive-based compensation was awarded, such that the covered person’s right to the incentive-based compensation is no longer contingent on the occurrence of any event. § 1232.3 Applicability. (a) When average total consolidated assets increase—(1) In general. A regulated institution other than a Federal Home Loan Bank shall become a Level 1, Level 2, or Level 3 covered institution when its average total consolidated assets increase to an amount that equals or exceeds $250 billion, $50 billion, or $1 billion, respectively. (2) Compliance date. A regulated institution that becomes a Level 1, Level 2, or Level 3 covered institution pursuant to paragraph (a)(1) of this section shall comply with the requirements of this part for a Level 1, Level 2, or Level 3 covered institution, respectively, not later than the first day of the first calendar quarter that begins at least 540 days after the date on which the regulated institution becomes a Level 1, Level 2, or Level 3 covered institution, respectively. Until that day, the Level 1, Level 2, or Level 3 covered institution will remain subject to the requirements of this part, if any, that applied to the regulated institution on the day before the date on which it became a Level 1, Level 2, or Level 3 covered institution. (3) Grandfathered plans. A regulated institution that becomes a Level 1, Level 2, or Level 3 covered institution under paragraph (a)(1) of this section is not required to comply with requirements of this part applicable to a Level 1, Level 2, or Level 3 covered institution, respectively, with respect to any incentive-based compensation plan with a performance period that begins before the date described in paragraph (a)(2) of this section. Any such incentive-based compensation plan shall remain subject to the requirements under this part, if any, that applied to the regulated institution at the beginning of the performance period. (b) When total consolidated assets decrease. A Level 1, Level 2, or Level 3 covered institution other than a Federal Home Loan Bank will remain subject to the requirements applicable to such covered institution under this part unless and until the total consolidated assets of the covered institution, as reported on the covered institution’s regulatory reports, fall below $250 PO 00000 Frm 00159 Fmt 4701 Sfmt 4702 37827 billion, $50 billion, or $1 billion, respectively, for each of four consecutive quarters. A Federal Home Loan Bank will remain subject to the requirements of a Level 2 covered institution under this part unless and until the total consolidated assets of the Federal Home Loan Bank, as reported on the Federal Home Loan Bank’s regulatory reports, fall below $1 billion for each of four consecutive quarters. The calculation will be effective on the as-of date of the fourth consecutive regulatory report. § 1232.4 Requirements and prohibitions applicable to all covered institutions. (a) In general. A covered institution must not establish or maintain any type of incentive-based compensation arrangement, or any feature of any such arrangement, that encourages inappropriate risks by the covered institution: (1) By providing a covered person with excessive compensation, fees, or benefits; or (2) That could lead to material financial loss to the covered institution. (b) Excessive compensation. Compensation, fees, and benefits are considered excessive for purposes of paragraph (a)(1) of this section when amounts paid are unreasonable or disproportionate to the value of the services performed by a covered person, taking into consideration all relevant factors, including, but not limited to: (1) The combined value of all compensation, fees, or benefits provided to the covered person; (2) The compensation history of the covered person and other individuals with comparable expertise at the covered institution; (3) The financial condition of the covered institution; (4) Compensation practices at comparable institutions, based upon such factors as asset size, geographic location, and the complexity of the covered institution’s operations and assets; (5) For post-employment benefits, the projected total cost and benefit to the covered institution; and (6) Any connection between the covered person and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the covered institution. (c) Material financial loss. An incentive-based compensation arrangement at a covered institution encourages inappropriate risks that could lead to material financial loss to the covered institution, unless the arrangement: (1) Appropriately balances risk and reward; E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37828 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules (2) Is compatible with effective risk management and controls; and (3) Is supported by effective governance. (d) Performance measures. An incentive-based compensation arrangement will not be considered to appropriately balance risk and reward for purposes of paragraph (c)(1) of this section unless: (1) The arrangement includes financial and non-financial measures of performance, including considerations of risk-taking, that are relevant to a covered person’s role within a covered institution and to the type of business in which the covered person is engaged and that are appropriately weighted to reflect risk-taking; (2) The arrangement is designed to allow non-financial measures of performance to override financial measures of performance when appropriate in determining incentivebased compensation; and (3) Any amounts to be awarded under the arrangement are subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance. (e) Board of directors. A covered institution’s board of directors, or a committee thereof, must: (1) Conduct oversight of the covered institution’s incentive-based compensation program; (2) Approve incentive-based compensation arrangements for senior executive officers, including the amounts of all awards and, at the time of vesting, payouts under such arrangements; and (3) Approve any material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers. (f) Disclosure and recordkeeping requirements. A covered institution must create annually and maintain for a period of at least seven years records that document the structure of all its incentive-based compensation arrangements and demonstrate compliance with this part. A covered institution must disclose the records to the Federal Housing Finance Agency upon request. At a minimum, the records must include copies of all incentive-based compensation plans, a record of who is subject to each plan, and a description of how the incentivebased compensation program is compatible with effective risk management and controls. (g) Rule of construction. A covered institution is not required to report the actual amount of compensation, fees, or VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 benefits of individual covered persons as part of the disclosure and recordkeeping requirements under this part, though it may be required to do so under other applicable regulations of the Federal Housing Finance Agency. § 1232.5 Additional disclosure and recordkeeping requirements for Level 1 and Level 2 covered institutions. (a) A Level 1 or Level 2 covered institution must create annually and maintain for a period of at least seven years records that document: (1) The covered institution’s senior executive officers and significant risktakers, listed by legal entity, job function, organizational hierarchy, and line of business; (2) The incentive-based compensation arrangements for senior executive officers and significant risk-takers, including information on percentage of incentive-based compensation deferred and form of award; (3) Any forfeiture and downward adjustment or clawback reviews and decisions for senior executive officers and significant risk-takers; and (4) Any material changes to the covered institution’s incentive-based compensation arrangements and policies. (b) A Level 1 or Level 2 covered institution must create and maintain records in a manner that allows for an independent audit of incentive-based compensation arrangements, policies, and procedures, including those required under § 1232.11. (c) A Level 1 or Level 2 covered institution must provide the records described in paragraph (a) of this section to the Federal Housing Finance Agency in such form and with such frequency as requested by the Federal Housing Finance Agency. § 1232.6 Reservation of authority for Level 3 covered institutions. (a) In general. The Federal Housing Finance Agency may require a Level 3 covered institution with average total consolidated assets greater than or equal to $10 billion and less than $50 billion to comply with some or all of the provisions of §§ 1232.5 and 1232.7 through 1232.11 if the Federal Housing Finance Agency determines that the Level 3 covered institution’s complexity of operations or compensation practices are consistent with those of a Level 1 or Level 2 covered institution. (b) Factors considered. Any exercise of authority under this section will be in writing by the Federal Housing Finance Agency in accordance with procedures established by the Federal Housing Finance Agency and will PO 00000 Frm 00160 Fmt 4701 Sfmt 4702 consider the activities, complexity of operations, risk profile, and compensation practices of the Level 3 covered institution, in addition to any other relevant factors. § 1232.7 Deferral, forfeiture and downward adjustment, and clawback requirements for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will not be considered to appropriately balance risk and reward, for purposes of § 1232.4(c)(1), unless the following requirements are met. (a) Deferral. (1) Qualifying incentivebased compensation must be deferred as follows: (i) Minimum required deferral amount. (A) A Level 1 covered institution must defer at least 60 percent of a senior executive officer’s qualifying incentive-based compensation awarded for each performance period. (B) A Level 1 covered institution must defer at least 50 percent of a significant risk-taker’s qualifying incentive-based compensation awarded for each performance period. (C) A Level 2 covered institution must defer at least 50 percent of a senior executive officer’s qualifying incentivebased compensation awarded for each performance period. (D) A Level 2 covered institution must defer at least 40 percent of a significant risk-taker’s qualifying incentive-based compensation awarded for each performance period. (ii) Minimum required deferral period. (A) For a senior executive officer or significant risk-taker of a Level 1 covered institution, the deferral period for deferred qualifying incentive-based compensation must be at least 4 years. (B) For a senior executive officer or significant risk-taker of a Level 2 covered institution, the deferral period for deferred qualifying incentive-based compensation must be at least 3 years. (iii) Vesting of amounts during deferral period—(A) Pro rata vesting. During a deferral period, deferred qualifying incentive-based compensation may not vest faster than on a pro rata annual basis beginning no earlier than the first anniversary of the end of the performance period for which the amounts were awarded. (B) Acceleration of vesting. A Level 1 or Level 2 covered institution must not accelerate the vesting of a covered person’s deferred qualifying incentivebased compensation that is required to be deferred under this part, except in the case of death or disability of such covered person. E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules (2) Incentive-based compensation awarded under a long-term incentive plan must be deferred as follows: (i) Minimum required deferral amount. (A) A Level 1 covered institution must defer at least 60 percent of a senior executive officer’s incentive-based compensation awarded under a longterm incentive plan for each performance period. (B) A Level 1 covered institution must defer at least 50 percent of a significant risk-taker’s incentive-based compensation awarded under a longterm incentive plan for each performance period. (C) A Level 2 covered institution must defer at least 50 percent of a senior executive officer’s incentive-based compensation awarded under a longterm incentive plan for each performance period. (D) A Level 2 covered institution must defer at least 40 percent of a significant risk-taker’s incentive-based compensation awarded under a longterm incentive plan for each performance period. (ii) Minimum required deferral period. (A) For a senior executive officer or significant risk-taker of a Level 1 covered institution, the deferral period for deferred long-term incentive plan amounts must be at least 2 years. (B) For a senior executive officer or significant risk-taker of a Level 2 covered institution, the deferral period for deferred long-term incentive plan amounts must be at least 1 year. (iii) Vesting of amounts during deferral period—(A) Pro rata vesting. During a deferral period, deferred longterm incentive plan amounts may not vest faster than on a pro rata annual basis beginning no earlier than the first anniversary of the end of the performance period for which the amounts were awarded. (B) Acceleration of vesting. A Level 1 or Level 2 covered institution must not accelerate the vesting of a covered person’s deferred long-term incentive plan amounts that is required to be deferred under this part, except in the case of death or disability of such covered person. (3) Adjustments of deferred qualifying incentive-based compensation and deferred long-term incentive plan compensation amounts. A Level 1 or Level 2 covered institution may not increase deferred qualifying incentivebased compensation or deferred longterm incentive plan amounts for a senior executive officer or significant risk-taker during the deferral period. For purposes of this paragraph, an increase in value attributable solely to a change in share VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 value, a change in interest rates, or the payment of interest according to terms set out at the time of the award is not considered an increase in incentivebased compensation amounts. (4) Composition of deferred qualifying incentive-based compensation and deferred long-term incentive plan compensation for Level 1 and Level 2 covered institutions—(i) Cash and equity-like instruments. For a senior executive officer or significant risk-taker of a Level 1 or Level 2 covered institution, any deferred qualifying incentive-based compensation or deferred long-term incentive plan amounts must include substantial portions of both deferred cash and, in the case of a covered institution that issues equity instruments and is permitted by the Federal Housing Finance Agency to use equity-like instruments as compensation for senior executive officers and significant risktakers, equity-like instruments throughout the deferral period. (ii) Options. If a senior executive officer or significant risk-taker of a Level 1 or Level 2 covered institution receives incentive-based compensation for a performance period in the form of options, the total amount of such options that may be used to meet the minimum deferral amount requirements of paragraph (a)(1)(i) or (a)(2)(i) of this section is limited to no more than 15 percent of the amount of total incentivebased compensation awarded to the senior executive officer or significant risk-taker for that performance period. (b) Forfeiture and downward adjustment—(1) Compensation at risk. (i) A Level 1 or Level 2 covered institution must place at risk of forfeiture all unvested deferred incentive-based compensation of any senior executive officer or significant risk-taker, including unvested deferred amounts awarded under long-term incentive plans. (ii) A Level 1 or Level 2 covered institution must place at risk of downward adjustment all of a senior executive officer’s or significant risktaker’s incentive-based compensation amounts not yet awarded for the current performance period, including amounts payable under long-term incentive plans. (2) Events triggering forfeiture and downward adjustment review. At a minimum, a Level 1 or Level 2 covered institution must consider forfeiture and downward adjustment of incentivebased compensation of senior executive officers and significant risk-takers described in paragraph (b)(3) of this section due to any of the following PO 00000 Frm 00161 Fmt 4701 Sfmt 4702 37829 adverse outcomes at the covered institution: (i) Poor financial performance attributable to a significant deviation from the risk parameters set forth in the covered institution’s policies and procedures; (ii) Inappropriate risk taking, regardless of the impact on financial performance; (iii) Material risk management or control failures; (iv) Non-compliance with statutory, regulatory, or supervisory standards that results in: (A) Enforcement or legal action against the covered institution brought by a federal or state regulator or agency; or (B) A requirement that the covered institution report a restatement of a financial statement to correct a material error; and (v) Other aspects of conduct or poor performance as defined by the covered institution. (3) Senior executive officers and significant risk-takers affected by forfeiture and downward adjustment. A Level 1 or Level 2 covered institution must consider forfeiture and downward adjustment for a senior executive officer or significant risk-taker with direct responsibility, or responsibility due to the senior executive officer’s or significant risk-taker’s role or position in the covered institution’s organizational structure, for the events related to the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section. (4) Determining forfeiture and downward adjustment amounts. A Level 1 or Level 2 covered institution must consider, at a minimum, the following factors when determining the amount or portion of a senior executive officer’s or significant risk-taker’s incentive-based compensation that should be forfeited or adjusted downward: (i) The intent of the senior executive officer or significant risk-taker to operate outside the risk governance framework approved by the covered institution’s board of directors or to depart from the covered institution’s policies and procedures; (ii) The senior executive officer’s or significant risk-taker’s level of participation in, awareness of, and responsibility for, the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section; (iii) Any actions the senior executive officer or significant risk-taker took or could have taken to prevent the events triggering the forfeiture and downward E:\FR\FM\10JNP2.SGM 10JNP2 37830 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules adjustment review set forth in paragraph (b)(2) of this section; (iv) The financial and reputational impact of the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section to the covered institution, the line or sub-line of business, and individuals involved, as applicable, including the magnitude of any financial loss and the cost of known or potential subsequent fines, settlements, and litigation; (v) The causes of the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section, including any decisionmaking by other individuals; and (vi) Any other relevant information, including past behavior and past risk outcomes attributable to the senior executive officer or significant risktaker. (c) Clawback. A Level 1 or Level 2 covered institution must include clawback provisions in incentive-based compensation arrangements for senior executive officers and significant risktakers that, at a minimum, allow the covered institution to recover incentivebased compensation from a current or former senior executive officer or significant risk-taker for seven years following the date on which such compensation vests, if the covered institution determines that the senior executive officer or significant risk-taker engaged in: (1) Misconduct that resulted in significant financial or reputational harm to the covered institution; (2) Fraud; or (3) Intentional misrepresentation of information used to determine the senior executive officer or significant risk-taker’s incentive-based compensation. mstockstill on DSK3G9T082PROD with PROPOSALS2 § 1232.8 Additional prohibitions for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will be considered to provide incentives that appropriately balance risk and reward for purposes of § 1232.4(c)(1) only if such institution complies with the following prohibitions. (a) Hedging. A Level 1 or Level 2 covered institution must not purchase a hedging instrument or similar instrument on behalf of a covered person to hedge or offset any decrease in the value of the covered person’s incentive-based compensation. (b) Maximum incentive-based compensation opportunity. A Level 1 or Level 2 covered institution must not award incentive-based compensation to: VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 (1) A senior executive officer in excess of 125 percent of the target amount for that incentive-based compensation; or (2) A significant risk-taker in excess of 150 percent of the target amount for that incentive-based compensation. (c) Relative performance measures. A Level 1 or Level 2 covered institution must not use incentive-based compensation performance measures that are based solely on industry peer performance comparisons. (d) Volume driven incentive-based compensation. A Level 1 or Level 2 covered institution must not provide incentive-based compensation to a covered person that is based solely on transaction revenue or volume without regard to transaction quality or compliance of the covered person with sound risk management. § 1232.9 Risk management and controls requirements for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will be considered to be compatible with effective risk management and controls for purposes of § 1232.4(c)(2) only if such institution meets the following requirements. (a) A Level 1 or Level 2 covered institution must have a risk management framework for its incentive-based compensation program that: (1) Is independent of any lines of business; (2) Includes an independent compliance program that provides for internal controls, testing, monitoring, and training with written policies and procedures consistent with § 1232.11; and (3) Is commensurate with the size and complexity of the covered institution’s operations. (b) A Level 1 or Level 2 covered institution must: (1) Provide individuals engaged in control functions with the authority to influence the risk-taking of the business areas they monitor; and (2) Ensure that covered persons engaged in control functions are compensated in accordance with the achievement of performance objectives linked to their control functions and independent of the performance of those business areas. (c) A Level 1 or Level 2 covered institution must provide for the independent monitoring of: (1) All incentive-based compensation plans in order to identify whether those plans provide incentives that appropriately balance risk and reward; PO 00000 Frm 00162 Fmt 4701 Sfmt 4702 (2) Events related to forfeiture and downward adjustment reviews and decisions of forfeiture and downward adjustment reviews in order to determine consistency with § 1232.7(b); and (3) Compliance of the incentive-based compensation program with the covered institution’s policies and procedures. § 1232.10 Governance requirements for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will not be considered to be supported by effective governance for purposes of § 1232.4(c)(3), unless: (a) The covered institution establishes a compensation committee composed solely of directors who are not senior executive officers to assist the board of directors in carrying out its responsibilities under § 1232.4(e); and (b) The compensation committee established pursuant to paragraph (a) of this section obtains: (1) Input from the risk and audit committees of the covered institution’s board of directors, or groups performing similar functions, and risk management function on the effectiveness of risk measures and adjustments used to balance risk and reward in incentivebased compensation arrangements; (2) A written assessment of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution, submitted on an annual or more frequent basis by the management of the covered institution and developed with input from the risk and audit committees of its board of directors, or groups performing similar functions, and from the covered institution’s risk management and audit functions; and (3) An independent written assessment of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution, submitted on an annual or more frequent basis by the internal audit or risk management function of the covered institution, developed independently of the covered institution’s management. § 1232.11 Policies and procedures requirements for Level 1 and Level 2 covered institutions. A Level 1 or Level 2 covered institution must develop and implement E:\FR\FM\10JNP2.SGM 10JNP2 37831 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules policies and procedures for its incentive-based compensation program that, at a minimum: (a) Are consistent with the prohibitions and requirements of this part; (b) Specify the substantive and procedural criteria for the application of forfeiture and clawback, including the process for determining the amount of incentive-based compensation to be clawed back; (c) Require that the covered institution maintain documentation of final forfeiture, downward adjustment, and clawback decisions; (d) Specify the substantive and procedural criteria for the acceleration of payments of deferred incentive-based compensation to a covered person, consistent with § 1232.7(a)(1)(iii)(B) and (a)(2)(iii)(B)); (e) Identify and describe the role of any employees, committees, or groups authorized to make incentive-based compensation decisions, including when discretion is authorized; (f) Describe how discretion is expected to be exercised to appropriately balance risk and reward; (g) Require that the covered institution maintain documentation of the establishment, implementation, modification, and monitoring of incentive-based compensation arrangements, sufficient to support the covered institution’s decisions; (h) Describe how incentive-based compensation arrangements will be monitored; (i) Specify the substantive and procedural requirements of the independent compliance program consistent with § 1232.9(a)(2); and (j) Ensure appropriate roles for risk management, risk oversight, and other control function personnel in the covered institution’s processes for: (1) Designing incentive-based compensation arrangements and determining awards, deferral amounts, deferral periods, forfeiture, downward adjustment, clawback, and vesting; and (2) Assessing the effectiveness of incentive-based compensation arrangements in restraining inappropriate risk-taking. mstockstill on DSK3G9T082PROD with PROPOSALS2 § 1232.12 Indirect actions. A covered institution must not indirectly, or through or by any other person, do anything that would be unlawful for such covered institution to do directly under this part. § 1232.13 Enforcement. The provisions of this part shall be enforced under subtitle C of the Safety and Soundness Act (12 U.S.C. ch. 46 subch. III). VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 § 1232.14 Covered institutions in conservatorship or receivership. (a) Scope. This section applies to covered institutions that are in conservatorship or receivership, or are limited-life regulated entities, under the Safety and Soundness Act. (b) Compensation requirements. For a covered institution subject to this section, the requirements that would otherwise apply under this part shall be those that are determined by the Agency to best fulfill the requirements and purposes of 12 U.S.C. 5641, taking into consideration the possible duration of the covered institution’s conservatorship or receivership, the nature of the institution’s governance while under conservatorship or receivership, the need to attract and retain management and other talent to such an institution, the limitations on such an institution’s ability to employ equity-like instruments as incentivebased compensation, and any other circumstances deemed relevant in the judgment of the Agency. The Agency may determine appropriate transition terms and provisions in the event that the covered institution ceases to be within the scope of this section. § 240.17a–4 Records to be preserved by certain exchange members, brokers and dealers. * * * * * (e) * * * (10) The records required pursuant to §§ 303.4(f), 303.5, and 303.11 of this chapter. * * * * * PART 275—RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940 10. The authority citation continues to read in part as follows: ■ Authority: 15 U.S.C. 80b–2(a)(11)(G), 80b– 2(a)(11)(H), 80b–2(a)(17), 80b–3, 80b–4, 80b– 4a, 80b–6(4), 80b–6a, and 80b–11, unless otherwise noted. * * * * * Section 275.204–2 is also issued under 15 U.S.C. 80b–6. * * * * * 11. Section 275.204–2 is amended by adding paragraph (a)(19) and by revising paragraph (e)(1). The additions and revisions read as follows: ■ § 275.204–2 Books and records to be maintained by investment advisers. (a) * * * (19) The records required pursuant to, and for the periods specified in, Securities and Exchange Commission §§ 303.4(f), 303.5, and 303.11 of this Authority and Issuance chapter. * * * * * For the reasons set forth in the joint (e)(1) All books and records required preamble, the SEC proposes to amend to be made under the provisions of title 17, chapter II of the Code of Federal paragraphs (a) to (c)(1)(i), inclusive, and Regulations as follows: (c)(2) of this section (except for books and records required to be made under PART 240—GENERAL RULES AND the provisions of paragraphs (a)(11), REGULATIONS, SECURITIES (a)(12)(i), (a)(12)(iii), (a)(13)(ii), EXCHANGE ACT OF 1934 (a)(13)(iii), (a)(16), (a)(17)(i), and (a)(19) of this section), shall be maintained and ■ 8. The authority citation for part 240 preserved in an easily accessible place continues to read in part as follows: for a period of not less than five years Authority: 15 U.S.C. 77c, 77d, 77g, 77j, from the end of the fiscal year during 77s, 77z–2, 77z–3, 77eee, 77ggg, 77nnn, which the last entry was made on such 77sss, 77ttt, 78c, 78c–3, 78c–5, 78d, 78e, 78f, record, the first two years in an 78g, 78i, 78j, 78j–1, 78k, 78k–1, 78l, 78m, appropriate office of the investment 78n, 78n–1, 78o, 78o–4, 78o–10, 78p, 78q, adviser. 78q–1, 78s, 78u–5, 78w, 78x, 78dd, 78ll, * * * * * 78mm, 80a–20, 80a–23, 80a–29, 80a–37, 80b– ■ 12. Add part 303 to read as follows: 3, 80b–4, 80b–11, 7201 et seq., and 8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C. 1350; and Pub. L. 111–203, 939A, 124 Stat. 1376 (2010), unless otherwise noted. * * * * * Section 240.17a–4 also issued under secs. 2, 17, 23(a), 48 Stat. 897, as amended; 15 U.S.C. 78a, 78d–1, 78d–2; sec. 14, Pub. L. 94– 29, 89 Stat. 137 (15 U.S.C. 78a); sec. 18, Pub. L. 94–29, 89 Stat. 155 (15 U.S.C. 78w); * * * * * 9. Section 240.17a–4 is amended by adding paragraph (e)(10). The addition reads as follows: ■ PO 00000 Frm 00163 Fmt 4701 Sfmt 4702 PART 303—INCENTIVE-BASED COMPENSATION ARRANGEMENTS Sec. 303.1 Authority, scope, and initial applicability. 303.2 Definitions. 303.3 Applicability. 303.4 Requirements and prohibitions applicable to all covered institutions. 303.5 Additional disclosure and recordkeeping requirements for Level 1 and Level 2 covered institutions. 303.6 Reservation of authority for Level 3 covered institutions. E:\FR\FM\10JNP2.SGM 10JNP2 37832 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules 303.7 Deferral, forfeiture and downward adjustment, and clawback requirements for Level 1 and Level 2 covered institutions. 303.8 Additional prohibitions for Level 1 and Level 2 covered institutions. 303.9 Risk management and controls requirements for Level 1 and Level 2 covered institutions. 303.10 Governance requirements for Level 1 and Level 2 covered institutions. 303.11 Policies and procedures requirements for Level 1 and Level 2 covered institutions. 303.12 Indirect actions. 303.13 Enforcement. Authority: 15 U.S.C. 78q, 78w, 80b–4, and 80b–11 and 12 U.S.C. 5641. § 303.1 Authority, scope, and initial applicability. (a) Authority. This part is issued pursuant to section 956 of the DoddFrank Wall Street Reform and Consumer Protection Act (12 U.S.C. 5641), 15 U.S.C. 78q, 78w, 80b–4, and 80b–11. (b) Scope. This part applies to a covered institution with average total consolidated assets greater than or equal to $1 billion that offers incentive-based compensation to covered persons. (c) Initial applicability—(1) Compliance date. A covered institution must meet the requirements of this part no later than [Date of the beginning of the first calendar quarter that begins at least 540 days after a final rule is published in the Federal Register]. Whether a covered institution is a Level 1, Level 2, or Level 3 covered institution at that time will be determined based on average total consolidated assets as of [Date of the beginning of the first calendar quarter that begins after a final rule is published in the Federal Register]. (2) Grandfathered plans. A covered institution is not required to comply with the requirements of this part with respect to any incentive-based compensation plan with a performance period that begins before [Compliance Date as described in paragraph (c)(1) of this section]. (d) Preservation of authority. Nothing in this part in any way limits the authority of the Commission under other provisions of applicable law and regulations. mstockstill on DSK3G9T082PROD with PROPOSALS2 § 303.2 Definitions. For purposes of this part only, the following definitions apply unless otherwise specified: (a) Affiliate means any company that controls, is controlled by, or is under common control with another company. (b) Average total consolidated assets means the average of a regulated institution’s total consolidated assets, as reported on the regulated institution’s VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 regulatory reports, for the four most recent consecutive quarters. If a regulated institution has not filed a regulatory report for each of the four most recent consecutive quarters, the regulated institution’s average total consolidated assets means the average of its total consolidated assets, as reported on its regulatory reports, for the most recent quarter or consecutive quarters, as applicable. Average total consolidated assets are measured on the as-of date of the most recent regulatory report used in the calculation of the average. Average total consolidated assets for a regulated institution that is an investment adviser means the regulated institution’s total assets (exclusive of non-proprietary assets) shown on the balance sheet for the regulated institution for the most recent fiscal year end. (c) To award incentive-based compensation means to make a final determination, conveyed to a covered person, of the amount of incentivebased compensation payable to the covered person for performance over a performance period. (d) Board of directors means the governing body of a covered institution that oversees the activities of the covered institution, often referred to as the board of directors or board of managers. (e) Clawback means a mechanism by which a covered institution can recover vested incentive-based compensation from a covered person. (f) Compensation, fees, or benefits means all direct and indirect payments, both cash and non-cash, awarded to, granted to, or earned by or for the benefit of, any covered person in exchange for services rendered to a covered institution. (g) Control means that any company has control over any company if— (1) The company directly or indirectly or acting through one or more other persons owns, controls, or has power to vote 25 percent or more of any class of voting securities of the company; (2) The company controls in any manner the election of a majority of the directors or trustees of the company; or (3) The Commission determines, after notice and opportunity for hearing, that the company directly or indirectly exercises a controlling influence over the management or policies of the company. (h) Control function means a compliance, risk management, internal audit, legal, human resources, accounting, financial reporting, or finance role responsible for identifying, measuring, monitoring, or controlling risk-taking. PO 00000 Frm 00164 Fmt 4701 Sfmt 4702 (i) Covered institution means a regulated institution with average total consolidated assets greater than or equal to $1 billion. (j) Covered person means any executive officer, employee, director, or principal shareholder who receives incentive-based compensation at a covered institution. (k) Deferral means the delay of vesting of incentive-based compensation beyond the date on which the incentivebased compensation is awarded. (l) Deferral period means the period of time between the date a performance period ends and the last date on which the incentive-based compensation awarded for such performance period vests. (m) Depository institution holding company means a top-tier depository institution holding company, where ‘‘depository institution holding company’’ has the same meaning as in section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813). (n) Director of a covered institution means a member of the board of directors. (o) Downward adjustment means a reduction of the amount of a covered person’s incentive-based compensation not yet awarded for any performance period that has already begun, including amounts payable under long-term incentive plans, in accordance with a forfeiture and downward adjustment review under § 303.7(b). (p) Equity-like instrument means: (1) Equity in the covered institution or any affiliate of the covered institution; or (2) A form of compensation: (i) Payable at least in part based on the price of the shares or other equity instruments of the covered institution or of any affiliate of the covered institution; or (ii) That requires, or may require, settlement in the shares of the covered institution or of any affiliate of the covered institution. (q) Forfeiture means a reduction of the amount of deferred incentive-based compensation awarded to a covered person that has not vested. (r) Incentive-based compensation means any variable compensation, fees, or benefits that serve as an incentive or reward for performance. (s) Incentive-based compensation arrangement means an agreement between a covered institution and a covered person, under which the covered institution provides incentivebased compensation to the covered person, including incentive-based compensation delivered through one or E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules more incentive-based compensation plans. (t) Incentive-based compensation plan means a document setting forth terms and conditions governing the opportunity for and the payment of incentive-based compensation payments to one or more covered persons. (u) Incentive-based compensation program means a covered institution’s framework for incentive-based compensation that governs incentivebased compensation practices and establishes related controls. (v) Level 1 covered institution means a: (i) Covered institution with average total consolidated assets greater than or equal to $250 billion; or (ii) Covered institution that is a subsidiary of a depository institution holding company that is a Level 1 covered institution pursuant to 12 CFR 236.2. (w) Level 2 covered institution means a: (i) Covered institution with average total consolidated assets greater than or equal to $50 billion that is not a Level 1 covered institution; or (ii) Covered institution that is a subsidiary of a depository institution holding company that is a Level 2 covered institution pursuant to 12 CFR 236.2. (x) Level 3 covered institution means a covered institution with average total consolidated assets greater than or equal to $1 billion that is not a Level 1 covered institution or Level 2 covered institution. (y) Long-term incentive plan means a plan to provide incentive-based compensation that is based on a performance period of at least three years. (z) Option means an instrument through which a covered institution provides a covered person the right, but not the obligation, to buy a specified number of shares representing an ownership stake in a company at a predetermined price within a set time period or on a date certain, or any similar instrument, such as a stock appreciation right. (aa) Performance period means the period during which the performance of a covered person is assessed for purposes of determining incentivebased compensation. (bb) Principal shareholder means a natural person who, directly or indirectly, or acting through or in concert with one or more persons, owns, controls, or has the power to vote 10 percent or more of any class of voting securities of a covered institution. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 (cc) Qualifying incentive-based compensation means the amount of incentive-based compensation awarded to a covered person for a particular performance period, excluding amounts awarded to the covered person for that particular performance period under a long-term incentive plan. (dd) Regulated institution means a broker or dealer registered under section 15 of the Securities Exchange Act of 1934 (15 U.S.C. 78o) and an investment adviser as such term is defined in section 202(a)(11) of the Investment Advisers Act of 1940 (15 U.S.C. 80b– 2(a)(11)). (ee) Regulatory report means, for a broker-dealer registered under section 15 of the Securities Exchange Act of 1934 (15 U.S.C. 78o), the Financial and Operational Combined Uniform Single Report, Form X–17A–5, 17 CFR 249.617, or any successors thereto. (ff) Section 956 affiliate means an affiliate that is an institution described in § 303.2(i), 12 CFR 42.2(i), 12 CFR 236.2(i), 12 CFR 372.2(i), 12 CFR 741.2(i), or 12 CFR 1232.2(i). (gg) Senior executive officer means a covered person who holds the title or, without regard to title, salary, or compensation, performs the function of one or more of the following positions at a covered institution for any period of time in the relevant performance period: President, chief executive officer, executive chairman, chief operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer, chief compliance officer, chief audit executive, chief credit officer, chief accounting officer, or head of a major business line or control function. (hh) Significant risk-taker means: (1) Any covered person at a Level 1 or Level 2 covered institution, other than a senior executive officer, who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period of which at least one-third is incentive-based compensation and is— (i) A covered person of a Level 1 covered institution who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period that placed the covered person among the highest 5 percent in annual base salary and incentive-based compensation among all covered persons (excluding senior executive officers) of the Level 1 covered institution together with all individuals who receive incentive-based PO 00000 Frm 00165 Fmt 4701 Sfmt 4702 37833 compensation at any section 956 affiliate of the Level 1 covered institution; (ii) A covered person of a Level 2 covered institution who received annual base salary and incentive-based compensation for the last calendar year that ended at least 180 days before the beginning of the performance period that placed the covered person among the highest 2 percent in annual base salary and incentive-based compensation among all covered persons (excluding senior executive officers) of the Level 2 covered institution together with all individuals who receive incentive-based compensation at any section 956 affiliate of the Level 2 covered institution; or (iii) A covered person of a covered institution who may commit or expose 0.5 percent or more of the common equity tier 1 capital, or in the case of a registered securities broker or dealer, 0.5 percent or more of the tentative net capital, of the covered institution or of any section 956 affiliate of the covered institution, whether or not the individual is a covered person of that specific legal entity; and (2) Any covered person at a Level 1 or Level 2 covered institution, other than a senior executive officer, who is designated as a ‘‘significant risk-taker’’ by the Commission because of that person’s ability to expose a covered institution to risks that could lead to material financial loss in relation to the covered institution’s size, capital, or overall risk tolerance, in accordance with procedures established by the Commission, or by the covered institution. (3) For purposes of this part, an individual who is an employee, director, senior executive officer, or principal shareholder of an affiliate of a Level 1 or Level 2 covered institution, where such affiliate has less than $1 billion in total consolidated assets, and who otherwise would meet the requirements for being a significant risktaker under paragraph (hh)(1)(iii) of this section, shall be considered to be a significant risk-taker with respect to the Level 1 or Level 2 covered institution for which the individual may commit or expose 0.5 percent or more of common equity tier 1 capital or tentative net capital. The Level 1 or Level 2 covered institution for which the individual commits or exposes 0.5 percent or more of common equity tier 1 capital or tentative net capital shall ensure that the individual’s incentive compensation arrangement complies with the requirements of this part. E:\FR\FM\10JNP2.SGM 10JNP2 37834 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules (4) If the Commission determines, in accordance with procedures established by the Commission, that a Level 1 covered institution’s activities, complexity of operations, risk profile, and compensation practices are similar to those of a Level 2 covered institution, the Level 1 covered institution may apply paragraph (hh)(1)(i) of this section to covered persons of the Level 1 covered institution by substituting ‘‘2 percent’’ for ‘‘5 percent.’’ (ii) Subsidiary means any company that is owned or controlled directly or indirectly by another company. (jj) Vesting of incentive-based compensation means the transfer of ownership of the incentive-based compensation to the covered person to whom the incentive-based compensation was awarded, such that the covered person’s right to the incentive-based compensation is no longer contingent on the occurrence of any event. mstockstill on DSK3G9T082PROD with PROPOSALS2 § 303.3 Applicability. (a) When average total consolidated assets increase—(1) In general. (i) A regulated institution shall become a Level 1, Level 2, or Level 3 covered institution when its average total consolidated assets increase to an amount that equals or exceeds $250 billion, $50 billion, or $1 billion, respectively. (ii) A covered institution regardless of its average total consolidated assets (provided that, for the avoidance of doubt, such covered institution has average total consolidated assets greater than or equal to $1 billion) that is a subsidiary of a depository institution holding company shall become a Level 1 or Level 2 covered institution when such depository institution holding company becomes a Level 1 or Level 2 covered institution, respectively, pursuant to 12 CFR 236.3. (2) Compliance date. (i) A regulated institution that becomes a Level 1, Level 2, or Level 3 covered institution pursuant to paragraph (a)(1)(i) of this section shall comply with the requirements of this part for a Level 1, Level 2, or Level 3 covered institution, respectively, not later than the first day of the first calendar quarter that begins at least 540 days after the date on which the regulated institution becomes a Level 1, Level 2, or Level 3 covered institution, respectively. Until that day, the Level 1, Level 2, or Level 3 covered institution will remain subject to the requirements of this part, if any, that applied to the regulated institution on the day before the date on which it became a Level 1, Level 2, or Level 3 covered institution. VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 (b) A covered institution that becomes a Level 1 or Level 2 covered institution pursuant to paragraph (a)(1)(ii) of this section shall comply with the requirements of this part for a Level 1 or Level 2 covered institution, respectively, not later than the first day of the first calendar quarter that begins at least 540 days after the date on which the regulated institution becomes a Level 1 or Level 2 covered institution, respectively. Until that day, the Level 1 or Level 2 covered institution will remain subject to the requirements of this part, if any, that applied to the covered institution on the day before the date on which it became a Level 1 or Level 2 covered institution. (3) Grandfathered plans. (i) A regulated institution that becomes a Level 1, Level 2, or Level 3 covered institution under paragraph (a)(1)(i) of this section is not required to comply with requirements of this part applicable to a Level 1, Level 2, or Level 3 covered institution, respectively, with respect to any incentive-based compensation plan with a performance period that begins before the date described in paragraph (a)(2)(i) of this section. Any such incentive-based compensation plan shall remain subject to the requirements under this part, if any, that applied to the regulated institution at the beginning of the performance period. (b) A covered institution that becomes a Level 1 or Level 2 covered institution under paragraph (a)(1)(ii) of this section is not required to comply with requirements of this part applicable to a Level 1 or Level 2 covered institution, respectively, with respect to any incentive-based compensation plan with a performance period that begins before the date described in paragraph (a)(2)(ii) of this section. Any such incentivebased compensation plan shall remain subject to the requirements under this part, if any, that applied to the covered institution at the beginning of the performance period. (b) When total consolidated assets decrease. (1) A Level 1, Level 2, or Level 3 covered institution will remain subject to the requirements applicable to such covered institution under this part unless and until the total consolidated assets of such covered institution, as reported on the covered institution’s regulatory reports, fall below $250 billion, $50 billion, or $1 billion, respectively, for each of four consecutive quarters. The calculation will be effective on the as-of date of the fourth consecutive regulatory report. (2) A Level 1, Level 2, or Level 3 covered institution that is an investment adviser will remain subject to the PO 00000 Frm 00166 Fmt 4701 Sfmt 4702 requirements applicable to such covered institution under this part unless and until the average total consolidated assets of the covered institution fall below $250 billion, $50 billion, or $1 billion, respectively as of the most recent fiscal year end. (3) A covered institution that is a Level 1 or Level 2 covered institution solely by virtue of its being a subsidiary of a depository institution holding company will remain subject to the requirements applicable to such covered institution under this part unless and until such depository institution holding company ceases to be subject to the requirements applicable to it in accordance with 12 CFR 236.3. § 303.4 Requirements and prohibitions applicable to all covered institutions. (a) In general. A covered institution must not establish or maintain any type of incentive-based compensation arrangement, or any feature of any such arrangement, that encourages inappropriate risks by the covered institution: (1) By providing a covered person with excessive compensation, fees, or benefits; or (2) That could lead to material financial loss to the covered institution. (b) Excessive compensation. Compensation, fees, and benefits are considered excessive for purposes of § 303.4(a)(1) when amounts paid are unreasonable or disproportionate to the value of the services performed by a covered person, taking into consideration all relevant factors, including, but not limited to: (1) The combined value of all compensation, fees, or benefits provided to the covered person; (2) The compensation history of the covered person and other individuals with comparable expertise at the covered institution; (3) The financial condition of the covered institution; (4) Compensation practices at comparable institutions, based upon such factors as asset size, geographic location, and the complexity of the covered institution’s operations and assets; (5) For post-employment benefits, the projected total cost and benefit to the covered institution; and (6) Any connection between the covered person and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the covered institution. (c) Material financial loss. An incentive-based compensation arrangement at a covered institution encourages inappropriate risks that E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules could lead to material financial loss to the covered institution, unless the arrangement: (1) Appropriately balances risk and reward; (2) Is compatible with effective risk management and controls; and (3) Is supported by effective governance. (d) Performance measures. An incentive-based compensation arrangement will not be considered to appropriately balance risk and reward for purposes of paragraph (c)(1) of this section, unless: (1) The arrangement includes financial and non-financial measures of performance, including considerations of risk-taking, that are relevant to a covered person’s role within a covered institution and to the type of business in which the covered person is engaged and that are appropriately weighted to reflect risk-taking; (2) The arrangement is designed to allow non-financial measures of performance to override financial measures of performance when appropriate in determining incentivebased compensation; and (3) Any amounts to be awarded under the arrangement are subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance. (e) Board of directors. A covered institution’s board of directors, or a committee thereof, must: (1) Conduct oversight of the covered institution’s incentive-based compensation program; (2) Approve incentive-based compensation arrangements for senior executive officers, including the amounts of all awards and, at the time of vesting, payouts under such arrangements; and (3) Approve any material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers. (f) Disclosure and recordkeeping requirements. A covered institution must create annually and maintain for a period of at least seven years records that document the structure of all its incentive-based compensation arrangements and demonstrate compliance with this part. A covered institution must disclose the records to the Commission upon request. At a minimum, the records must include copies of all incentive-based compensation plans, a record of who is subject to each plan, and a description of how the incentive-based compensation program is compatible VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 with effective risk management and controls. (g) Rule of construction. A covered institution is not required to report the actual amount of compensation, fees, or benefits of individual covered persons as part of the disclosure and recordkeeping requirements under this part. § 303.5 Additional disclosure and recordkeeping requirements for Level 1 and Level 2 covered institutions. (a) A Level 1 or Level 2 covered institution must create annually and maintain for a period of at least seven years records that document: (1) The covered institution’s senior executive officers and significant risktakers, listed by legal entity, job function, organizational hierarchy, and line of business; (2) The incentive-based compensation arrangements for senior executive officers and significant risk-takers, including information on percentage of incentive-based compensation deferred and form of award; (3) Any forfeiture and downward adjustment or clawback reviews and decisions for senior executive officers and significant risk-takers; and (4) Any material changes to the covered institution’s incentive-based compensation arrangements and policies. (b) A Level 1 or Level 2 covered institution must create and maintain records in a manner that allows for an independent audit of incentive-based compensation arrangements, policies, and procedures, including those required under § 303.11. (c) A Level 1 or Level 2 covered institution must provide the records described in paragraph (a) of this section to the Commission in such form and with such frequency as requested by the Commission. § 303.6 Reservation of authority for Level 3 covered institutions. (a) In general. The Commission may require a Level 3 covered institution with average total consolidated assets greater than or equal to $10 billion and less than $50 billion to comply with some or all of the provisions of §§ 303.5 and 303.7 through 303.11 if the Commission determines that the Level 3 covered institution’s complexity of operations or compensation practices are consistent with those of a Level 1 or Level 2 covered institution. (b) Factors considered. Any exercise of authority under this section will be in writing by the Commission in accordance with procedures established by the Commission and will consider PO 00000 Frm 00167 Fmt 4701 Sfmt 4702 37835 the activities, complexity of operations, risk profile, and compensation practices of the Level 3 covered institution, in addition to any other relevant factors. § 303.7 Deferral, forfeiture and downward adjustment, and clawback requirements for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will not be considered to appropriately balance risk and reward, for purposes of § 303.4(c)(1), unless the following requirements are met. (a) Deferral. (1) Qualifying incentivebased compensation must be deferred as follows: (i) Minimum required deferral amount. (A) A Level 1 covered institution must defer at least 60 percent of a senior executive officer’s qualifying incentive-based compensation awarded for each performance period. (B) A Level 1 covered institution must defer at least 50 percent of a significant risk-taker’s qualifying incentive-based compensation awarded for each performance period. (C) A Level 2 covered institution must defer at least 50 percent of a senior executive officer’s qualifying incentivebased compensation awarded for each performance period. (D) A Level 2 covered institution must defer at least 40 percent of a significant risk-taker’s qualifying incentive-based compensation awarded for each performance period. (ii) Minimum required deferral period. (A) For a senior executive officer or significant risk-taker of a Level 1 covered institution, the deferral period for deferred qualifying incentive-based compensation must be at least 4 years. (B) For a senior executive officer or significant risk-taker of a Level 2 covered institution, the deferral period for deferred qualifying incentive-based compensation must be at least 3 years. (iii) Vesting of amounts during deferral period. (A) Pro rata vesting. During a deferral period, deferred qualifying incentive-based compensation may not vest faster than on a pro rata annual basis beginning no earlier than the first anniversary of the end of the performance period for which the amounts were awarded. (B) Acceleration of vesting. A Level 1 or Level 2 covered institution must not accelerate the vesting of a covered person’s deferred qualifying incentivebased compensation that is required to be deferred under this part, except in the case of death or disability of such covered person. (2) Incentive-based compensation awarded under a long-term incentive plan must be deferred as follows: E:\FR\FM\10JNP2.SGM 10JNP2 mstockstill on DSK3G9T082PROD with PROPOSALS2 37836 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules (i) Minimum required deferral amount. (A) A Level 1 covered institution must defer at least 60 percent of a senior executive officer’s incentivebased compensation awarded under a long-term incentive plan for each performance period. (B) A Level 1 covered institution must defer at least 50 percent of a significant risk-taker’s incentive-based compensation awarded under a longterm incentive plan for each performance period. (C) A Level 2 covered institution must defer at least 50 percent of a senior executive officer’s incentive-based compensation awarded under a longterm incentive plan for each performance period. (D) A Level 2 covered institution must defer at least 40 percent of a significant risk-taker’s incentive-based compensation awarded under a longterm incentive plan for each performance period. (ii) Minimum required deferral period. (A) For a senior executive officer or significant risk-taker of a Level 1 covered institution, the deferral period for deferred long-term incentive plan amounts must be at least 2 years. (B) For a senior executive officer or significant risk-taker of a Level 2 covered institution, the deferral period for deferred long-term incentive plan amounts must be at least 1 year. (iii) Vesting of amounts during deferral period—(A) Pro rata vesting. During a deferral period, deferred longterm incentive plan amounts may not vest faster than on a pro rata annual basis beginning no earlier than the first anniversary of the end of the performance period for which amounts were awarded. (B) Acceleration of vesting. A Level 1 or Level 2 covered institution must not accelerate the vesting of a covered person’s deferred long-term incentive plan amounts that is required to be deferred under this part, except in the case of death or disability of such covered person. (3) Adjustments of deferred qualifying incentive-based compensation and deferred long-term incentive plan compensation amounts. A Level 1 or Level 2 covered institution may not increase deferred qualifying incentivebased compensation or deferred longterm incentive plan amounts for a senior executive officer or significant risk-taker during the deferral period. For purposes of this paragraph, an increase in value attributable solely to a change in share value, a change in interest rates, or the payment of interest according to terms set out at the time of the award is not VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 considered an increase in incentivebased compensation amounts. (4) Composition of deferred qualifying incentive-based compensation and deferred long-term incentive plan compensation for Level 1 and Level 2 covered institutions—(i) Cash and equity-like instruments. For a senior executive officer or significant risk-taker of a Level 1 or Level 2 covered institution that issues equity or is an affiliate of a covered institution that issues equity, any deferred qualifying incentive-based compensation or deferred long-term incentive plan amounts must include substantial portions of both deferred cash and equity-like instruments throughout the deferral period. (ii) Options. If a senior executive officer or significant risk-taker of a Level 1 or Level 2 covered institution receives incentive-based compensation for a performance period in the form of options, the total amount of such options that may be used to meet the minimum deferral amount requirements of paragraph (a)(1)(i) or (a)(2)(i) of this section is limited to no more than 15 percent of the amount of total incentivebased compensation awarded to the senior executive officer or significant risk-taker for that performance period. (b) Forfeiture and downward adjustment—(1) Compensation at risk. (i) A Level 1 or Level 2 covered institution must place at risk of forfeiture all unvested deferred incentive-based compensation of any senior executive officer or significant risk-taker, including unvested deferred amounts awarded under long-term incentive plans. (ii) A Level 1 or Level 2 covered institution must place at risk of downward adjustment all of a senior executive officer’s or significant risktaker’s incentive-based compensation amounts not yet awarded for the current performance period, including amounts payable under long-term incentive plans. (2) Events triggering forfeiture and downward adjustment review. At a minimum, a Level 1 or Level 2 covered institution must consider forfeiture and downward adjustment of incentivebased compensation of senior executive officers and significant risk-takers described in paragraph (b)(3) of this section due to any of the following adverse outcomes at the covered institution: (i) Poor financial performance attributable to a significant deviation from the risk parameters set forth in the covered institution’s policies and procedures; PO 00000 Frm 00168 Fmt 4701 Sfmt 4702 (ii) Inappropriate risk taking, regardless of the impact on financial performance; (iii) Material risk management or control failures; (iv) Non-compliance with statutory, regulatory, or supervisory standards that results in: (A) Enforcement or legal action against the covered institution brought by a federal or state regulator or agency; or (B) A requirement that the covered institution report a restatement of a financial statement to correct a material error; and (v) Other aspects of conduct or poor performance as defined by the covered institution. (3) Senior executive officers and significant risk-takers affected by forfeiture and downward adjustment. A Level 1 or Level 2 covered institution must consider forfeiture and downward adjustment for a senior executive officer or significant risk-taker with direct responsibility, or responsibility due to the senior executive officer’s or significant risk-taker’s role or position in the covered institution’s organizational structure, for the events related to the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section. (4) Determining forfeiture and downward adjustment amounts. A Level 1 or Level 2 covered institution must consider, at a minimum, the following factors when determining the amount or portion of a senior executive officer’s or significant risk-taker’s incentive-based compensation that should be forfeited or adjusted downward: (i) The intent of the senior executive officer or significant risk-taker to operate outside the risk governance framework approved by the covered institution’s board of directors or to depart from the covered institution’s policies and procedures; (ii) The senior executive officer’s or significant risk-taker’s level of participation in, awareness of, and responsibility for, the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section; (iii) Any actions the senior executive officer or significant risk-taker took or could have taken to prevent the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section; (iv) The financial and reputational impact of the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section to the covered institution, the line or sub-line of business, and E:\FR\FM\10JNP2.SGM 10JNP2 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules individuals involved, as applicable, including the magnitude of any financial loss and the cost of known or potential subsequent fines, settlements, and litigation; (v) The causes of the events triggering the forfeiture and downward adjustment review set forth in paragraph (b)(2) of this section, including any decisionmaking by other individuals; and (vi) Any other relevant information, including past behavior and past risk outcomes attributable to the senior executive officer or significant risktaker. (c) Clawback. A Level 1 or Level 2 covered institution must include clawback provisions in incentive-based compensation arrangements for senior executive officers and significant risktakers that, at a minimum, allow the covered institution to recover incentivebased compensation from a current or former senior executive officer or significant risk-taker for seven years following the date on which such compensation vests, if the covered institution determines that the senior executive officer or significant risk-taker engaged in: (1) Misconduct that resulted in significant financial or reputational harm to the covered institution; (2) Fraud; or (3) Intentional misrepresentation of information used to determine the senior executive officer or significant risk-taker’s incentive-based compensation. mstockstill on DSK3G9T082PROD with PROPOSALS2 § 303.8 Additional prohibitions for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will be considered to provide incentives that appropriately balance risk and reward for purposes of § 303.4(c)(1) only if such institution complies with the following prohibitions. (a) Hedging. A Level 1 or Level 2 covered institution must not purchase a hedging instrument or similar instrument on behalf of a covered person to hedge or offset any decrease in the value of the covered person’s incentive-based compensation. (b) Maximum incentive-based compensation opportunity. A Level 1 or Level 2 covered institution must not award incentive-based compensation to: (1) A senior executive officer in excess of 125 percent of the target amount for that incentive-based compensation; or (2) A significant risk-taker in excess of 150 percent of the target amount for that incentive-based compensation. (c) Relative performance measures. A Level 1 or Level 2 covered institution VerDate Sep<11>2014 00:00 Jun 10, 2016 Jkt 238001 must not use incentive-based compensation performance measures that are based solely on industry peer performance comparisons. (d) Volume driven incentive-based compensation. A Level 1 or Level 2 covered institution must not provide incentive-based compensation to a covered person that is based solely on transaction revenue or volume without regard to transaction quality or compliance of the covered person with sound risk management. § 303.9 Risk management and controls requirements for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will be considered to be compatible with effective risk management and controls for purposes of § 303.4(c)(2) only if such institution meets the following requirements. (a) A Level 1 or Level 2 covered institution must have a risk management framework for its incentive-based compensation program that: (1) Is independent of any lines of business; (2) Includes an independent compliance program that provides for internal controls, testing, monitoring, and training with written policies and procedures consistent with § 303.11; and (3) Is commensurate with the size and complexity of the covered institution’s operations. (b) A Level 1 or Level 2 covered institution must: (1) Provide individuals engaged in control functions with the authority to influence the risk-taking of the business areas they monitor; and (2) Ensure that covered persons engaged in control functions are compensated in accordance with the achievement of performance objectives linked to their control functions and independent of the performance of those business areas. (c) A Level 1 or Level 2 covered institution must provide for the independent monitoring of: (1) All incentive-based compensation plans in order to identify whether those plans provide incentives that appropriately balance risk and reward; (2) Events related to forfeiture and downward adjustment reviews and decisions of forfeiture and downward adjustment reviews in order to determine consistency with § 303.7(b); and (3) Compliance of the incentive-based compensation program with the covered institution’s policies and procedures. PO 00000 Frm 00169 Fmt 4701 Sfmt 4702 37837 § 303.10 Governance requirements for Level 1 and Level 2 covered institutions. An incentive-based compensation arrangement at a Level 1 or Level 2 covered institution will not be considered to be supported by effective governance for purposes of § 303.4(c)(3), unless: (a) The covered institution establishes a compensation committee composed solely of directors who are not senior executive officers to assist the board of directors in carrying out its responsibilities under § 303.4(e); and (b) The compensation committee established pursuant to paragraph (a) of this section obtains: (1) Input from the risk and audit committees of the covered institution’s board of directors, or groups performing similar functions, and risk management function on the effectiveness of risk measures and adjustments used to balance risk and reward in incentivebased compensation arrangements; (2) A written assessment of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution, submitted on an annual or more frequent basis by the management of the covered institution and developed with input from the risk and audit committees of its board of directors, or groups performing similar functions, and from the covered institution’s risk management and audit functions; and (3) An independent written assessment of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution, submitted on an annual or more frequent basis by the internal audit or risk management function of the covered institution, developed independently of the covered institution’s management. § 303.11 Policies and procedures requirements for Level 1 and Level 2 covered institutions. A Level 1 or Level 2 covered institution must develop and implement policies and procedures for its incentive-based compensation program that, at a minimum: (a) Are consistent with the prohibitions and requirements of this part; (b) Specify the substantive and procedural criteria for the application of forfeiture and clawback, including the process for determining the amount of E:\FR\FM\10JNP2.SGM 10JNP2 37838 Federal Register / Vol. 81, No. 112 / Friday, June 10, 2016 / Proposed Rules mstockstill on DSK3G9T082PROD with PROPOSALS2 incentive-based compensation to be clawed back; (c) Require that the covered institution maintain documentation of final forfeiture, downward adjustment, and clawback decisions; (d) Specify the substantive and procedural criteria for the acceleration of payments of deferred incentive-based compensation to a covered person, consistent with § 303.7(a)(1)(iii)(B) and (a)(2)(iii)(B); (e) Identify and describe the role of any employees, committees, or groups authorized to make incentive-based compensation decisions, including when discretion is authorized; (f) Describe how discretion is expected to be exercised to appropriately balance risk and reward; (g) Require that the covered institution maintain documentation of the establishment, implementation, modification, and monitoring of incentive-based compensation arrangements, sufficient to support the covered institution’s decisions; (h) Describe how incentive-based compensation arrangements will be monitored; VerDate Sep<11>2014 00:37 Jun 10, 2016 Jkt 238001 (i) Specify the substantive and procedural requirements of the independent compliance program consistent with § 303.9(a)(2); and (j) Ensure appropriate roles for risk management, risk oversight, and other control function personnel in the covered institution’s processes for: (1) Designing incentive-based compensation arrangements, and determining awards, deferral amounts, deferral periods, forfeiture, downward adjustment, clawback, and vesting; and (2) Assessing the effectiveness of incentive-based compensation arrangements in restraining inappropriate risk-taking. Dated: April 26, 2016. Thomas J. Curry, Comptroller of the Currency. By order of the Board of Governors of the Federal Reserve System, May 2, 2016. Margaret McCloskey Shanks, Deputy Secretary of the Board. Dated at Washington, DC this 26th day of April, 2016. By order of the Board of Directors. Federal Deposit Insurance Corporation. Robert E. Feldman, Executive Secretary. Dated: April 21, 2016. By the Federal Housing Finance Agency. § 303.12 Melvin L. Watt, Director. Indirect actions. A covered institution must not, indirectly or through or by any other person, do anything that would be unlawful for such covered institution to do directly under this part. § 303.13 Enforcement. The provisions of this part shall be enforced under section 505 of the Gramm-Leach-Bliley Act and, for purposes of such section, a violation of this part shall be treated as a violation of subtitle A of title V of such Act. PO 00000 Frm 00170 Fmt 4701 Sfmt 9990 By the National Credit Union Administration Board on April 21, 2016. Gerard Poliquin, Secretary of the Board. Dated: May 6, 2016. By the Securities and Exchange Commission. Robert W. Errett, Deputy Secretary. [FR Doc. 2016–11788 Filed 6–9–16; 8:45 am] BILLING CODE 8011–01–P E:\FR\FM\10JNP2.SGM 10JNP2

Agencies

[Federal Register Volume 81, Number 112 (Friday, June 10, 2016)]
[Proposed Rules]
[Pages 37669-37838]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-11788]

[[Page 37669]]

Vol. 81

Friday,

No. 112

June 10, 2016

Part II

Department of the Treasury

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Office of the Comptroller of the Currency

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12 CFR Part 42

Federal Reserve System

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12 CFR Part 236

Federal Deposit Insurance Corporation

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12 CFR Part 372

National Credit Union Administration

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12 CFR Parts 741 and 751

Federal Housing Finance Agency

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12 CFR Part 1232

Securities and Exchange Commission

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17 CFR Parts 240, 275, and 303

Incentive-Based Compensation Arrangements; Proposed Rule

Federal Register / Vol. 81 , No. 112 / Friday, June 10, 2016 /
Proposed Rules

[[Page 37670]]

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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 42

[Docket No. OCC-2011-0001]
RIN 1557-AD39

FEDERAL RESERVE SYSTEM

12 CFR Part 236

[Docket No. R-1536]
RIN 7100 AE-50

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 372

RIN 3064-AD86

NATIONAL CREDIT UNION ADMINISTRATION

12 CFR Parts 741 and 751

RIN 3133-AE48

FEDERAL HOUSING FINANCE AGENCY

12 CFR Part 1232

RIN 2590-AA42

SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 240, 275, and 303

[Release No. 34-77776; IA-4383; File No. S7-07-16]
RIN 3235-AL06

Incentive-Based Compensation Arrangements

AGENCY: Office of the Comptroller of the Currency, Treasury (OCC);
Board of Governors of the Federal Reserve System (Board); Federal
Deposit Insurance Corporation (FDIC); Federal Housing Finance Agency
(FHFA); National Credit Union Administration (NCUA); and U.S.
Securities and Exchange Commission (SEC).

ACTION: Notice of proposed rulemaking and request for comment.

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SUMMARY: The OCC, Board, FDIC, FHFA, NCUA, and SEC (the Agencies) are
seeking comment on a joint proposed rule (the proposed rule) to revise
the proposed rule the Agencies published in the Federal Register on
April 14, 2011, and to implement section 956 of the Dodd-Frank Wall
Street Reform and Consumer Protection Act (Dodd-Frank Act). Section 956
generally requires that the Agencies jointly issue regulations or
guidelines: (1) Prohibiting incentive-based payment arrangements that
the Agencies determine encourage inappropriate risks by certain
financial institutions by providing excessive compensation or that
could lead to material financial loss; and (2) requiring those
financial institutions to disclose information concerning incentive-
based compensation arrangements to the appropriate Federal regulator.

DATES: Comments must be received by July 22, 2016.

ADDRESSES: Although the Agencies will jointly review the comments
submitted, it would facilitate review of the comments if interested
parties send comments to the Agency that is the appropriate Federal
regulator, as defined in section 956(e) of the Dodd-Frank Act, for the
type of covered institution addressed in the comments. Commenters are
encouraged to use the title ``Incentive-based Compensation
Arrangements'' to facilitate the organization and distribution of
comments among the Agencies. Interested parties are invited to submit
written comments to:
Office of the Comptroller of the Currency: Because paper mail in
the Washington, DC area and at the OCC is subject to delay, commenters
are encouraged to submit comments by the Federal eRulemaking Portal or
email, if possible. Please use the title ``Incentive-based Compensation
Arrangements'' to facilitate the organization and distribution of the
comments. You may submit comments by any of the following methods:
Federal eRulemaking Portal--Regulations.gov: Go to
www.regulations.gov. Enter ``Docket ID OCC-2011-0001'' in the Search
Box and click ``Search.'' Click on ``Comment Now'' to submit public
comments.
Click on the ``Help'' tab on the Regulations.govhome page
to get information on using Regulations.gov, including instructions for
submitting public comments.
Email: regs.comments@occ.treas.gov.
Mail: Legislative and Regulatory Activities Division,
Office of the Comptroller of the Currency, 400 7th Street SW., Suite
3E-218, Mail Stop 9W-11, Washington, DC 20219.
Fax: (571) 465-4326.
Hand Delivery/Courier: 400 7th Street SW., Suite 3E-218,
Mail Stop 9W-11, Washington, DC 20219.
Instructions: You must include ``OCC'' as the agency name and
``Docket ID OCC-2011-0001'' in your comment. In general, OCC will enter
all comments received into the docket and publish them on the
Regulations.gov Web site without change, including any business or
personal information that you provide such as name and address
information, email addresses, or phone numbers. Comments received,
including attachments and other supporting materials, are part of the
public record and subject to public disclosure. Do not enclose any
information in your comment or supporting materials that you consider
confidential or inappropriate for public disclosure.
You may review comments and other related materials that pertain to
this proposed rule by any of the following methods:
Viewing Comments Electronically: Go to
www.regulations.gov. Enter ``Docket ID OCC-2011-0001'' in the Search
box and click ``Search.'' Click on ``Open Docket Folder'' on the right
side of the screen and then ``Comments.'' Comments can be filtered by
clicking on ``View All'' and then using the filtering tools on the left
side of the screen.
Click on the ``Help'' tab on the Regulations.gov home page
to get information on using Regulations.gov. Supporting materials may
be viewed by clicking on ``Open Docket Folder'' and then clicking on
``Supporting Documents.'' The docket may be viewed after the close of
the comment period in the same manner as during the comment period.
Viewing Comments Personally: You may personally inspect
and photocopy comments at the OCC, 400 7th Street SW., Washington, DC.
For security reasons, the OCC requires that visitors make an
appointment to inspect comments. You may do so by calling (202) 649-
6700 or, for persons who are deaf or hard of hearing, TTY, (202) 649-
5597. Upon arrival, visitors will be required to present valid
government-issued photo identification and to submit to security
screening in order to inspect and photocopy comments.
Board of Governors of the Federal Reserve System: You may submit
comments, identified by Docket No. 1536 and RIN No. 7100 AE-50, by any
of the following methods:
Agency Web site: https://www.federalreserve.gov. Follow the
instructions for submitting comments at https://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.
Federal eRulemaking Portal: https://www.regulations.gov.
Follow the instructions for submitting comments.
Email: regs.comments@federalreserve.gov. Include the
docket number and RIN number in the subject line of the message.

[[Page 37671]]

Fax: (202) 452-3819 or (202) 452-3102.
Mail: Address to Robert deV. Frierson, Secretary, Board of
Governors of the Federal Reserve System, 20th Street and Constitution
Avenue NW., Washington, DC 20551.
All public comments will be made available on the Board's Web site
at https://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as
submitted, unless modified for technical reasons. Accordingly, comments
will not be edited to remove any identifying or contact information.
Public comments may also be viewed electronically or in paper form in
Room 3515, 1801 K Street NW. (between 18th and 19th Streets NW.),
Washington, DC 20006 between 9:00 a.m. and 5:00 p.m. on weekdays.
Federal Deposit Insurance Corporation: You may submit comments,
identified by RIN 3064-AD86, by any of the following methods:
Agency Web site: https://www.FDIC.gov/regulations/laws/federal/propose.html. Follow instructions for submitting comments on
the Agency Web site.
Email: Comments@FDIC.gov. Include the RIN 3064-AD86 on the
subject line of the message.
Mail: Robert E. Feldman, Executive Secretary, Attention:
Comments, Federal Deposit Insurance Corporation, 550 17th Street NW.,
Washington, DC 20429.
Hand Delivery: Comments may be hand delivered to the guard
station at the rear of the 550 17th Street Building (located on F
Street) on business days between 7:00 a.m. and 5:00 p.m.
Public Inspection: All comments received, including any
personal information provided, will be posted generally without change
to https://www.fdic.gov/regulations/laws/federal.
Federal Housing Finance Agency: You may submit your written
comments on the proposed rulemaking, identified by RIN number, by any
of the following methods:
Agency Web site: www.fhfa.gov/open-for-comment-or-input.
Federal eRulemaking Portal: https://www.regulations.gov.
Follow the instructions for submitting comments. If you submit your
comment to the Federal eRulemaking Portal, please also send it by email
to FHFA at RegComments@fhfa.gov to ensure timely receipt by the Agency.
Please include ``RIN 2590-AA42'' in the subject line of the message.
Hand Delivery/Courier: The hand delivery address is:
Alfred M. Pollard, General Counsel, Attention: Comments/RIN 2590-AA42,
Federal Housing Finance Agency, Eighth Floor, 400 7th Street SW.,
Washington, DC 20219. The package should be delivered at the 7th Street
entrance Guard Desk, First Floor, on business days between 9 a.m. and 5
p.m.
U.S. Mail, United Parcel Service, Federal Express, or
Other Mail Service: The mailing address for comments is: Alfred M.
Pollard, General Counsel, Attention: Comments/RIN 2590-AA42, Federal
Housing Finance Agency, 400 7th Street SW., Washington, DC 20219.
Please note that all mail sent to FHFA via U.S. Mail is routed through
a national irradiation facility, a process that may delay delivery by
approximately two weeks.
All comments received by the deadline will be posted without change
for public inspection on the FHFA Web site at https://www.fhfa.gov, and
will include any personal information provided, such as name, address
(mailing and email), and telephone numbers. Copies of all comments
timely received will be available for public inspection and copying at
the address above on government-business days between the hours of
10:00 a.m. and 3:00 p.m. To make an appointment to inspect comments
please call the Office of General Counsel at (202) 649-3804.
National Credit Union Administration: You may submit comments by
any of the following methods (please send comments by one method only):
Federal eRulemaking Portal: https://www.regulations.gov.
Follow the instructions for submitting comments.
Agency Web site: https://www.ncua.gov. Follow the
instructions for submitting comments.
Email: Address to regcomments@ncua.gov. Include ``[Your
name] Comments on ``Notice of Proposed Rulemaking for Incentive-based
Compensation Arrangements'' in the email subject line.
Fax: (703) 518-6319. Use the subject line described above
for email.
Mail: Address to Gerard S. Poliquin, Secretary of the
Board, National Credit Union Administration, 1775 Duke Street,
Alexandria, Virginia 22314-3428.
Hand Delivery/Courier: Same as mail address.
Public Inspection: All public comments are available on
the agency's Web site at https://www.ncua.gov/Legal/Regs/Pages/PropRegs.aspx as submitted, except when not possible for technical
reasons. Public comments will not be edited to remove any identifying
or contact information. Paper copies of comments may be inspected in
NCUA's law library at 1775 Duke Street, Alexandria, Virginia 22314, by
appointment weekdays between 9:00 a.m. and 3:00 p.m. To make an
appointment, call (703) 518-6546 or send an email to OGCMail@ncua.gov.
Securities and Exchange Commission: You may submit comments by the
following method:

Electronic Comments

Use the SEC's Internet comment form (https://www.sec.gov/rules/proposed.shtml);
Send an email to rule-comments@sec.gov. Please include
File Number S7-07-16 on the subject line; or
Use the Federal eRulemaking Portal (https://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

Send paper comments in triplicate to Brent J. Fields,
Secretary, Securities and Exchange Commission, 100 F Street NE.,
Washington, DC 20549.

All submissions should refer to File Number S7-07-16. This file number
should be included on the subject line if email is used. To help us
process and review your comments more efficiently, please use only one
method. The SEC will post all comments on the SEC's Internet Web site
(https://www.sec.gov/rules/proposed.shtml). Comments are also available
for Web site viewing and printing in the SEC's Public Reference Room,
100 F Street NE., Washington, DC 20549 on official business days
between the hours of 10:00 a.m. and 3:00 p.m. All comments received
will be posted without change; the SEC does not edit personal
identifying information from submissions. You should submit only
information that you wish to make available publicly.
Studies, memoranda or other substantive items may be added by the
SEC or staff to the comment file during this rulemaking. A notification
of the inclusion in the comment file of any such materials will be made
available on the SEC's Web site. To ensure direct electronic receipt of
such notifications, sign up through the ``Stay Connected'' option at
www.sec.gov to receive notifications by email.

FOR FURTHER INFORMATION CONTACT:
OCC: Patrick T. Tierney, Assistant Director, Alison MacDonald,
Senior Attorney, and Melissa Lisenbee, Attorney, Legislative and
Regulatory Activities, (202) 649-5490, and Judi McCormick, Analyst,
Operational Risk Policy, (202) 649-6415, Office of the Comptroller of
the Currency, 400 7th Street SW., Washington, DC 20219.
Board: Teresa Scott, Manager, (202) 973-6114, Meg Donovan, Senior
Supervisory Financial Analyst, (202)

[[Page 37672]]

872-7542, or Joe Maldonado, Supervisory Financial Analyst, (202) 973-
7341, Division of Banking Supervision and Regulation; or Laurie
Schaffer, Associate General Counsel, (202) 452-2272, Michael Waldron,
Special Counsel, (202) 452-2798, Gillian Burgess, Counsel, (202) 736-
5564, Flora Ahn, Counsel, (202) 452-2317, or Steve Bowne, Senior
Attorney, (202) 452-3900, Legal Division, Board of Governors of the
Federal Reserve System, 20th and C Streets NW., Washington, DC 20551.
FDIC: Rae-Ann Miller, Associate Director, Risk Management Policy,
Division of Risk Management Supervision (202) 898-3898, Catherine
Topping, Counsel, Legal Division, (202) 898-3975, and Nefretete Smith,
Counsel, Legal Division, (202) 898-6851.
FHFA: Mary Pat Fox, Manager, Executive Compensation Branch, (202)
649-3215; or Lindsay Simmons, Assistant General Counsel, (202) 649-
3066, Federal Housing Finance Agency, 400 7th Street SW., Washington,
DC 20219. The telephone number for the Telecommunications Device for
the Hearing Impaired is (800) 877-8339.
NCUA: Vickie Apperson, Program Officer, and Jeffrey Marshall,
Program Officer, Office of Examination & Insurance, (703) 518-6360; or
Elizabeth Wirick, Senior Staff Attorney, Office of General Counsel,
(703) 518-6540, National Credit Union Administration, 1775 Duke Street,
Alexandria, Virginia 22314.
SEC: Raymond A. Lombardo, Branch Chief, Kevin D. Schopp, Special
Counsel, Division of Trading & Markets, (202) 551-5777 or
tradingandmarkets@sec.gov; Sirimal R. Mukerjee, Senior Counsel, Melissa
R. Harke, Branch Chief, Division of Investment Management, (202) 551-
6787 or IARules@SEC.gov, U.S. Securities and Exchange Commission, 100 F
Street NE., Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction
A. Background
B. Supervisory Experience
C. Overview of the 2011 Proposed Rule and Public Comment
D. International Developments
E. Overview of the Proposed Rule
II. Section-by-Section Description of the Proposed Rule
Sec. __.1 Authority, Scope and Initial Applicability
Sec. __.2 Definitions
Definitions Pertaining to Covered Institutions
Consolidation
Level 1, Level 2, and Level 3 Covered Institutions
Definitions Pertaining to Covered Persons
Relative Compensation Test
Exposure Test
Exposure Test at Certain Affiliates
Dollar Threshold Test
Other Definitions
Relationship Between Defined Terms
Sec. __.3 Applicability
(a) When Average Total Consolidated Assets Increase
(b) When Total Consolidated Assets Decrease
(c) Compliance of Covered Institutions That Are Subsidiaries of
Covered Institutions
Sec. __.4 Requirements and Prohibitions Applicable to All
Covered Institutions
(a) In General
(b) Excessive Compensation
(c) Material Financial Loss
(d) Performance Measures
(e) Board of Directors
(f) Disclosure and Recordkeeping Requirements and (g) Rule of
Construction
Sec. __.5 Additional Disclosure and Recordkeeping Requirements
for Level 1 and Level 2 Covered Institutions
Sec. __.6 Reservation of Authority for Level 3 Covered
Institutions
Sec. __.7 Deferral, Forfeiture and Downward Adjustment, and
Clawback Requirements for Level 1 and Level 2 Covered Institutions
Sec. __.7(a) Deferral
Sec. __.7(a)(1) and Sec. __.7(a)(2) Minimum Deferral Amounts
and Deferral Periods for Qualifying Incentive-Based Compensation and
Incentive-Based Compensation Awarded Under a Long-Term Incentive
Plan
Pro Rata Vesting
Acceleration of Payments
Qualifying Incentive-Based Compensation and Incentive-Based
Compensation Awarded Under a Long-Term Incentive Plan
Sec. __.7(a)(3) Adjustments of Deferred Qualifying Incentive-
Based Compensation and Deferred Long-Term Incentive Plan
Compensation Amounts
Sec. __.7(a)(4) Composition of Deferred Qualifying Incentive-
Based Compensation and Deferred Long-Term Incentive Plan
Compensation for Level 1 and Level 2 Covered Institutions
Cash and Equity-Like Instruments
Options
Sec. __.7(b) Forfeiture and Downward Adjustment
Sec. __.7(b)(1) Compensation at Risk
Sec. __.7(b)(2) Events Triggering Forfeiture and Downward
Adjustment Review
Sec. __.7(b)(3) Senior Executive Officers and Significant Risk-
Takers Affected by Forfeiture and Downward Adjustment
Sec. __.7(b)(4) Determining Forfeiture and Downward Adjustment
Amounts
Sec. __.7(c) Clawback
Sec. __.8 Additional Prohibitions for Level 1 and Level 2
Covered Institutions
Sec. __.8(a) Hedging
Sec. __.8(b) Maximum Incentive-Based Compensation Opportunity
Sec. __.8(c) Relative Performance Measures
Sec. __.8(d) Volume-Driven Incentive-Based Compensation
Sec. __.9 Risk Management and Controls Requirements for Level 1
and Level 2 Covered Institutions
Sec. __.10 Governance Requirements for Level 1 and Level 2
Covered Institutions
Sec. __.11 Policies and Procedures Requirements for Level 1 and
Level 2 Covered Institutions
Sec. __.12 Indirect Actions
Sec. __.13 Enforcement
Sec. __.14 NCUA and FHFA Covered Institutions in
Conservatorship, Receivership, or Liquidation
SEC Amendment to Exchange Act Rule 17a-4
SEC Amendment to Investment Advisers Act Rule 204-2
III. Appendix to the Supplementary Information: Example Incentive-
Based Compensation Arrangement and Forfeiture and Downward
Adjustment Review
Ms. Ledger: Senior Executive Officer at Level 2 Covered
Institution Balance
Award of Incentive-Based Compensation for Performance Periods
Ending December 31, 2024
Vesting Schedule
Use of Options in Deferred Incentive-Based Compensation
Other Requirements Specific to Ms. Ledger's Incentive-Based
Compensation Arrangement
Risk Management and Controls and Governance
Recordkeeping
Mr. Ticker: Forfeiture and Downward Adjustment Review
IV. Request for Comments
V. Regulatory Analysis
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
C. The Treasury and General Government Appropriations Act,
1999--Assessment of Federal Regulations and Policies on Families
D. Riegle Community Development and Regulatory Improvement Act
of 1994
E. Solicitation of Comments on Use of Plain Language
F. OCC Unfunded Mandates Reform Act of 1995 Determination
G. Differences Between the Federal Home Loan Banks and the
Enterprises
H. NCUA Executive Order 13132 Determination
I. SEC Economic Analysis
J. Small Business Regulatory Enforcement Fairness Act
List of Subjects

I. Introduction

Section 956 of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (the ``Dodd-Frank Act'' or the ``Act'') \1\ requires the
Agencies to jointly prescribe regulations or guidelines with respect to
incentive-based compensation practices at certain financial
institutions (referred to as ``covered financial

[[Page 37673]]

institutions'').\2\ Specifically, section 956 of the Dodd-Frank Act
(``section 956'') requires that the Agencies prohibit any types of
incentive-based compensation \3\ arrangements, or any feature of any
such arrangements, that the Agencies determine encourage inappropriate
risks by a covered financial institution: (1) By providing an executive
officer, employee, director, or principal shareholder of the covered
financial institution with excessive compensation, fees, or benefits;
or (2) that could lead to material financial loss to the covered
financial institution. Under the Act, a covered financial institution
also must disclose to its appropriate Federal regulator the structure
of its incentive-based compensation arrangements sufficient to
determine whether the structure provides excessive compensation, fees,
or benefits or could lead to material financial loss to the
institution. The Dodd-Frank Act does not require a covered financial
institution to report the actual compensation of particular
individuals.
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\1\ Public Law 111-203, 124 Stat. 1376 (2010).
\2\ 12 U.S.C. 5641.
\3\ Section 956(b) uses the term ``incentive-based payment
arrangement.'' It appears that Congress used the terms ``incentive-
based payment arrangement'' and ``incentive-based compensation
arrangement'' interchangeably. The Agencies have chosen to use the
term ``incentive-based compensation arrangement'' throughout the
proposed rule and this SUPPLEMENTARY INFORMATION section for the
sake of clarity.
---------------------------------------------------------------------------

The Act defines ``covered financial institution'' to include any of
the following types of institutions that have $1 billion or more in
assets: (A) A depository institution or depository institution holding
company, as such terms are defined in section 3 of the Federal Deposit
Insurance Act (``FDIA'') (12 U.S.C. 1813); (B) a broker-dealer
registered under section 15 of the Securities Exchange Act of 1934 (15
U.S.C. 78o); (C) a credit union, as described in section
19(b)(1)(A)(iv) of the Federal Reserve Act; (D) an investment adviser,
as such term is defined in section 202(a)(11) of the Investment
Advisers Act of 1940 (15 U.S.C. 80b-2(a)(11)); (E) the Federal National
Mortgage Association (Fannie Mae); (F) the Federal Home Loan Mortgage
Corporation (Freddie Mac); and (G) any other financial institution that
the appropriate Federal regulators, jointly, by rule, determine should
be treated as a covered financial institution for these purposes.
The Act also requires that any compensation standards adopted under
section 956 be comparable to the safety and soundness standards
applicable to insured depository institutions under section 39 of the
FDIA \4\ and that the Agencies take the compensation standards
described in section 39 of the FDIA into consideration in establishing
compensation standards under section 956.\5\ As explained in greater
detail below, the standards established by the proposed rule are
comparable to the standards established under section 39 of the FDIA.
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\4\ 12 U.S.C. 1831p-1. The OCC, Board, and FDIC (collectively,
the ``Federal Banking Agencies'') each have adopted guidelines
implementing the compensation-related and other safety and soundness
standards in section 39 of the FDIA. See Interagency Guidelines
Establishing Standards for Safety and Soundness (the ``Federal
Banking Agency Safety and Soundness Guidelines''), 12 CFR part 30,
Appendix A (OCC); 12 CFR part 208, Appendix D-1 (Board); 12 CFR part
364, Appendix A (FDIC).
\5\ 12 U.S.C. 1831p-1(c).
---------------------------------------------------------------------------

In April 2011, the Agencies published a joint notice of proposed
rulemaking that proposed to implement section 956 (2011 Proposed
Rule).\6\ Since the 2011 Proposed Rule was published, incentive-based
compensation practices have evolved in the financial services industry.
The Board, the OCC, and the FDIC have gained experience in applying
guidance on incentive-based compensation,\7\ FHFA has gained
supervisory experience in applying compensation-related rules \8\
adopted under the authority of the Safety and Soundness Act,\9\ and
foreign jurisdictions have adopted incentive-based compensation
remuneration codes, regulations, and guidance.\10\ In light of these
developments and the comments received on the 2011 Proposed Rule, the
Agencies are publishing a new proposed rule to implement section 956.
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\6\ 76 FR 21170 (April 14, 2011).
\7\ OCC, Board, FDIC, and Office of Thrift Supervision,
``Guidance on Sound Incentive Compensation Policies'' (``2010
Federal Banking Agency Guidance''), 75 FR 36395 (June 25, 2010).
\8\ These include the Executive Compensation Rule (12 CFR part
1230), the Golden Parachute Payments Rule (12 CFR part 1231), and
the Federal Home Loan Bank Directors' Compensation and Expenses Rule
(12 CFR part 1261 subpart C).
\9\ The Safety and Soundness Act means the Federal Housing
Enterprises Financial Safety and Soundness Act of 1992, as amended
(12 U.S.C. 4501 et seq.). 12 CFR 1201.1.
\10\ See, e.g., the European Union, Directive 2013/36/EU
(effective January 1, 2014); United Kingdom Prudential Regulation
Authority (``PRA'') and Financial Conduct Authority (``FCA''), ``PRA
PS12/15/FCA PS15/16: Strengthening the Alignment of Risk and Reward:
New Remuneration Rules'' (June 25, 2015) (``UK Remuneration
Rules''), available at https://www.bankofengland.co.uk/pra/Documents/publications/ps/2015/ps1215.pdf; Australian Prudential Regulation
Authority (``APRA''), Prudential Practice Guide SPG 511--
Remuneration (November 2013), available at https://www.apra.gov.au/Super/Documents/Prudential-Practice-Guide-SPG-511-Remuneration.pdf;
Canada, The Office of the Superintendent of Financial Institutions
(``OSFI'') Corporate Governance Guidelines (January 2013) (``OSFI
Corporate Governance Guidelines''), available at https://www.osfi-bsif.gc.ca/eng/fi-if/rg-ro/gdn-ort/gl-ld/pages/cg_guideline.aspx and
Supervisory Framework (December 2010) (``OSFI Supervisory
Framework''), available at https://www.osfi-bsif.gc.ca/Eng/Docs/sframew.pdf; Switzerland, Financial Market Supervisory Authority
(``FINMA''), 2010/01 FINMA Circular on Remuneration Schemes (October
2009) (``FINMA Remuneration Circular''), available at https://www.finma.ch/en/documentation/circulars/#Order=2.
---------------------------------------------------------------------------

The first part of this SUPPLEMENTARY INFORMATION section provides
background information on the proposed rule, including a summary of the
2011 Proposed Rule and areas in which the proposed rule differs from
the 2011 Proposed Rule. The second part contains a section-by-section
description of the proposed rule.\11\ To help explain how the
requirements of the proposed rule would work in practice, the Appendix
to this SUPPLEMENTARY INFORMATION section sets out an example of an
incentive-based compensation arrangement for a hypothetical senior
executive officer at a hypothetical large banking organization and an
example of how a forfeiture and downward adjustment review might be
conducted for a senior manager at a hypothetical large banking
organization.
---------------------------------------------------------------------------

\11\ This section-by-section description also includes certain
examples of how the proposed rule would work in practice. These
examples are intended solely for purposes of illustration and do not
cover every aspect of the proposed rule. They are provided as an aid
to understanding the proposed rule and do not carry the force and
effect of law or regulation.
---------------------------------------------------------------------------

For ease of reference, the proposed rules of the Agencies are
referenced in this Supplementary Information section using a common
designation of section __.1 to section __.14 (excluding the title and
part designations for each agency). Each agency would codify its rule,
if adopted, within its respective title of the Code of Federal
Regulations.\12\
---------------------------------------------------------------------------

\12\ Specifically, the Agencies propose to codify the rules as
follows: 12 CFR part 42 (OCC); 12 CFR part 236 (the Board); 12 CFR
part 372 (FDIC); 17 CFR part 303 (SEC); 12 CFR parts 741 and 751
(NCUA); and 12 CFR part 1232 (FHFA).
---------------------------------------------------------------------------

A. Background

Incentive-based compensation arrangements are critical tools in the
management of financial institutions. These arrangements serve several
important objectives, including attracting and retaining skilled staff
and promoting better performance of the institution and individual
employees. Well-structured incentive-based compensation arrangements
can promote the health of a financial institution by aligning the
interests of executives and employees with those of

[[Page 37674]]

the institution's shareholders and other stakeholders. At the same
time, poorly structured incentive-based compensation arrangements can
provide executives and employees with incentives to take inappropriate
risks that are not consistent with the long-term health of the
institution and, in turn, the long-term health of the U.S. economy.
Larger financial institutions in particular are interconnected with one
another and with many other companies and markets, which can mean that
any negative impact from inappropriate risk-taking can have broader
consequences. The risk of these negative externalities may not be fully
taken into account in incentive-based compensation arrangements, even
arrangements that otherwise align the interests of shareholders and
other stakeholders with those of executives and employees.
There is evidence that flawed incentive-based compensation
practices in the financial industry were one of many factors
contributing to the financial crisis that began in 2007. Some
compensation arrangements rewarded employees--including non-executive
personnel like traders with large position limits, underwriters, and
loan officers--for increasing an institution's revenue or short-term
profit without sufficient recognition of the risks the employees'
activities posed to the institutions, and therefore potentially to the
broader financial system.\13\ Traders with large position limits,
underwriters, and loan officers are three examples of non-executive
personnel who had the ability to expose an institution to material
amounts of risk. Significant losses caused by actions of individual
traders or trading groups occurred at some of the largest financial
institutions during and after the financial crisis.\14\
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\13\ See, e.g., Financial Crisis Inquiry Commission, ``Financial
Crisis Inquiry Report'' (January 2011), at 209, 279, 291, 343,
available at https://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf; Senior Supervisors Group, ``Observations on Risk
Management Practices during the Recent Market Turbulence'' (March 6,
2008), available at https://www.newyorkfed.org/medialibrary/media/newsevents/news/banking/2008/SSG_Risk_Mgt_doc_final.pdf.
\14\ A large financial institution suffered losses in 2012 from
trading by an investment office in its synthetic credit portfolio.
These losses amounted to approximately $5.8 billion, which was
approximately 3.6 percent of the holding company's tier 1 capital.
https://www.sec.gov/Archives/edgar/data/19617/000001961713000221/0000019617-13-000221-index.htm Form 10-K 2013, Pages 69 and 118. In
2007, a proprietary trading group at another large institution
caused losses of an estimated $7.8 billion (approximately 25 percent
of the firm's total stockholder's equity). https://www.morganstanley.com/about-us-ir/shareholder/10k113008/10k1108.pdf
Form 10-K 2008, Pages 45 and 108. Between 2005 and 2008, one futures
trader at a large financial institution engaged in activities that
caused losses of an estimated EUR4.9 billion in 2007, which was
approximately 23 percent of the firm's 2007 tier 1 capital. https://www.societegenerale.com/sites/default/files/03%20March%202008%202008%20Registration%20Document.pdf, Pages, 52,
159-160; https://www.societegenerale.com/sites/default/files/12%20May%202008%20The%20report%20by%20the%20General%20Inspection%20of%20Societe%20Generale.pdf, Pages 1-71. In 2011, one trader at
another large financial institution caused losses of an estimated
$2.25 billion, which represented approximately 5.4 percent of the
firm's tier 1 capital. https://www.fca.org.uk/news/press-releases/fca-bans-kweku-mawuli-adoboli-from-the-financial-services-industry,
Page 1; https://www.ubs.com/global/en/about_ubs/investor_relations/other_filings/sec.html. 2012 SEC Form 20-F, Page 34. In 2007, one
trader caused losses of an estimated $264 million at a large
financial institution, which represented approximately 1.7 percent
of its tier 1 capital. https://www.federalreserve.gov/newsevents/press/enforcement/20081118a.htm, Page 1; https://www.bmo.com/ci/ar2008/downloads/bmo_ar2008.pdf, Page 61.
---------------------------------------------------------------------------

Of particular note were incentive-based compensation arrangements
for employees in a position to expose the institution to substantial
risk that failed to align the employees' interests with those of the
institution. For example, some institutions gave loan officers
incentives to write a large amount of loans or gave traders incentives
to generate high levels of trading revenues, without sufficient regard
for the risks associated with those activities. The revenues that
served as the basis for calculating bonuses were generated immediately,
while the risk outcomes might not have been realized for months or
years after the transactions were completed. When these, or similarly
misaligned incentive-based compensation arrangements, are common in an
institution, the foundation of sound risk management can be undermined
by the actions of employees seeking to maximize their own compensation.
The effect of flawed incentive-based compensation practices is
demonstrated by the arrangements implemented by Washington Mutual
(WaMu). According to the Senate Permanent Subcommittee on
Investigations Staff's report on the failure of WaMu ``[l]oan officers
and processors were paid primarily on volume, not primarily on the
quality of their loans, and were paid more for issuing higher risk
loans. Loan officers and mortgage brokers were also paid more when they
got borrowers to pay higher interest rates, even if the borrower
qualified for a lower rate--a practice that enriched WaMu in the short
term, but made defaults more likely down the road.'' \15\
---------------------------------------------------------------------------

\15\ Staff of S. Permanent Subcomm. on Investigations, Wall
Street and the Financial Crisis: Anatomy of a Financial Collapse at
143 (Comm. Print 2011).
---------------------------------------------------------------------------

Flawed incentive-based compensation arrangements were evident in
not just U.S. financial institutions, but also major financial
institutions worldwide.\16\ In a 2009 survey of banking organizations
engaged in wholesale banking activities, the Institute of International
Finance found that 98 percent of respondents recognized the
contribution of incentive-based compensation practices to the financial
crisis.\17\
---------------------------------------------------------------------------

\16\ See Financial Stability Forum, ``FSF Principles for Sound
Compensation Practices'' (April 2009) (the ``FSB Principles''),
available at https://www.financialstabilityboard.org/publications/r_0904b.pdf; Senior Supervisors Group, ``Risk-management Lessons
from the Global Banking Crisis of 2008'' (October 2009), available
at https://www.newyorkfed.org/newsevents/news/banking/2009/ma091021.html. The Financial Stability Forum was renamed the
Financial Stability Board (``FSB'') in April 2009.
\17\ See Institute of International Finance, Inc.,
``Compensation in Financial Services: Industry Progress and the
Agenda for Change'' (March 2009), available at https://www.oliverwyman.com/ow/pdf_files/OW_En_FS_Publ_2009_CompensationInFS.pdf. See also UBS, ``Shareholder
Report on UBS's Write-Downs,'' (April 18, 2008), at 41-42
(identifying incentive effects of UBS compensation practices as
contributing factors in losses suffered by UBS due to exposure to
the subprime mortgage market), available at https://www.ubs.com/1/ShowMedia/investors/agm?contentId=140333&name=080418ShareholderReport.pdf.
---------------------------------------------------------------------------

Shareholders and other stakeholders in a covered institution \18\
have an interest in aligning the interests of executives, managers, and
other employees with the institution's long-term health. However,
aligning the interests of shareholders (or members, in the case of
credit unions, mutual savings associations, mutual savings banks, some
mutual holding companies, and Federal Home Loan Banks) and other
stakeholders with employees may not always be sufficient to protect the
safety and soundness of an institution, deter excessive compensation,
or deter behavior or inappropriate risk-taking that could lead to
material financial loss at the institution. Executive officers and
employees of a covered institution may be willing to tolerate a degree
of risk that is inconsistent with the interests of stakeholders, as
well as broader public policy goals.
---------------------------------------------------------------------------

\18\ As discussed below, the proposed rule uses the term
``covered institution'' rather than the statutory term ``covered
financial institution.''
---------------------------------------------------------------------------

Generally, the incentive-based compensation arrangements of a
covered institution should reflect the interests of the shareholders
and other stakeholders, to the extent that the incentive-based
compensation makes those covered persons demand more or less reward for
their risk-taking at the covered institution, and to the extent that
incentive-based compensation

[[Page 37675]]

changes those covered persons' risk-taking. However, risks undertaken
by a covered institution--particularly a larger institution--can spill
over into the broader economy, affecting other institutions and
stakeholders. Therefore, there may be reasons why the preferences of
all of the stakeholders are not fully reflected in incentive-based
compensation arrangements. Hence, there is a public interest in
curtailing the inappropriate risk-taking incentives provided by
incentive-based compensation arrangements. Without restrictions on
incentive-based compensation arrangements, covered institutions may
engage in more risk-taking than is optimal from a societal perspective,
suggesting that regulatory measures may be required to cut back on the
risk-taking incentivized by such arrangements. Particularly at larger
institutions, shareholders and other stakeholders may have difficulty
effectively monitoring and controlling the impact of incentive-based
compensation arrangements throughout the institution that may affect
the institution's risk profile, the full range of stakeholders, and the
larger economy.
As a result, supervision and regulation of incentive-based
compensation can play an important role in helping safeguard covered
institutions against incentive-based compensation practices that
threaten safety and soundness, are excessive, or could lead to material
financial loss. In particular, such supervision and regulation can help
address the negative externalities affecting the broader economy or
other institutions that may arise from inappropriate risk-taking by
large financial institutions.

B. Supervisory Experience

To address such practices, the Federal Banking Agencies proposed,
and then later adopted, the 2010 Federal Banking Agency Guidance
governing incentive-based compensation programs, which applies to all
banking organizations regardless of asset size. This Guidance uses a
principles-based approach to ensure that incentive-based compensation
arrangements appropriately tie rewards to longer-term performance and
do not undermine the safety and soundness of banking organizations or
create undue risks to the financial system. In addition, to foster
implementation of improved incentive-based compensation practices, the
Board, in cooperation with the OCC and FDIC, initiated in late 2009 a
multidisciplinary, horizontal review (``Horizontal Review'') of
incentive-based compensation practices at 25 large, complex banking
organizations, which is still ongoing.\19\ One goal of the Horizontal
Review is to help improve the Federal Banking Agencies' understanding
of the range and evolution of incentive-based compensation practices
across institutions and categories of employees within institutions.
The second goal is to provide guidance to each institution in
implementing the 2010 Federal Banking Agency Guidance. The supervisory
experience of the Federal Banking Agencies in this area is also
relevant to the incentive-based compensation practices at broker-
dealers and investment advisers.
---------------------------------------------------------------------------

\19\ The financial institutions in the Horizontal Review are
Ally Financial Inc.; American Express Company; Bank of America
Corporation; The Bank of New York Mellon Corporation; Capital One
Financial Corporation; Citigroup Inc.; Discover Financial Services;
The Goldman Sachs Group, Inc.; JPMorgan Chase & Co.; Morgan Stanley;
Northern Trust Corporation; The PNC Financial Services Group, Inc.;
State Street Corporation; SunTrust Banks, Inc.; U.S. Bancorp; and
Wells Fargo & Company; and the U.S. operations of Barclays plc, BNP
Paribas, Credit Suisse Group AG, Deutsche Bank AG, HSBC Holdings
plc, Royal Bank of Canada, The Royal Bank of Scotland Group plc,
Societe Generale, and UBS AG.
---------------------------------------------------------------------------

As part of the Horizontal Review, the Board conducted reviews of
line of business operations in the areas of trading, mortgage, credit
card, and commercial lending operations as well as senior executive
incentive-based compensation awards and payouts. The institutions
subject to the Horizontal Review have made progress in developing
practices that would incorporate the principles of the 2010 Federal
Banking Agency Guidance into their risk management systems, including
through better recognition of risk in incentive-based compensation
decision-making and improved practices to better balance risk and
reward. Many of those changes became evident in the actual compensation
arrangements of the institutions as the review progressed. In 2011, the
Board made public its initial findings from the Horizontal Review,
recognizing the steps the institutions had made towards improving their
incentive-based compensation practices, but also noting that each
institution needed to do more.\20\ In early 2012, the Board initiated a
second, cross-firm review of 12 additional large banking organizations
(``2012 LBO Review''). The Board also monitors incentive-based
compensation as part of ongoing supervision. Supervisory oversight
focuses most intensively on large banking organizations because they
are significant users of incentive-based compensation and because
flawed approaches at these organizations are more likely to have
adverse effects on the broader financial system. As part of that
supervision, the Board also conducts targeted incentive-based
compensation exams and considers incentive-based compensation in the
course of wider line of business and risk-related reviews.
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\20\ Board, ``Incentive Compensation Practices: A Report on the
Horizontal Review of Practices at Large Banking Organizations''
(October 2011) (``2011 FRB White Paper), available at https://www.federalreserve.gov/publications/other-reports/files/incentive-compensation-practices-report-201110.pdf.
---------------------------------------------------------------------------

For the past several years, the Board also has been actively
engaged in international compensation, governance, and conduct working
groups that have produced a variety of publications aimed at further
improving incentive-based compensation practices.\21\
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\21\ See, e.g., FSB Principles; FSB, ``FSB Principles for Sound
Compensation Practices: Implementation Standards, Basel,
Switzerland'' (September 2009), available at https://www.fsb.org/wp-content/uploads/r_090925c.pdf?page_moved=1 (together with the FSB
Principles, the ``FSB Principles and Implementation Standards'');
Basel Committee on Banking Supervision, ``Report on Range of
Methodologies for Risk and Performance Alignment of Remuneration''
(May 2011); Basel Committee on Banking Supervision, ``Principles for
the Effective Supervision of Financial Conglomerates'' (September
2012); FSB, ``Implementing the FSB Principles for Sound Compensation
Practices and their Implementation Standards--First, Second, Third,
and Fourth Progress Reports'' (June 2012, August 2013, November
2014, November 2015), available at https://www.fsb.org/publications/?policy_area%5B%5D=24.
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The FDIC reviews incentive-based compensation practices as part of
its safety and soundness examinations of state nonmember banks, most of
which are smaller community institutions that would not be covered by
the proposed rule. FDIC incentive-based compensation reviews are
conducted in the context of the 2010 Federal Banking Agency Guidance
and Section 39 of the FDIA. Of the 518 bank failures resolved by the
FDIC between 2007 and 2015, 65 involved banks with total assets of $1
billion or more that would have been covered by the proposed rule. Of
the 65 institutions that failed with total assets of $1 billion or
more, 18 institutions or approximately 28 percent, were identified as
having some level of issues or concerns related to compensation
arrangements, many of which involved incentive-based compensation.
Overall, most of the compensation issues related to either excessive
compensation or tying financial incentives to metrics such as corporate
performance or loan production without adequate consideration of
related risks. Also, several cases involved poor governance practices,
most commonly, dominant

[[Page 37676]]

management influencing improper incentives.\22\
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\22\ The Inspector General of the appropriate federal banking
agency must conduct a Material Loss Review (``MLR'') when losses to
the Deposit Insurance Fund from failure of an insured depository
institution exceed certain thresholds. See FDIC MLRs, available at
https://www.fdicig.gov/mlr.shtml; Board MLRs available at https://oig.federalreserve.gov/reports/audit-reports.htm; and OCC MLRs,
available at https://www.treasury.gov/about/organizational-structure/ig/Pages/audit_reports_index.aspx. See also the
Subcommittee Report.
---------------------------------------------------------------------------

The OCC reviews and assesses compensation practices at individual
banks as part of its normal supervisory activities. For example, the
OCC identifies matters requiring attention (MRAs) relating to
compensation practices, including matters relating to governance and
risk management and controls for compensation. The OCC's Guidelines
Establishing Heightened Standards for Certain Large Insured National
Banks, Insured Federal Savings Associations, and Insured Federal
Branches \23\ (the ``OCC's Heightened Standards'') require covered
banks to establish and adhere to compensation programs that prohibit
incentive-based payment arrangements that encourage inappropriate risks
by providing excessive compensation or that could lead to material
financial loss. The OCC includes an assessment of the banks'
compensation practices when determining compliance with the OCC's
Heightened Standards.
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\23\ 12 CFR part 30, appendix D.
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In addition to safety and soundness oversight, FHFA has express
statutory authorities and mandates related to compensation paid by its
regulated entities. FHFA reviews compensation arrangements before they
are implemented at Fannie Mae, Freddie Mac, the Federal Home Loan
Banks, and the Office of Finance of the Federal Home Loan Bank System.
By statute, FHFA must prohibit its regulated entities from providing
compensation to any executive officer of a regulated entity that is not
reasonable and comparable with compensation for employment in other
similar businesses (including publicly held financial institutions or
major financial services companies) involving similar duties and
responsibilities.\24\ FHFA also has additional authority over the
Enterprises during conservatorship, and has established compensation
programs for Enterprise executives.\25\
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\24\ 12 U.S.C. 4518(a).
\25\ As conservator, FHFA succeeded to all rights, titles,
powers and privileges of the Enterprises, and of any shareholder,
officer or director of each company with respect to the company and
its assets. The Enterprises have been under conservatorship since
September 2008.
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In early 2014, FHFA issued two final rules related to compensation
pursuant to its authority over compensation under the Safety and
Soundness Act.\26\ The Executive Compensation Rule sets forth
requirements and processes with respect to compensation provided to
executive officers by the Enterprises, the Federal Home Loan Banks, and
the Federal Home Loan Bank System's Office of Finance.\27\ Under the
rule, those entities may not enter into an incentive plan with an
executive officer or pay any incentive compensation to an executive
officer without providing advance notice to FHFA.\28\ FHFA's Golden
Parachute Payments Rule governs golden parachute payments in the case
of a regulated entity's insolvency, conservatorship, or troubled
condition.\29\
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\26\ 12 CFR parts 1230 and 1231, under the authority of the
Safety and Soundness Act (12 U.S.C. 4518), as amended by the Housing
and Economic Recovery Act of 2008. Congress enacted HERA, including
new or amended provisions addressing compensation at FHFA's
regulated entities, at least in part in response to the financial
crisis that began in 2007.
\27\ 12 CFR part 1230.
\28\ 12 CFR 1230.3(d).
\29\ 12 CFR part 1231.
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In part because of the work described above, incentive-based
compensation practices and the design of incentive-based compensation
arrangements at banking organizations supervised by the Federal Banking
Agencies have improved significantly in the years since the recent
financial crisis. However, the Federal Banking Agencies have continued
to evaluate incentive-based compensation practices as a part of their
ongoing supervision responsibilities, with a particular focus on the
design of incentive-based compensation arrangements for senior
executive officers; deferral practices (including compensation at risk
through forfeiture and clawback mechanisms); governance and the use of
discretion; ex ante risk adjustment; and control function participation
in incentive-based compensation design and risk evaluation. The Federal
Banking Agencies' supervision has been focused on ensuring robust risk
management and governance practices rather than on prescribing levels
of pay.
Generally, the supervisory work of the Federal Banking Agencies and
FHFA has promoted more risk-sensitive incentive-based compensation
practices and effective risk governance. Incentive-based compensation
decision-making increasingly leverages underlying risk management
frameworks to help ensure better risk identification, monitoring, and
escalation of risk issues. Prior to the recent financial crisis, many
institutions had no effective risk adjustments to incentive-based
compensation at all. Today, the Board has observed that incentive-based
compensation arrangements at the largest banking institutions reflect
risk adjustments, the largest banking institutions take into
consideration adverse outcomes, more pay is deferred, and more of the
deferred amount is subject to reduction based on failure to meet
assigned performance targets or as a result of adverse outcomes that
trigger forfeiture and clawback reviews.\30\
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\30\ See generally 2011 FRB White Paper. The 2011 FRB White
Paper provides specific examples of how compensation practices at
the institutions involved in the Board's Horizontal Review of
Incentive Compensation have changed since the recent financial
crisis.
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Similarly, prior to the recent financial crisis, institutions
rarely involved risk management and control personnel in incentive-
based compensation decision-making. Today, control functions frequently
play an increased role in the design and operation of incentive-based
compensation, and institutions have begun to build out frameworks to
help validate the effectiveness of risk adjustment mechanisms. Risk-
related performance objectives and ``risk reviews'' are increasingly
common. Prior to the recent financial crisis, boards of directors had
begun to consider the relationship between incentive-based compensation
and risk, but were focused on incentive-based compensation for senior
executives. Today, refined policies and procedures promote some
consistency and effectiveness across incentive-based compensation
arrangements. The role of boards of directors has expanded and the
quality of risk information provided to those boards has improved.
Finance and audit committees work together with compensation committees
with the goal of having incentive-based compensation result in prudent
risk-taking.
Notwithstanding the recent progress, incentive-based compensation
practices are still in need of improvement, including better targeting
of performance measures and risk metrics to specific activities, more
consistent application of risk adjustments, and better documentation of
the decision-making process. Congress has required the Agencies to
jointly prescribe regulations or guidelines that cover not only
depository institutions and depository institution holding companies,
but also other financial institutions. While the Federal Banking
Agencies' supervisory approach based on the 2010 Federal Banking Agency

[[Page 37677]]

Guidance and the work of FHFA have resulted in improved incentive-based
compensation practices, there are even greater benefits possible under
rule-based supervision. Using their collective supervisory experiences,
the Agencies are proposing a uniform set of enforceable standards
applicable to a larger group of institutions supervised by all of the
Agencies. The proposed rule would promote better incentive-based
compensation practices, while still allowing for some flexibility in
the design and operation of incentive-based compensation arrangements
among the varied institutions the Agencies supervise, including through
the tiered application of the proposed rule's requirements.

C. Overview of the 2011 Proposed Rule and Public Comment

The Agencies proposed a rule in 2011, rather than guidelines, to
establish requirements applicable to the incentive-based compensation
arrangements of all covered institutions. The 2011 Proposed Rule would
have supplemented existing rules, guidance, and ongoing supervisory
efforts of the Agencies.
The 2011 Proposed Rule would have prohibited incentive-based
compensation arrangements that could encourage inappropriate risks. It
would have required compensation practices at regulated financial
institutions to be consistent with three key principles--that
incentive-based compensation arrangements should appropriately balance
risk and financial rewards, be compatible with effective risk
management and controls, and be supported by strong corporate
governance. The Agencies proposed that financial institutions with $1
billion or more in assets be required to have policies and procedures
to ensure compliance with the requirements of the rule, and submit an
annual report to their Federal regulator describing the structure of
their incentive-based compensation arrangements.
The 2011 Proposed Rule included two additional requirements for
``larger financial institutions.'' \31\ The first would have required
these larger financial institutions to defer 50 percent of the
incentive-based compensation for executive officers for a period of at
least three years. The second would have required the board of
directors (or a committee thereof) to identify and approve the
incentive-based compensation for those covered persons who individually
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, such as traders with large position limits and other
individuals who have the authority to place at risk a substantial part
of the capital of the covered institution.
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\31\ In the 2011 Proposed Rule, the term ``larger covered
financial institution'' for the Federal Banking Agencies and the SEC
meant those covered institutions with total consolidated assets of
$50 billion or more. For the NCUA, all credit unions with total
consolidated assets of $10 billion or more would have been larger
covered institutions. For FHFA, Fannie Mae, Freddie Mac, and all
Federal Home Loan Banks with total consolidated assets of $1 billion
or more would have been larger covered institutions.
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The Agencies received more than 10,000 comments on the 2011
Proposed Rule, including from private individuals, community groups,
several members of Congress, pension funds, labor federations, academic
faculty, covered institutions, financial industry associations, and
industry consultants.
The vast majority of the comments were substantively identical form
letters of two types. The first type of form letter urged the Agencies
to minimize the incentives for short-term risk-taking by executives by
requiring at least a five-year deferral period for executive bonuses at
big banks, banning executives' hedging of their pay packages, and
requiring specific details from banks on precisely how they ensure that
executives will share in the long-term risks created by their
decisions. These commenters also asserted that the final rule should
apply to the full range of important financial institutions and cover
all the key executives at those institutions. The second type of form
letter stated that the commenter or the commenter's family had been
affected by the financial crisis that began in 2007, a major cause of
which the commenter believed to be faulty pay practices at financial
institutions. These commenters suggested various methods of improving
these practices, including basing incentive-based compensation on
measures of a financial institution's safety and stability, such as the
institution's bond price or the spread on credit default swaps.
Comments from community groups, members of Congress, labor
federations, and pension funds generally urged the Agencies to
strengthen the proposed rule and many cited evidence suggesting that
flawed incentive-based compensation practices in the financial industry
were a major contributing factor to the recent financial crisis. Their
suggestions included: Revising the 2011 Proposed Rule's definition of
``incentive-based compensation''; defining ``excessive compensation'';
increasing the length of time for or amount of compensation subject to
the mandatory deferral provision; requiring financial institutions to
include quantitative data in their annual incentive-based compensation
reports; providing for the annual public reporting by the Agencies of
information quantifying the overall sensitivity of incentive-based
compensation to long-term risks at major financial institutions;
prohibiting stock ownership by board members; and prohibiting hedging
strategies used by highly-paid executives on their own incentive-based
compensation.
The academic faculty commenters submitted analyses of certain
compensation issues and recommendations. These recommendations
included: Adopting a corporate governance measure tied to stock
ownership by board members; regulating how deferred compensation is
reduced at future payment dates; requiring covered institutions'
executives to have ``skin in the game'' for the entire deferral period;
and requiring disclosure of personal hedging transactions rather than
prohibiting them.
A number of covered institutions and financial industry
associations favored the issuance of guidelines instead of rules to
implement section 956. Others expressed varying degrees of support for
the 2011 Proposed Rule but also requested numerous clarifications and
modifications. Many of these commenters raised questions concerning the
2011 Proposed Rule's scope, suggesting that certain types of
institutions be excluded from the coverage of the final rule. Some of
these commenters questioned the need for the excessive compensation
prohibition or requested that the final rule provide specific standards
for determining when compensation is excessive. Many of these
commenters also opposed the 2011 Proposed Rule's mandatory deferral
provision, and some asserted that the provision was unsupported by
empirical evidence and potentially harmful to a covered institution's
ability to attract and retain key employees. In addition, many of these
commenters asserted that the material risk-taker provision in the 2011
Proposed Rule was unclear or imposed on the boards of directors of
covered institutions duties more appropriately undertaken by the
institutions' management. Finally, these commenters expressed concerns
about the burden and timing of the 2011 Proposed Rule.

D. International Developments

The Agencies considered international developments in

[[Page 37678]]

developing the 2011 Proposed Rule, mindful that some covered
institutions operate in both domestic and international competitive
environments.\32\ Since the release of the 2011 Proposed Rule, a number
of foreign jurisdictions have introduced new compensation regulations
that require certain financial institutions to meet certain standards
in relation to compensation policies and practices. In June 2013, the
European Union adopted the Capital Requirements Directive (``CRD'') IV,
which sets out requirements for compensation structures, policies, and
practices that apply to all banks and investment firms subject to the
CRD.\33\ The rules require that up to 100 percent of the variable
remuneration shall be subject to malus \34\ or clawback arrangements,
among other requirements.\35\ The PRA's and the FCA's Remuneration Code
requires covered companies to defer 40 to 60 percent of a covered
person's variable remuneration--and recently updated their implementing
regulations to extend deferral periods to seven years for senior
executives and to five years for certain other covered persons.\36\ The
PRA also implemented, in July 2014, a policy requiring firms to set
specific criteria for the application of malus and clawback. The PRA's
clawback policy requires that variable remuneration be subject to
clawback for a period of at least seven years from the date on which it
is awarded.\37\
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\32\ See 76 FR at 21178. See, e.g., FSB Principles and
Implementation Standards.
\33\ Directive 2013/36/EU of the European Parliament and of the
Council of 26 June 2013 (effective January 1, 2014). The
remuneration rules in CRD IV were carried over from CRD III with a
few additional requirements. CRD III directed the Committee of
European Bank Supervisors (``CEBS''), now the European Banking
Authority (``EBA''), to develop guidance on how it expected the
compensation principles under CRD III to be implemented. See CEBS
Guidelines on Remuneration Policies and Practices (December 10,
2010) (``CEBS Guidelines''), available at https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32010L0076&from=EN.
\34\ Malus is defined by the European Union as ``an arrangement
that permits the institution to prevent vesting of all or part of
the amount of a deferred remuneration award in relation to risk
outcomes or performance.'' See, PRA expectations regarding the
application of malus to variable remuneration--SS2/13 UPDATE,
available at: https://www.bankofengland.co.uk/pra/Documents/publications/ss/2015/ss213update.pdf.
\35\ CRD IV provides that at least 50 percent of total variable
remuneration should consist of equity-linked interests and at least
40 percent of any variable remuneration must be deferred over a
period of three to five years. In the case of variable remuneration
of a particularly high amount, the minimum amount required to be
deferred is increased to 60 percent.
\36\ See UK Remuneration Rules.
\37\ See PRA, ``PRA PS7/14: Clawback'' (July 2014), available at
https://www.bankofengland.co.uk/pra/Pages/publications/ps/2014/ps714.aspx.
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Also in 2013, the EBA finalized the process and criteria for the
identification of categories of staff who have a material impact on the
institution's risk profile (``Identified Staff'').\38\ These Identified
Staff are subject to provisions related, in particular, to the payment
of variable compensation. The standards cover remuneration packages for
Identified Staff categories and aim to ensure that appropriate
incentives for prudent, long-term oriented risk-taking are provided.
The criteria used to determine who is identified are both qualitative
(i.e., related to the role and decision-making authority of staff
members) and quantitative (i.e., related to the level of total gross
remuneration in absolute or in relative terms).
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\38\ EBA Regulatory Technical Standards on criteria to identify
categories of staff whose professional activities have a material
impact on an institution's risk profile under Article 94(2) of
Directive 2013/36/EU. Directive 2013/36/EU of the European
Parliament and of the Council of 26 June 2013 (December 16, 2013),
available at https://www.eba.europa.eu/documents/10180/526386/EBA-RTS-2013-11+%28On+identified+staff%29.pdf/c313a671-269b-45be-a748-29e1c772ee0e.
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More recently, in December 2015, the EBA released its final
Guidelines on Sound Remuneration Policies.\39\ The final Guidelines on
Sound Remuneration Policies set out the governance process for
implementing sound compensation policies across the European Union
under CRD IV, as well as the specific criteria for categorizing all
compensation components as either fixed or variable pay. The final
Guidelines on Sound Remuneration Policies also provide guidance on the
application of deferral arrangements and pay-out instruments to ensure
that variable pay is aligned with an institution's long-term risks and
that any ex-post risk adjustments can be applied as appropriate. These
Guidelines will apply as of January 1, 2017, and will replace the
Guidelines on Remuneration Policies and Practices that were published
by the CEBS in December 2010.
---------------------------------------------------------------------------

\39\ EBA, ``Guidelines for Sound Remuneration Policies under
Articles 74(3) and 75(2) of Directive 2013/36/EU and Disclosures
under Article 450 of Regulation (EU) No 575/2013'' (December 21,
2015) (``EBA Remuneration Guidelines''), available at https://www.eba.europa.eu/documents/10180/1314839/EBA-GL-2015-22+Guidelines+on+Sound+Remuneration+Policies.pdf/1b0f3f99-f913-461a-b3e9-fa0064b1946b.
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Other regulators, including those in Canada, Australia, and
Switzerland, have taken either a guidance-based approach to the
supervision and regulation of incentive-based compensation or an
approach that combines guidance and regulation that is generally
consistent with the FSB Principles and Implementation Standards. In
Australia,\40\ all deposit-taking institutions and insurers are
expected to comply in full with all the requirements in the APRA's
Governance standard (which includes remuneration provisions). APRA also
supervises according to its Remuneration Prudential Practice Guide
(guidance). In Canada,\41\ all federally regulated financial
institutions (domestic and foreign) are expected to comply with the FSB
Principles and Implementation Standards, and the six Domestic
Systemically Important Banks and three largest life insurance companies
are expected to comply with the FSB's Principles and Implementation
Standards. OSFI has also issued a Corporate Governance Guideline that
contain compensation provisions.\42\ Switzerland's Swiss Financial
Markets Supervisory Authority has also published a principles-based
rule on remuneration consistent with the FSB Principles and
Implementation Standards that applies to major banks and insurance
companies.\43\
---------------------------------------------------------------------------

\40\ See APRA, ``Prudential Standard CPS 510 Governance''
(January 2015), available at https://www.apra.gov.au/CrossIndustry/Documents/Final-Prudential-Standard-CPS-510-Governance-%28January-2014%29.pdf; APRA, Prudential Practice Guide PPG 511--Remuneration
(November 30, 2009), available at https://www.apra.gov.au/adi/PrudentialFramework/Pages/adi-prudential-framework.aspx.
\41\ See OSFI Corporate Governance Guidelines and OSFI
Supervisory Framework.
\42\ See OSFI Corporate Governance Guidelines.
\43\ See FINMA Remuneration Circular.
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As compensation practices continue to evolve, the Agencies
recognize that international coordination in this area is important to
ensure that internationally active financial organizations are subject
to consistent requirements. For this reason, the Agencies will continue
to work with their domestic and international counterparts to foster
sound compensation practices across the financial services industry.
Importantly, the proposed rule is consistent with the FSB Principles
and Implementation Standards.

E. Overview of the Proposed Rule

The Agencies are re-proposing a rule, rather than proposing
guidelines, to establish general requirements applicable to the
incentive-based compensation arrangements of all covered institutions.
Like the 2011 Proposed Rule, the proposed rule would prohibit
incentive-based compensation arrangements at covered institutions that
could encourage inappropriate risks by providing excessive compensation
or that could lead to a material financial

[[Page 37679]]

loss. However, the proposed rule reflects the Agencies' collective
supervisory experiences since they proposed the 2011 Proposed Rule.
These supervisory experiences, which are described above, have allowed
the Agencies to propose a rule that incorporates practices that
financial institutions and foreign regulators have adopted to address
the deficiencies in incentive-based compensation practices that helped
contribute to the financial crisis that began in 2007. For that reason,
the proposed rule differs in some respects from the 2011 Proposed Rule.
This section provides a general overview of the proposed rule and
highlights areas in which the proposed rule differs from the 2011
Proposed Rule. A more detailed, section-by-section description of the
proposed rule and the reasons for the proposed rule's requirements is
provided later in this Supplementary Information section.
Scope and Initial Applicability. Similar to the 2011 Proposed Rule,
the proposed rule would apply to any covered institution with average
total consolidated assets greater than or equal to $1 billion that
offers incentive-based compensation to covered persons.
The compliance date of the proposed rule would be no later than the
beginning of the first calendar quarter that begins at least 540 days
after a final rule is published in the Federal Register. The proposed
rule would not apply to any incentive-based compensation plan with a
performance period that begins before the compliance date.
Definitions. The proposed rule includes a number of new definitions
that were not included in the 2011 Proposed Rule. These definitions are
described later in the section-by-section analysis in this
Supplementary Information section. Notably, the Agencies have added a
definition of significant risk-taker, which is intended to include
individuals who are not senior executive officers but who are in the
position to put a Level 1 or Level 2 covered institution at risk of
material financial loss. This definition is explained in more detail
below.
Applicability. The proposed rule distinguishes covered institutions
by asset size, applying less prescriptive incentive-based compensation
program requirements to the smallest covered institutions within the
statutory scope and progressively more rigorous requirements to the
larger covered institutions. Although the 2011 Proposed Rule contained
specific requirements for covered financial institutions with at least
$50 billion in total consolidated assets, the proposed rule creates an
additional category of institutions with at least $250 billion in
average total consolidated assets. These larger institutions are
subject to the most rigorous requirements under the proposed rule.
The proposed rule identifies three categories of covered
institutions based on average total consolidated assets: \44\
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\44\ For covered institutions that are subsidiaries of other
covered institutions, levels would generally be determined by
reference to the average total consolidated assets of the top-tier
parent covered institution. A detailed explanation of consolidation
under the proposed rule is included under the heading ``Definitions
pertaining to covered institutions'' below in this Supplementary
Information section.
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Level 1 (greater than or equal to $250 billion);
Level 2 (greater than or equal to $50 billion and less
than $250 billion); and
Level 3 (greater than or equal to $1 billion and less than
$50 billion).\45\
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\45\ As explained later in this Supplementary Information
section, the proposed rule includes a reservation of authority that
would allow the appropriate Federal regulator of a Level 3 covered
institution with average total consolidated assets greater than or
equal to $10 billion and less than $50 billion to require the Level
3 covered institution to comply with some or all of the provisions
of sections __.5 and __.7 through __.11 of the proposed rule if the
agency determines that the complexity of operations or compensation
practices of the Level 3 covered institution are consistent with
those of a Level 1 or Level 2 covered institution.
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Upon an increase in average total consolidated assets, a covered
institution would be required to comply with any newly applicable
requirements under the proposed rule no later than the first day of the
first calendar quarter that begins at least 540 days after the date on
which the covered institution becomes a Level 1, Level 2, or Level 3
covered institution. The proposed rule would grandfather any incentive-
based compensation plan with a performance period that begins before
such date. Upon a decrease in total consolidated assets, a covered
institution would remain subject to the provisions of the proposed rule
that applied to it before the decrease until total consolidated assets
fell below $250 billion, $50 billion, or $1 billion, as applicable, for
four consecutive regulatory reports (e.g., Call Reports).
A covered institution under the Board's, the OCC's, or the FDIC's
proposed rule that is a subsidiary of another covered institution under
the Board's, the OCC's, or the FDIC's proposed rule, respectively, may
meet any requirement of the Board's, OCC's, or the FDIC's proposed rule
if the parent covered institution complies with that requirement in
such a way that causes the relevant portion of the incentive-based
compensation program of the subsidiary covered institution to comply
with that requirement.
Requirements and Prohibitions Applicable to All Covered
Institutions. Similar to the 2011 Proposed Rule, the proposed rule
would prohibit all covered institutions from establishing or
maintaining incentive-based compensation arrangements that encourage
inappropriate risk by providing covered persons with excessive
compensation, fees, or benefits or that could lead to material
financial loss to the covered institution.
Also consistent with the 2011 Proposed Rule, the proposed rule
provides that compensation, fees, and benefits will be considered
excessive when amounts paid are unreasonable or disproportionate to the
value of the services performed by a covered person, taking into
consideration all relevant factors, including:
The combined value of all compensation, fees, or benefits
provided to a covered person;
The compensation history of the covered person and other
individuals with comparable expertise at the covered institution;
The financial condition of the covered institution;
Compensation practices at comparable institutions, based
upon such factors as asset size, geographic location, and the
complexity of the covered institution's operations and assets;
For post-employment benefits, the projected total cost and
benefit to the covered institution; and
Any connection between the covered person and any
fraudulent act or omission, breach of trust or fiduciary duty, or
insider abuse with regard to the covered institution.
The proposed rule is also similar to the 2011 Proposed Rule in that
it provides that an incentive-based compensation arrangement will be
considered to encourage inappropriate risks that could lead to material
financial loss to the covered institution, unless the arrangement:
Appropriately balances risk and reward;
Is compatible with effective risk management and controls;
and
Is supported by effective governance.
However, unlike the 2011 Proposed Rule, the proposed rule
specifically provides that an incentive-based compensation arrangement
would not be considered to appropriately balance risk and reward unless
it:
Includes financial and non-financial measures of
performance;

[[Page 37680]]

Is designed to allow non-financial measures of performance
to override financial measures of performance, when appropriate; and
Is subject to adjustment to reflect actual losses,
inappropriate risks taken, compliance deficiencies, or other measures
or aspects of financial and non-financial performance.
The proposed rule also contains requirements for the board of
directors of a covered institution that are similar to requirements
included in the 2011 Proposed Rule. Under the proposed rule, the board
of directors of each covered institution (or a committee thereof) would
be required to:
Conduct oversight of the covered institution's incentive-
based compensation program;
Approve incentive-based compensation arrangements for
senior executive officers, including amounts of awards and, at the time
of vesting, payouts under such arrangements; and
Approve material exceptions or adjustments to incentive-
based compensation policies or arrangements for senior executive
officers.
The 2011 Proposed Rule contained an annual reporting requirement,
which has been replaced by a recordkeeping requirement in the proposed
rule. Covered institutions would be required to create annually and
maintain for at least seven years records that document the structure
of incentive-based compensation arrangements and that demonstrate
compliance with the proposed rule. The records would be required to be
disclosed to the covered institution's appropriate Federal regulator
upon request.
Disclosure and Recordkeeping Requirements for Level 1 and Level 2
Covered Institutions. The proposed rule includes more detailed
disclosure and recordkeeping requirements for larger covered
institutions than the 2011 Proposed Rule. The proposed rule would
require all Level 1 and Level 2 covered institutions to create annually
and maintain for at least seven years records that document: (1) The
covered institution's senior executive officers and significant risk-
takers, listed by legal entity, job function, organizational hierarchy,
and line of business; (2) the incentive-based compensation arrangements
for senior executive officers and significant risk-takers, including
information on the percentage of incentive-based compensation deferred
and form of award; (3) any forfeiture and downward adjustment or
clawback reviews and decisions for senior executive officers and
significant risk-takers; and (4) any material changes to the covered
institution's incentive-based compensation arrangements and policies.
Level 1 and Level 2 covered institutions would be required to create
and maintain records in a manner that would allow for an independent
audit of incentive-based compensation arrangements, policies, and
procedures, and to provide the records described above in such form and
frequency as the appropriate Federal regulator requests.
Deferral, Forfeiture and Downward Adjustment, and Clawback
Requirements for Level 1 and Level 2 Covered Institutions. The proposed
rule would require incentive-based compensation arrangements that
appropriately balance risk and reward. For Level 1 and Level 2 covered
institutions, the proposed rule would require that incentive-based
compensation arrangements for certain covered persons include deferral
of payments, risk of downward adjustment and forfeiture, and clawback
to appropriately balance risk and reward. The 2011 Proposed Rule
required deferral for three years of 50 percent of annual incentive-
based compensation for executive officers of covered financial
institutions with $50 billion or more in total consolidated assets. The
proposed rule would apply deferral requirements to significant risk-
takers as well as senior executive officers, and, as described below,
would require 40, 50, or 60 percent deferral depending on the size of
the covered institution and whether the covered person receiving the
incentive-based compensation is a senior executive officer or a
significant risk-taker. Unlike the 2011 Proposed Rule, the proposed
rule would explicitly require a shorter deferral period for incentive-
based compensation awarded under a long-term incentive plan. The
proposed rule also provides more detailed requirements and prohibitions
than the 2011 Proposed Rule with respect to the measurement,
composition, and acceleration of deferred incentive-based compensation;
the manner in which deferred incentive-based compensation can vest;
increases to the amount of deferred incentive-based compensation; and
the amount of deferred incentive-based compensation that can be in the
form of options.
Deferral. Under the proposed rule, the mandatory deferral
requirements for Level 1 and Level 2 covered institutions for
incentive-based compensation awarded each performance period would be
as follows:
A Level 1 covered institution would be required to defer
at least 60 percent of a senior executive officer's ``qualifying
incentive-based compensation'' (as defined in the proposed rule) and 50
percent of a significant risk-taker's qualifying incentive-based
compensation for at least four years. A Level 1 covered institution
also would be required to defer for at least two years after the end of
the related performance period at least 60 percent of a senior
executive officer's incentive-based compensation awarded under a
``long-term incentive plan'' (as defined in the proposed rule) and 50
percent of a significant risk-taker's incentive-based compensation
awarded under a long-term incentive plan. Deferred compensation may
vest no faster than on a pro rata annual basis, and, for covered
institutions that issue equity or are subsidiaries of covered
institutions that issue equity, the deferred amount would be required
to consist of substantial amounts of both deferred cash and equity-like
instruments throughout the deferral period. Additionally, if a senior
executive officer or significant risk-taker receives incentive-based
compensation in the form of options for a performance period, the
amount of such options used to meet the minimum required deferred
compensation may not exceed 15 percent of the amount of total
incentive-based compensation awarded for that performance period.
A Level 2 covered institution would be required to defer
at least 50 percent of a senior executive officer's qualifying
incentive-based compensation and 40 percent of a significant risk-
taker's qualifying incentive-based compensation for at least three
years. A Level 2 covered institution also would be required to defer
for at least one year after the end of the related performance period
at least 50 percent of a senior executive officer's incentive-based
compensation awarded under a long-term incentive plan and 40 percent of
a significant risk-taker's incentive-based compensation awarded under a
long-term incentive plan. Deferred compensation may vest no faster than
on a pro rata annual basis, and, for covered institutions that issue
equity or are subsidiaries of covered institutions that issue equity,
the deferred amount would be required to consist of substantial amounts
of both deferred cash and equity-like instruments throughout the
deferral period. Additionally, if a senior executive officer or
significant risk-taker receives incentive-based compensation in the
form of options for a performance period, the amount of such options
used to meet the minimum required deferred compensation may not exceed
15 percent of the amount of total incentive-based compensation awarded
for that performance period.

[[Page 37681]]

The proposed rule would also prohibit Level 1 and Level 2 covered
institutions from accelerating the payment of a covered person's
deferred incentive-based compensation, except in the case of death or
disability of the covered person.
Forfeiture and Downward Adjustment. Compared to the 2011 Proposed
Rule, the proposed rule provides more detailed requirements for Level 1
and Level 2 covered institutions to reduce (1) incentive-based
compensation that has not yet been awarded to a senior executive
officer or significant risk-taker, and (2) deferred incentive-based
compensation of a senior executive officer or significant risk-taker.
Under the proposed rule, ``forfeiture'' means a reduction of the amount
of deferred incentive-based compensation awarded to a person that has
not vested. ``Downward adjustment'' means a reduction of the amount of
a covered person's incentive-based compensation not yet awarded for any
performance period that has already begun. The proposed rule would
require a Level 1 or Level 2 covered institution to make subject to
forfeiture all unvested deferred incentive-based compensation of any
senior executive officer or significant risk-taker, including unvested
deferred amounts awarded under long-term incentive plans. This
forfeiture requirement would apply to all unvested, deferred incentive-
based compensation for those individuals, regardless of whether the
deferral was required by the proposed rule. Similarly, a Level 1 or
Level 2 covered institution would also be required to make subject to
downward adjustment all incentive-based compensation amounts not yet
awarded to any senior executive officer or significant risk-taker for
the current performance period, including amounts payable under long-
term incentive plans. A Level 1 or Level 2 covered institution would be
required to consider forfeiture or downward adjustment of incentive-
based compensation if any of the following adverse outcomes occur:
Poor financial performance attributable to a significant
deviation from the covered institution's risk parameters set forth in
the covered institution's policies and procedures;
Inappropriate risk-taking, regardless of the impact on
financial performance;
Material risk management or control failures;
Non-compliance with statutory, regulatory, or supervisory
standards resulting in enforcement or legal action brought by a federal
or state regulator or agency, or a requirement that the covered
institution report a restatement of a financial statement to correct a
material error; and
Other aspects of conduct or poor performance as defined by
the covered institution.
Clawback. In addition to deferral, downward adjustment, and
forfeiture, the proposed rule would require a Level 1 or Level 2
covered institution to include clawback provisions in the incentive-
based compensation arrangements for senior executive officers and
significant risk-takers. The term ``clawback'' refers to a mechanism by
which a covered institution can recover vested incentive-based
compensation from a senior executive officer or significant risk-taker
if certain events occur. The proposed rule would require clawback
provisions that, at a minimum, allow the covered institution to recover
incentive-based compensation from a current or former senior executive
officer or significant risk-taker for seven years following the date on
which such compensation vests, if the covered institution determines
that the senior executive officer or significant risk-taker engaged in
misconduct that resulted in significant financial or reputational harm
to the covered institution, fraud, or intentional misrepresentation of
information used to determine the senior executive officer or
significant risk-taker's incentive-based compensation. The 2011
Proposed Rule did not include a clawback requirement.
Additional Prohibitions. The proposed rule contains a number of
additional prohibitions for Level 1 and Level 2 covered institutions
that were not included in the 2011 Proposed Rule. These prohibitions
would apply to:
Hedging;
Maximum incentive-based compensation opportunity (also
referred to as leverage);
Relative performance measures; and
Volume-driven incentive-based compensation.
Risk Management and Controls. The proposed rule's risk management
and controls requirements for large covered institutions are generally
more extensive than the requirements contained in the 2011 Proposed
Rule. The proposed rule would require all Level 1 and Level 2 covered
institutions to have a risk management framework for their incentive-
based compensation programs that is independent of any lines of
business; includes an independent compliance program that provides for
internal controls, testing, monitoring, and training with written
policies and procedures; and is commensurate with the size and
complexity of the covered institution's operations. In addition, the
proposed rule would require Level 1 and Level 2 covered institutions
to:
Provide individuals in control functions with appropriate
authority to influence the risk-taking of the business areas they
monitor and ensure covered persons engaged in control functions are
compensated independently of the performance of the business areas they
monitor; and
Provide for independent monitoring of: (1) Incentive-based
compensation plans to identify whether the plans appropriately balance
risk and reward; (2) events related to forfeiture and downward
adjustment and decisions of forfeiture and downward adjustment reviews
to determine consistency with the proposed rule; and (3) compliance of
the incentive-based compensation program with the covered institution's
policies and procedures.
Governance. Unlike the 2011 Proposed Rule, the proposed rule would
require each Level 1 or Level 2 covered institution to establish a
compensation committee composed solely of directors who are not senior
executive officers to assist the board of directors in carrying out its
responsibilities under the proposed rule. The compensation committee
would be required to obtain input from the covered institution's risk
and audit committees, or groups performing similar functions, and risk
management function on the effectiveness of risk measures and
adjustments used to balance incentive-based compensation arrangements.
Additionally, management would be required to submit to the
compensation committee on an annual or more frequent basis a written
assessment of the effectiveness of the covered institution's incentive-
based compensation program and related compliance and control processes
in providing risk-taking incentives that are consistent with the risk
profile of the covered institution. The compensation committee would
also be required to obtain an independent written assessment from the
internal audit or risk management function of the effectiveness of the
covered institution's incentive-based compensation program and related
compliance and control processes in providing risk-taking incentives
that are consistent with the risk profile of the covered institution.
Policies and Procedures. The proposed rule would require all Level
1 and Level 2 covered institutions to have policies and procedures
that, among other requirements:
Are consistent with the requirements and prohibitions of
the proposed rule;

[[Page 37682]]

Specify the substantive and procedural criteria for
forfeiture and clawback;
Document final forfeiture, downward adjustment, and
clawback decisions;
Specify the substantive and procedural criteria for the
acceleration of payments of deferred incentive-based compensation to a
covered person;
Identify and describe the role of any employees,
committees, or groups authorized to make incentive-based compensation
decisions, including when discretion is authorized;
Describe how discretion is exercised to achieve balance;
Require that the covered institution maintain
documentation of its processes for the establishment, implementation,
modification, and monitoring of incentive-based compensation
arrangements;
Describe how incentive-based compensation arrangements
will be monitored;
Specify the substantive and procedural requirements of the
independent compliance program; and
Ensure appropriate roles for risk management, risk
oversight, and other control personnel in the covered institution's
processes for designing incentive-based compensation arrangements and
determining awards, deferral amounts, deferral periods, forfeiture,
downward adjustment, clawback, and vesting and assessing the
effectiveness of incentive-based compensation arrangements in
restraining inappropriate risk-taking.
These policies and procedures requirements for Level 1 and Level 2
covered institutions are generally more detailed than the requirements
in the 2011 Proposed Rule.
Indirect Actions. The proposed rule would prohibit covered
institutions from doing indirectly, or through or by any other person,
anything that would be unlawful for the covered institution to do
directly under the proposed rule. This prohibition is similar to the
evasion provision contained in the 2011 Proposed Rule.
Enforcement. For five of the Agencies, the proposed rule would be
enforced under section 505 of the Gramm-Leach-Bliley Act, as specified
in section 956. For FHFA, the proposed rule would be enforced under
subtitle C of the Safety and Soundness Act.
Conservatorship or Receivership for Certain Covered Institutions.
FHFA's and NCUA's proposed rules contain provisions that would apply to
covered institutions that are managed by a government agency or a
government-appointed agent, or that are in conservatorship or
receivership or are limited-life regulated entities under the Safety
and Soundness Act or the Federal Credit Union Act.\46\
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\46\ The FDIC's proposed rule would not apply to institutions
for which the FDIC is appointed receiver under the FDIA or Title II
of the Dodd-Frank Act, as appropriate, as those statutes govern such
cases.
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A detailed description of the proposed rule and requests for
comments are set forth below.

II. Section-by-Section Description of the Proposed Rule

Sec. __.1 Authority, Scope and Initial Applicability

Section __.1 provides that the proposed rule is issued pursuant to
section 956. The Agencies also have listed applicable additional
rulemaking authority in their respective authority citations.
The OCC is issuing the proposed rule under its general rulemaking
authority, 12 U.S.C. 93a and the Home Owners' Loan Act, 12 U.S.C. 1461
et seq., its safety and soundness authority under 12 U.S.C. 1818, and
its authority to regulate compensation under 12 U.S.C. 1831p-1.
The Board is issuing the proposed rule under its safety and
soundness authority under section 5136 of the Revised Statutes (12
U.S.C. 24), the Federal Reserve Act (12 U.S.C. 321-338a), the FDIA (12
U.S.C. 1818), the Bank Holding Company Act (12 U.S.C. 1844(b)), the
Home Owners' Loan Act (12 U.S.C. 1462a and 1467a), and the
International Banking Act (12 U.S.C. 3108).
The FDIC is issuing the proposed rule under its general rulemaking
authority, 12 U.S.C. 1819 Tenth, as well as its general safety and
soundness authority under 12 U.S.C. 1818 and authority to regulate
compensation under 12 U.S.C. 1831p-1.
FHFA is issuing the proposed rule pursuant to its authority under
the Safety and Soundness Act (particularly 12 U.S.C. 4511(b), 4513,
4514, 4518, 4526, and ch. 46 subch. III.).
NCUA is issuing the proposed rule under its general rulemaking and
safety and soundness authorities in the Federal Credit Union Act, 12
U.S.C. 1751 et seq.
The SEC is issuing the proposed rule pursuant to its rulemaking
authority under the Securities Exchange Act of 1934 and the Investment
Advisers Act of 1940 (15 U.S.C. 78q, 78w, 80b-4, and 80b-11).
The approach taken in the proposed rule is within the authority
granted by section 956. The proposed rule would prohibit types and
features of incentive-based compensation arrangements that encourage
inappropriate risks. As explained more fully below, incentive-based
compensation arrangements that result in payments that are unreasonable
or disproportionate to the value of services performed could encourage
inappropriate risks by providing excessive compensation, fees, and
benefits. Further, incentive-based compensation arrangements that do
not appropriately balance risk and reward, that are not compatible with
effective risk management and controls, or that are not supported by
effective governance are the types of incentive-based compensation
arrangements that could encourage inappropriate risks that could lead
to material financial loss to covered institutions. Because these types
of incentive-based compensation arrangements encourage inappropriate
risks, they would be prohibited under the proposed rule.
The Federal Banking Agencies have found that any incentive-based
compensation arrangement at a covered institution will encourage
inappropriate risks if it does not sufficiently expose the risk-takers
to the consequences of their risk decisions over time, and that in
order to do this, it is necessary that meaningful portions of
incentive-based compensation be deferred and placed at risk of
reduction or recovery. The proposed rule reflects the minimums that are
required to be effective for that purpose, as well as minimum standards
of robust governance, and the disclosures that the statute requires.
The Agencies' position in this respect is informed by the country's
experience in the recent financial crisis, as well as by their
experience supervising their respective institutions and their
observation of the experience and judgments of regulators in other
countries.
Consistent with section 956, section __.1 provides that the
proposed rule would apply to a covered institution with average total
consolidated assets greater than or equal to $1 billion that offers
incentive-based compensation arrangements to covered persons.
The Agencies propose the compliance date of the proposed rule to be
the beginning of the first calendar quarter that begins at least 540
days after the final rule is published in the Federal Register. Any
incentive-based compensation plan with a performance period that begins
before such date would not be required to comply with the requirements
of the proposed rule. Whether a covered institution is a Level 1, Level
2, or Level 3 covered

[[Page 37683]]

institution \47\ on the compliance date would be determined based on
average total consolidated assets as of the beginning of the first
calendar quarter that begins after a final rule is published in the
Federal Register. For example, if the final rule is published in the
Federal Register on November 1, 2016, then the compliance date would be
July 1, 2018. In that case, any incentive-based compensation plan with
a performance period that began before July 1, 2018 would not be
required to comply with the rule. Whether a covered institution is a
Level 1, Level 2, or Level 3 covered institution on July 1, 2018 would
be determined based on average total consolidated assets as of the
beginning of the first quarter of 2017.
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\47\ As discussed below, the proposed rule includes baseline
requirements for all covered institutions and additional
requirements for Level 1 and Level 2 covered institutions, which are
larger covered institutions.
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The Agencies recognize that most incentive-based compensation plans
are implemented at the beginning of the fiscal or calendar year.
Depending on the date of publication of a final rule, the proposed
compliance date would provide at least 18 months, and in most cases
more than two years, for covered institutions to develop and approve
new incentive-based compensation plans and 18 months for covered
institutions to develop and implement the supporting policies,
procedures, risk management framework, and governance that would be
required under the proposed rule.
1.1. The Agencies invite comment on whether this timing would be
sufficient to allow covered institutions to implement any changes
necessary for compliance with the proposed rule, particularly the
development and implementation of policies and procedures. Is the
length of time too long or too short and why? What specific changes
would be required to bring existing policies and procedures into
compliance with the rule? What constraints exist on the ability of
covered institutions to meet the proposed deadline?
1.2. The Agencies invite comment on whether the compliance date
should instead be the beginning of the first performance period that
starts at least 365 days after the final rule is published in the
Federal Register in order to have the proposed rule's policies,
procedures, risk management, and governance requirements begin when the
requirements applicable to incentive-compensation plans and
arrangements begin. Why or why not?
Section __.1 also specifies that the proposed rule is not intended
to limit the authority of any Agency under other provisions of
applicable law and regulations. For example, the proposed rule would
not affect the Federal Banking Agencies' authority under section 39 of
the FDIA and the Federal Banking Agency Safety and Soundness
Guidelines. The Board's Enhanced Prudential Standards under 12 CFR part
252 (Regulation YY) would not be affected. The OCC's Heightened
Standards also would continue to be in effect. The NCUA's authority
under 12 U.S.C. 1761a, 12 CFR 701.2, part 701 App. A, Art. VII. section
8, 701.21(c)(8)(i), 701.23(g) (1), 701.33, 702.203, 702.204, 703.17,
704.19, 704.20, part 708a, 712.8, 721.7, and part 750, and the NCUA
Examiners Guide, Chapter 7,\48\ would not be affected. Neither would
the proposed rule affect the applicability of FHFA's executive
compensation rule, under section 1318 of the Safety and Soundness Act
(12 U.S.C. 4518), 12 CFR part 1230.
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\48\ The NCUA Examiners Guide, Chapter 7, available at https://www.ncua.gov/Legal/GuidesEtc/ExaminerGuide/Chapter07.pdf.
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The Agencies acknowledge that some individuals who would be
considered covered persons, senior executive officers, or significant
risk-takers under the proposed rule are subject to other Federal
compensation-related requirements. Further, some covered institutions
may be subject to SEC rules regarding the disclosure of executive
compensation,\49\ and mortgage loan originators are subject to the
Consumer Financial Protection Bureau's restrictions on compensation.
This rule is not intended to affect the application of these other
Federal compensation-related requirements.
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\49\ See Item 402 of Regulation S-K. 17 CFR 229.402.
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Sec. __.2 Definitions

Section __.2 defines the various terms used in the proposed rule.
Where the proposed rule uses a term defined in section 956, the
proposed rule generally adopts the definition included in section
956.\50\
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\50\ The definitions in the proposed rule would be for purposes
of administering section 956 and would not affect the interpretation
or construction of the same or similar terms for purposes of any
other statute or regulation administered by the Agencies.
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Definitions Pertaining to Covered Institutions
Section 956(e)(2) of the Dodd-Frank Act 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; the Federal National Mortgage Association
(``Fannie Mae'') and the Federal Home Loan Mortgage Corporation
(``Freddie Mac'') (together, the ``Enterprises''); and any other
financial institution that the Agencies determine, jointly, by rule,
should be treated as a covered financial institution for purposes of
section 956. Section 956(f) provides that the requirements of section
956 do not apply to covered financial institutions with assets of less
than $1 billion.
The Agencies propose to jointly, by rule, designate additional
financial institutions as covered institutions. The Agencies propose to
include the Federal Home Loan Banks as covered institutions because
they pose risks similar to those of some institutions covered under the
proposed rule and should be subject to the same regulatory regime. The
Agencies also propose to include as covered institutions the state-
licensed uninsured branches and agencies of a foreign bank,
organizations operating under section 25 or 25A of the Federal Reserve
Act (i.e., Edge and Agreement Corporations), as well as the other 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). Applying the same requirements to these
institutions would be consistent with other regulatory requirements
that are applicable to foreign banking organizations operating in the
United States and would not distort competition for human resources
between U.S. banking organizations and foreign banking organizations
operating in the United States. These offices and operations currently
are referenced in the Federal Banking Agency Guidance and are subject
to section 8 of the FDIA (12 U.S.C. 1818), which prohibits institutions
from engaging in unsafe or unsound practices to the same extent as
insured depository institutions and bank holding companies.\51\
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\51\ See 12 U.S.C. 1813(c)(3) and 1818(b)(4).
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In addition, the Agencies propose to jointly, by rule, designate
state-chartered non-depository trust companies that are members of the
Federal Reserve System as covered institutions. The definition of
``covered financial institution'' under section 956 of the Dodd-Frank
Act includes a depository institution as such term is defined in
section 3 of the FDIA (12 U.S.C. 1813); that term includes all national
banks and any state banks, including trust companies, that are engaged
in the business of receiving deposits other than trust funds. As a
consequence of these definitions, all

[[Page 37684]]

national banks, including national banks that are non-depository trust
companies, are ``depository institutions'' within the meaning of
section 956, but non-FDIC insured state non-depository trust companies
that are members of the Federal Reserve System are not. In order to
achieve equal treatment across similar entities with different
charters, the Agencies propose to include state-chartered non-
depository member trust companies as covered institutions. These
institutions would be ``regulated institutions'' under the definition
of ``state member bank'' in the Board's rule.
Each Agency's proposed rule contains a definition of the term
``covered institution'' that describes the covered financial
institutions the Agency regulates.
The Agencies have tailored the requirements of the proposed rule to
the size and complexity of covered institutions, and are proposing to
designate covered institutions as Level 1, Level 2, or Level 3 covered
institutions to effectuate this tailoring. The Agencies have observed
through their supervisory experience that large financial institutions
typically have complex business activities in multiple lines of
business, distinct subsidiaries, and regulatory jurisdictions, and
frequently operate and manage their businesses in ways that cross those
lines of business, subsidiaries, and jurisdictions. Level 3 covered
institutions would generally be subject to only the basic set of
prohibitions and disclosure requirements. The proposed rule would apply
additional prohibitions and requirements to incentive-based
compensation arrangements at Level 1 and Level 2 covered institutions,
as discussed below. Whether a covered institution that is a subsidiary
of a depository institution holding company is a Level 1, Level 2, or
Level 3 covered institution would be based on the average total
consolidated assets of the top-tier depository institution holding
company. Whether that subsidiary has at least $1 billion will be based
on the subsidiary's average total consolidated assets.
The Agency definitions of covered institution, Level 1, Level 2,
and Level 3 covered institution, and related terms are summarized
below.
Covered Institution and Regulated Institution. Each Agency has set
forth text for its Agency-specific definition of the term ``covered
institution'' that specifies the entities to which that Agency's rule
applies.\52\ Under the proposed rule, a ``covered institution'' would
include all of the following:
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\52\ The Agency-specific definitions are intended to be applied
only for purposes of administering a final rule under section 956.
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In the case of the OCC:
[cir] A national bank, Federal savings association, or Federal
branch or agency of a foreign bank \53\ with average total consolidated
assets greater than or equal to $1 billion; and
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\53\ The term ``Federal branch or agency of a foreign bank''
refers to both insured and uninsured Federal branches and agencies
of foreign banks.
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[cir] A subsidiary of a national bank, Federal savings association,
or Federal branch or agency of a foreign bank, if the subsidiary (A) is
not a broker, dealer, person providing insurance, investment company,
or investment adviser; and (B) has average total consolidated assets
greater than or equal to $1 billion.
In the case of the Board, the proposed definition of the
term ``covered institution'' is a ``regulated institution'' with
average total consolidated assets greater than or equal to $1 billion,
and the Board's definition of the term ``regulated institution''
includes:
[cir] A state member bank, as defined in 12 CFR 208.2(g);
[cir] A bank holding company, as defined in 12 CFR 225.2(c), that
is not a foreign banking organization, as defined in 12 CFR 211.21(o),
and a subsidiary of such a bank holding company that is not a
depository institution, broker-dealer or investment adviser;
[cir] A savings and loan holding company, as defined in 12 CFR
238.2(m), and a subsidiary of a savings and loan holding company that
is not a depository institution, broker-dealer or investment adviser;
[cir] An organization operating under section 25 or 25A of the
Federal Reserve Act (Edge and Agreement Corporation);
[cir] A state-licensed uninsured branch or agency of a foreign
bank, as defined in section 3 of the FDIA (12 U.S.C. 1813); and
[cir] The U.S. operations of a foreign banking organization, as
defined in 12 CFR 211.21(o), and a U.S. subsidiary of such foreign
banking organization that is not a depository institution, broker-
dealer, or investment adviser.
In the case of the FDIC, ``covered institution'' means a:
[cir] State nonmember bank, state savings association, and a state
insured branch of a foreign bank, as such terms are defined in section
3 of the FDIA, 12 U.S.C. 1813, with average total consolidated assets
greater than or equal to $1 billion; and
[cir] A subsidiary of a state nonmember bank, state savings
association, or a state insured branch of a foreign bank, as such terms
are defined in section 3 of the FDIA, 12 U.S.C. 1813, that: (i) Is not
a broker, dealer, person providing insurance, investment company, or
investment adviser; and (ii) Has average total consolidated assets
greater than or equal to $1 billion.
In the case of the NCUA, a credit union, as described in
section 19(b)(1)(A)(iv) of the Federal Reserve Act, meaning an insured
credit union as defined under 12 U.S.C. 1752(7) or credit union
eligible to make application to become an insured credit union under 12
U.S.C. 1781. Instead of the term ``covered financial institution,'' the
NCUA uses the term ``credit union'' throughout its proposed rule, as
credit unions are the only type of covered institution NCUA regulates.
The scope section of the rule defines the credit unions that will be
subject to this rule--that is, credit unions with $1 billion or more in
total consolidated assets.
In the case of the SEC, a broker or dealer registered
under section 15 of the Securities Exchange Act of 1934, 15 U.S.C. 78o;
and an investment adviser, as such term is defined in section
202(a)(11) of the Investment Advisers Act of 1940, 15 U.S.C. 80b-
2(a)(11).\54\ The proposed rule would not apply to persons excluded
from the definition of investment adviser contained in section
202(a)(11) of the Investment Advisers Act nor would it apply to such
other persons not within the intent of section 202(a)(11) of the
Investment Advisers Act, as the SEC may designate by rules and
regulations or order. Section 956 does not contain exceptions or
exemptions for investment advisers based on registration.\55\
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\54\ By its terms, the definition of ``covered financial
institution'' in section 956 includes any institution that meets the
definition of ``investment adviser'' under the Investment Advisers
Act of 1940 (``Investment Advisers Act''), regardless of whether the
institution is registered as an investment adviser under that Act.
Banks and bank holding companies are generally excluded from the
definition of ``investment adviser'' under section 202(a)(11) of the
Investment Advisers Act, although they would still be ``covered
institutions'' under the relevant Agency's proposed rule.
\55\ Commenters to the 2011 Proposed Rule requested
clarification with respect to those entities that are excluded from
the definition of ``investment adviser'' under the Investment
Advisers Act and those that are exempt from registration as an
investment adviser under the Investment Advisers Act. Section 956
expressly includes any institution that meets the definition of
investment adviser regardless of whether the institution is
registered under the Investment Advisers Act. See supra note 54.
Thus, the proposed rule would apply to institutions that meet the
definition of investment adviser under section 202(a)(11) of the
Investment Advisers Act and would not exempt any such institutions
that may be prohibited or exempted from registering with the SEC
under the Investment Advisers Act.

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[[Page 37685]]

In the case of FHFA, the proposed definition of the term
``covered institution'' is a ``regulated institution'' with average
total consolidated assets greater than or equal to $1 billion, and
FHFA's definition of the term ``regulated institution'' means an
Enterprise, as defined in 12 U.S.C. 4502(10), and a Federal Home Loan
Bank.
Level 1, Level 2, and Level 3 covered institutions. The Agencies
have tailored the requirements of the proposed rule to the size and
complexity of covered institutions. All covered institutions would be
subject to a basic set of prohibitions and disclosure requirements, as
described in section __.4 of the proposed rule.
The Agencies are proposing to group covered institutions into three
levels. The first level, Level 1 covered institutions, would generally
be covered institutions with average total consolidated assets of
greater than $250 billion and subsidiaries of such institutions that
are covered institutions. The next level, Level 2 covered institutions,
would generally be covered institutions with average total consolidated
assets between $50 billion and $250 billion and subsidiaries of such
institutions that are covered institutions. The smallest covered
institutions, those with average total consolidated assets between $1
and $50 billion, would be Level 3 covered institutions and generally
would be subject to only the basic set of prohibitions and
requirements.\56\
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\56\ As discussed later in this Supplemental Information
section, under section __.6 of the proposed rule, an Agency would be
able to require a covered institution with average total
consolidated assets greater than or equal to $10 billion and less
than $50 billion to comply with some or all of the provisions of
section __.5 and sections __.7 through__.11, if the Agency
determines that the activities, complexity of operations, risk
profile, or compensation practices of the covered institution are
consistent with those of a Level 1 or Level 2 covered institution.
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The proposed rule would apply additional prohibitions and
requirements to incentive-based compensation arrangements at Level 1
and Level 2 covered institutions, as described in section __.5 and
sections __.7 through __.11 of the proposed rule and further discussed
below. The specific requirements of the proposed rule that would apply
to Level 1 and Level 2 covered institutions are the same, with the
exception of the deferral amounts and deferral periods described in
section __.7(a)(1) and section __.7(a)(2).
Consolidation
Generally, the Agencies also propose that covered institutions that
are subsidiaries of other covered institutions would be subject to the
same requirements, and defined to be the same level, as the parent
covered institution,\57\ even if the subsidiary covered institution is
smaller than the parent covered institution.\58\ This approach of
assessing risks at the level of the holding company for a consolidated
organization recognizes that financial stress or the improper
management of risk in one part of an organization has the potential to
spread rapidly to other parts of the organization. Large depository
institution holding companies increasingly operate and manage their
businesses in such a way that risks affect different subsidiaries
within the consolidated organization and are managed on a consolidated
basis. For example, decisions about business lines including management
and resource allocation may be made by executives and employees in
different subsidiaries. Integrating products and operations may offer
significant efficiencies but can also result in financial stress or the
improper management of risk in one part of a consolidated organization
and has the potential to spread risk rapidly to other parts of the
consolidated organization. Even when risk is assessed at the level of
the holding company, risk will also be assessed at individual
institutions within that consolidated organization. For example, a bank
subsidiary of a large, complex bank holding company might have a
different risk profile than the bank holding company. In that
situation, a risk assessment would have different results when
conducted at the level of the bank and at the level of the bank holding
company.
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\57\ Commenters on the 2011 Proposed Rule questioned how the
requirements would apply in the context of consolidated
organizations where a parent holding company structure may include
one or more subsidiary banks, broker-dealers, or investment advisers
each with total consolidated assets either above or below, or
somewhere in between, the relevant thresholds. They also expressed
concern that the 2011 Proposed Rule could lead to ``regulatory
overlap'' where the parent holding company and individual
subsidiaries are regulated by different agencies.
\58\ For the U.S. operations of a foreign banking organization,
level would be determined by the total consolidated U.S. assets of
the foreign banking organization, including the assets of any U.S.
branches or agencies of the foreign banking organization, any U.S.
subsidiaries of the foreign banking organization, and any U.S.
operations held pursuant to section 2(h)(2) of the Bank Holding
Company Act. In contrast, the level of an OCC-regulated Federal
branch or agency of a foreign bank would be determined with
reference to the assets of the Federal branch or agency. This
treatment is consistent with the determination of the level of a
national bank or Federal savings association that is not a
subsidiary of a holding company and the OCC's approach to regulation
of Federal branches and agencies.
---------------------------------------------------------------------------

Moreover, in the experience of the Federal Banking Agencies,
incentive-based compensation programs generally are designed at the
holding company level and are applied throughout the consolidated
organization. Many holding companies establish incentive-based
compensation programs in this manner because it can help maintain
effective risk management and controls for the entire consolidated
organization. More broadly, the expectations and incentives established
by the highest levels of corporate leadership set the tone for the
entire organization and are important factors of whether an
organization is capable of maintaining fully effective risk management
and internal control processes. The Board has observed that some large,
complex depository institution holding companies have evolved toward
comprehensive, consolidated risk management to measure and assess the
range of their exposures and the way these exposures interrelate,
including in the context of incentive-based compensation programs. In
supervising the activities of depository institution holding companies,
the Board has adopted and continues to follow the principle that
depository institution holding companies should serve as a source of
financial and managerial strength for their subsidiary depository
institutions.\59\
---------------------------------------------------------------------------

\59\ See 12 U.S.C. 1831o-1; 12 CFR 225.4(a)(1).
---------------------------------------------------------------------------

The proposed rule is designed to reinforce the ability of
institutions to establish and maintain effective risk management and
controls for the entire consolidated organization with respect to the
organization's incentive-based compensation program. Moreover, the
structure of the proposed rule is also consistent with the reality that
within many large depository institution holding companies, covered
persons may be employed by one legal entity but may do work for one or
more of that entity's affiliates. For example, an employee of a
national bank might also perform certain responsibilities on behalf of
an affiliated broker-dealer. Applying the same requirements to all
subsidiary covered institutions may reduce the possibility of evasion
of the more specific standards applicable to certain individuals at
Level 1 or Level 2 covered institutions. Finally, this approach may
enable holding company structures to more effectively manage

[[Page 37686]]

human resources, because applying the same requirements to all
subsidiary covered institutions would treat similarly the incentive-
based compensation arrangements for similar positions at different
subsidiaries within a holding company structure.\60\
---------------------------------------------------------------------------

\60\ For example, requirements that apply to certain job
functions in one part of a consolidated organization but not to the
same job function in another operating unit of the same holding
company structure could create uneven treatment across the legal
entities.
---------------------------------------------------------------------------

The proposed rule would also be consistent with the requirements of
overseas regulators who have examined the role that incentive-based
compensation plays in institutions. After examining the risks posed by
certain incentive-based compensation programs, many foreign regulators
are now requiring that the rules governing incentive-based compensation
be applied at the group, parent, and subsidiary operating levels
(including those in offshore financial centers).\61\
---------------------------------------------------------------------------

\61\ See, e.g., Article 92 of the CRD IV (2013/36/EU).
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The Agencies are cognizant that the approach being proposed may
have some disadvantages for smaller subsidiaries within a larger
depository institution holding company structure by applying the more
specific provisions of the proposed rule to these smaller institutions
that would not otherwise apply to them but for being a subsidiary of a
depository institution holding company. As further discussed below, in
an effort to reduce burden, the Board's proposed rule would permit
institutions that are subsidiaries of depository institution holding
companies and that are subject to the Board's proposed rule to meet the
requirements of the proposed rule if the parent covered institution
complies with the requirements in such a way that causes the relevant
portion of the incentive-based compensation program of the subsidiary
covered institution to comply with the requirements.\62\
---------------------------------------------------------------------------

\62\ See section __.3(c) of the proposed rule.
---------------------------------------------------------------------------

Similarly, the OCC's proposed rule would allow a covered
institution subject to the OCC's proposed rule that is a subsidiary of
another covered institution subject to the OCC's proposed rule to meet
a requirement of the OCC's proposed rule if the parent covered
institution complies with that requirement in a way that causes the
relevant portion of the incentive-based compensation program of the
subsidiary covered institution to comply with that requirement.
The FDIC's proposed rule would similarly allow a covered
institution subject to the FDIC's proposed rule that is a subsidiary of
another covered institution subject to the FDIC's proposed rule to meet
a requirement of the FDIC's proposed rule if the parent covered
institution complies with that requirement in a way that causes the
relevant portion of the incentive-based compensation program of the
subsidiary covered institution to comply with that requirement.
The SEC is not proposing to require a covered institution under its
proposed rule that is a subsidiary of another covered institution under
that proposed rule to be subject to the same requirements, and defined
to be the same levels, as the parent covered institution. In general,
the operations, services, and products of broker-dealers and
investments advisers are not typically effected through subsidiaries
\63\ and it is expected that their incentive-based compensation
arrangements are typically derived from the activities of the broker-
dealers and investment advisers themselves. Because of this, any
inappropriate risks for which the incentive-based compensation programs
at these firms may encourage should be localized, and the management of
these risks similarly should reside at the broker-dealer or investment
adviser. Where that is not the case, individuals that are employed by
subsidiaries of a broker-dealer or investment adviser may still be
considered to be a ``significant risk-taker'' for the covered
institution and, therefore, subject to the proposed rule.\64\ In
addition, broker-dealers and investment advisers that are subsidiaries
of depository institution holding companies would be consolidated on
the basis of such depository institution holding companies generally,
where there is often a greater integration of products and operations,
public interest, and assessment and management of risk (including those
related to incentive-based compensation) across the depository
institution holding companies and their subsidiaries.\65\
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\63\ In addition, the SEC's regulatory regime with respect to
broker-dealers and investment advisers generally applies on an
entity-by-entity basis. For example, subject to certain exclusions,
any person that for compensation is engaged in the business of
providing advice, making recommendations, issuing reports, or
furnishing analyses on securities, either directly or through
publications is subject to the Investment Advisers Act. See 15
U.S.C. 80b-2(a)(11).
\64\ The proposed rule also prohibits a covered institution from
doing indirectly, or through or by any other person, anything that
would be unlawful for such covered institution to do directly. See
section 303.12. For example, the SEC has stated that it will, based
on facts and circumstances, treat as a single investment adviser two
or more affiliated investment advisers that are separate legal
entities but are operationally integrated. See Exemptions for
Advisers to Venture Capital Funds, Private Fund Advisers With Less
Than $150 Million in Assets Under Management, and Foreign Private
Advisers, Investment Advisers Act Release No. 3222 (June 22, 2011)
76 FR 39,646 (July 6, 2011); In the Matter of TL Ventures, Inc.,
Investment Advisers Act Release No. 3859 (June 20, 2014) (settled
action); section 15 U.S.C. 80b-8.
\65\ As discussed above in this Supplementary Information, the
Agencies propose that covered institutions that are subsidiaries of
covered institutions that are depository institution holding
companies would be subject to the same requirements, and defined to
be the same level, as the parent covered institutions. Because the
failure of a depository institution may cause losses to the deposit
insurance fund, there is a heightened interest in the safety and
soundness of depository institutions and their holding companies.
Moreover, as noted above, depository institution holding companies
should serve as a source of financial and managerial strength for
their subsidiary depository institutions. Additionally, in the
experience of the Federal Banking Agencies, incentive-based
compensation programs generally are designed at the holding company
level and are applied throughout the consolidated organization. The
Board has observed that complex depository institution holding
companies have evolved toward comprehensive, consolidated risk
management to measure and assess the range of their exposures and
the way these exposures interrelate, including in the context of
incentive-based compensation programs.
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Level 1, Level 2, and Level 3 Covered Institutions
For purposes of the proposed rule, the Agencies have specified the
three levels of covered institutions as:
In the case of the OCC:
[cir] A ``Level 1 covered institution'' means: (i) A covered
institution that is a subsidiary of a depository institution holding
company with average total consolidated assets greater than or equal to
$250 billion; (ii) a covered institution with average total
consolidated assets greater than or equal to $250 billion that is not a
subsidiary of a covered institution or of a depository institution
holding company; and (iii) a covered institution that is a subsidiary
of a covered institution with average total consolidated assets greater
than or equal to $250 billion.
[cir] A ``Level 2 covered institution'' means: (i) A covered
institution that is a subsidiary of a depository institution holding
company with average total consolidated assets greater than or equal to
$50 billion but less than $250 billion; (ii) a covered institution with
average total consolidated assets greater than or equal to $50 billion
but less than $250 billion that is not a subsidiary of a covered
institution or of a depository institution holding company; and (iii) a
covered institution that is a subsidiary of a covered institution with
average total consolidated assets greater than or equal to $50 billion
but less than $250 billion.
[cir] A ``Level 3 covered institution'' means: (i) A covered
institution with average total consolidated assets greater

[[Page 37687]]

than or equal to $1 billion but less than $50 billion; and (ii) a
covered institution that is a subsidiary of a covered institution with
average total consolidated assets greater than or equal to $1 billion
but less than $50 billion.
In the case of the Board:
[cir] A ``Level 1 covered institution'' means a covered institution
with average total consolidated assets greater than or equal to $250
billion and any subsidiary of a Level 1 covered institution that is a
covered institution.
[cir] A ``Level 2 covered institution'' means a covered institution
with average total consolidated assets greater than or equal to $50
billion that is not a Level 1 covered institution and any subsidiary of
a Level 2 covered institution that is a covered institution.
[cir] A ``Level 3 covered institution'' means a covered institution
with average total consolidated assets greater than or equal to $1
billion that is not a Level 1 or Level 2 covered institution.
In the case of the FDIC:
[cir] A ``Level 1 covered institution'' means: (i) A covered
institution that is a subsidiary of a depository institution holding
company with average total consolidated assets greater than or equal to
$250 billion; (ii) a covered institution with average total
consolidated assets greater than or equal to $250 billion that is not a
subsidiary of a depository institution holding company; and (iii) a
covered institution that is a subsidiary of a covered institution with
average total consolidated assets greater than or equal to $250
billion.
[cir] A ``Level 2 covered institution'' means: (i) A covered
institution that is a subsidiary of a depository institution holding
company with average total consolidated assets greater than or equal to
$50 billion but less than $250 billion; (ii) a covered institution with
average total consolidated assets greater than or equal to $50 billion
but less than $250 billion that is not a subsidiary of a depository
institution holding company; and (iii) a covered institution that is a
subsidiary of a covered institution with average total consolidated
assets greater than or equal to $50 billion but less than $250 billion.
[cir] A ``Level 3 covered institution'' means: (i) A covered
institution that is a subsidiary of a depository institution holding
company with average total consolidated assets greater than or equal to
$1 billion but less than $50 billion; (ii) a covered institution with
average total consolidated assets greater than or equal to $1 billion
but less than $50 billion that is not a subsidiary of a depository
institution holding company; and (iii) a covered institution that is a
subsidiary of a covered institution with average total consolidated
assets greater than or equal to $1 billion but less than $50 billion.
In the case of the NCUA:
[cir] A ``Level 1 credit union'' means a credit union with average
total consolidated assets of $250 billion or more.
[cir] A ``Level 2 credit union'' means a credit union with average
total consolidated assets greater than or equal to $50 billion that is
not a Level 1 credit union.
[cir] A ``Level 3 credit union'' means a credit union with average
total consolidated assets greater than or equal to $1 billion that is
not a Level 1 or Level 2 credit union.
In the case of the SEC:
[cir] A ``Level 1 covered institution'' means: (i) A covered
institution with average total consolidated assets greater than or
equal to $250 billion; or (ii) a covered institution that is a
subsidiary of a depository institution holding company that is a Level
1 covered institution pursuant to 12 CFR 236.2.
[cir] A ``Level 2 covered institution'' means: (i) A covered
institution with average total consolidated assets greater than or
equal to $50 billion that is not a Level 1 covered institution; or (ii)
a covered institution that is a subsidiary of a depository institution
holding company that is a Level 2 covered institution pursuant to 12
CFR 236.2.
[cir] A ``Level 3 covered institution'' means a covered institution
with average total consolidated assets greater than or equal to $1
billion that is not a Level 1 covered institution or Level 2 covered
institution.
In the case of FHFA:
[cir] A ``Level 1 covered institution'' means a covered institution
with average total consolidated assets greater than or equal to $250
billion that is not a Federal Home Loan Bank.
[cir] A ``Level 2 covered institution'' means a covered institution
with average total consolidated assets greater than or equal to $50
billion that is not a Level 1 covered institution and any Federal Home
Loan Bank that is a covered institution.
[cir] A ``Level 3 covered institution'' means a covered institution
with average total consolidated assets greater than or equal to $1
billion that is not a Level 1 covered institution or Level 2 covered
institution.
The Agencies considered the varying levels of complexity and risks
across covered institutions that would be subject to this proposed
rule, as well as the general correlation of asset size with those
potential risks, in proposing to distinguish covered institutions by
their asset size.\66\ In general, larger financial institutions have
more complex structures and operations. These more complex structures
make controlling risk-taking more difficult. Moreover, these larger,
more complex institutions also tend to be significant users of
incentive-based compensation. Significant use of incentive-based
compensation combined with more complex business operations can make it
more difficult to immediately recognize and assess risks for the
institution as a whole. Therefore, the requirements of the proposed
rule are tailored to reflect the size and complexity of each of the
three levels of covered institutions identified in the proposed rule.
The proposed rule assigns covered institutions to one of three levels,
based on each institution's average total consolidated assets.
---------------------------------------------------------------------------

\66\ But see earlier discussion regarding consolidation.
---------------------------------------------------------------------------

Additionally, the Agencies considered the exemption in section 956
for institutions with less than $1 billion in assets along with other
asset-level thresholds in the Dodd-Frank Act \67\ as an indication that
Congress views asset size as an appropriate basis for the requirements
and prohibitions established under this proposed rule. Consistent with
this approach, the Agencies also looked to asset size to determine the
types of prohibitions that would be necessary to discourage
inappropriate risks at covered institutions that could lead to material
financial loss.
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\67\ See, e.g., section 116 of the Dodd-Frank Act (12 U.S.C.
5326) (allowing the Financial Stability Oversight Council to require
a bank holding company with total consolidated assets of $50 billion
or more to submit reports); section 163 of the Dodd-Frank Act (12
U.S.C. 5363) (requiring prior notice to the Board for certain
acquisitions by bank holding companies with total consolidated
assets of $50 billion or more); section 165 of the Dodd-Frank Act
(12 U.S.C. 5365) (requiring enhanced prudential standards for bank
holding companies with total consolidated assets of $50 billion or
more); section 318(c) of the Dodd-Frank Act (12 U.S.C. 16)
(authorizing the Board to collect assessments, fees, and other
charges from bank holding companies and savings and loan holding
companies with total consolidated assets of $50 billion or more).
---------------------------------------------------------------------------

The Agencies are proposing that more rigorous requirements apply to
institutions with $50 billion or more in assets. These institutions
with assets of $50 billion or more tend to be significantly more
complex and, the risk-taking of these institutions, and their potential
failure, implicates greater risks for the financial system and the
overall economy. Tailoring application of the requirements of the
proposed rule is consistent with other provisions of the Dodd-Frank
Act, which distinguish requirements for institutions with $50

[[Page 37688]]

billion or more in total consolidated assets. For example, the enhanced
supervision and prudential standards for nonbank financial companies
and bank holding companies under section 165 \68\ apply to bank holding
companies with total consolidated assets of $50 billion or greater. It
is also consistent with the definitions of advanced approaches
institutions under the Federal Banking Agencies' domestic capital
rules,\69\ which are linked to the total consolidated assets of an
institution. Other statutory and regulatory provisions recognize this
difference.\70\
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\68\ 12 U.S.C. 5365.
\69\ See 12 CFR 3.100(b)(1) (advanced approaches national banks
and Federal savings associations); 12 CFR 324.100(b)(1) (advanced
approaches state nonmember banks, state savings associations, and
insured branches of foreign banks); 12 CFR 217.100(b)(1) (advanced
approaches bank holding companies, savings and loan holding
companies, and state member banks).
\70\ See, e.g., Board, ``Regulatory Capital Rules:
Implementation of Risk-Based Capital Surcharges for Global
Systemically Important Bank Holding Companies,'' 80 FR 49081 (August
14, 2015); Board, ``Single-Counterparty Credit Limits for Large
Banking Organizations; Proposed Rule,'' 81 FR 14327 (March 4, 2016);
Board, ``Debit Card Interchange Fees and Routing; Final Rule,'' 76
FR 43393 (July 20, 2011); Board, ``Supervision and Regulation
Assessments for Bank Holding Companies and Savings and Loan Holding
Companies With Total Consolidated Assets of $50 Billion or More and
Nonbank Financial Companies Supervised by the Federal Reserve,'' 78
FR 52391 (August 23, 2013); OCC, Board, FDIC, ``Supplementary
Leverage Ratio; Final Rule,'' 79 FR 57725 (September 26, 2014).
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Most of the requirements of the proposed rule would apply to Level
1 and Level 2 covered institutions in a similar manner. Deferral
requirements, however, would be different for Level 1 and Level 2
covered institutions, as discussed further below: Incentive-based
compensation for senior executive officers and significant risk-takers
at covered institutions with average total consolidated assets equal to
or greater than $250 billion would be subject to a higher percentage of
deferral, and longer deferral periods. In the experience of the
Agencies, covered institutions with assets of $250 billion or more tend
to be significantly more complex and thus exposed to a higher level of
risk than those with assets of less than $250 billion. The risk-taking
of these institutions, and their potential failure, implicates the
greatest risks for the broader economy and financial system. Other
statutory and regulatory provisions recognize this difference. For
example, the definitions of advanced approaches institutions under the
Federal Banking Agencies' domestic capital rules establish a $250
billion threshold for coverage. This approach is similar to that used
in the international standards published by the Basel Committee on
Banking Supervision, and rules implementing such capital standards,
under which banks with consolidated assets of $250 billion or more are
subject to enhanced capital and leverage standards.
As noted above, the Agencies propose to designate the Federal Home
Loan Banks as covered institutions. Under FHFA's proposed rule, each
Federal Home Loan Bank would be a Level 2 covered institution by
definition, as opposed to by total consolidated assets. As long as a
Federal Home Loan Bank is a covered institution under this part, with
average total consolidated assets greater than or equal to $1 billion,
it is a Level 2 covered institution. FHFA proposes this approach
because generally for the Federal Home Loan Banks, asset size is not a
meaningful indicator of risk. The Federal Home Loan Banks all operate
in a similar enough manner that treating them differently based on
asset size is not justifiable. Because of the scalability of the
Federal Home Loan Bank business model, it is possible for a Federal
Home Loan Bank to pass back and forth over the asset-size threshold
without any meaningful change in risk profile. FHFA proposes to
designate the Federal Home Loan Banks as Level 2 covered institutions
instead of Level 3 covered institutions because at the time of the
proposed rule, at least one Federal Home Loan Bank would be a Level 2
covered institution if determined by asset size, and the regulatory
requirements under the proposed rule that seem most appropriate for the
Federal Home Loan Banks are those of Level 2 covered institutions.
Similar to the approach used by the Federal Banking Agencies in
their general supervision of banking organizations, if the proposed
rule were adopted, the Agencies would generally expect to coordinate
oversight and, to the extent applicable, supervision for consolidated
organizations in order to assess compliance throughout the consolidated
organization with any final rule. The Agencies are cognizant that
effective and consistent supervision generally requires coordination
among the Agencies that regulate the various entities within a
consolidated organization. The supervisory authority of each
appropriate Federal regulator to examine and review its covered
institutions for compliance with the proposed rule would not be
affected under this approach.
Affiliate. For the OCC, the Board, the FDIC, and the SEC, the
proposed rule would define ``affiliate'' to mean any company that
controls, is controlled by, or is under common control with another
company. FHFA's proposed rule would not include a definition of
``affiliate.'' The Federal Home Loan Banks have no affiliates, and
affiliates of the Enterprises are included as part of the definition of
Enterprise in the Safety and Soundness Act, which is referenced in the
definition of regulated entity. The NCUA's proposed rule also would not
include a definition of ``affiliate.'' While in some cases, credit
union service organizations (``CUSOs'') might be considered affiliates
of a credit union, NCUA has determined that this rule would not apply
to CUSOs.
Average total consolidated assets. Consistent with section 956, the
proposed rule would not apply to institutions with less than $1 billion
in assets. Additionally, as discussed above, under the proposed rule,
more specific requirements would apply to institutions with higher
levels of assets. The Agencies propose to use average total
consolidated assets to measure assets for the purposes of determining
applicability of the requirements of this rule. Whether a covered
institution that is a subsidiary of a depository institution holding
company is a Level 1, Level 2, or Level 3 covered institution would be
based on the average total consolidated assets of the top-tier
depository institution holding company. Whether that subsidiary has at
least $1 billion will be based on the subsidiary's average total
consolidated assets.
For an institution that is not an investment adviser, average total
consolidated assets would be determined with reference to the average
of the total consolidated assets reported on regulatory reports for the
four most recent consecutive quarters. This method is consistent with
those used to calculate total consolidated assets for purposes of other
rules that have $50 billion thresholds,\71\ and it may reduce
administrative burden on institutions--particularly Level 3 covered
institutions that become Level 2 covered institutions--if average total
consolidated assets are calculated in the same way for the proposed
rule. For an institution that does not have a regulatory report for
each of the four most recent consecutive quarters to reference, average
total consolidated assets would mean the average of total consolidated
assets, as reported on the relevant regulatory reports, for the most
recent quarter or consecutive quarters available, as applicable.
Average total

[[Page 37689]]

consolidated assets would be measured on the as-of date of the most
recent regulatory report used in the calculation of the average. For a
covered institution that is an investment adviser, average total
consolidated assets would be determined by the investment adviser's
total assets (exclusive of non-proprietary assets) shown on the balance
sheet for the adviser's most recent fiscal year end.\72\
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\71\ See, e.g., OCC's Heightened Standards (12 CFR part 30,
Appendix D); 12 CFR 46.3; 12 CFR 225.8; 12 CFR 243.2; 12 CFR 252.30;
2 CFR 252.132; 12 CFR 325.202; 12 CFR 381.2.
\72\ This proposed method of calculation for investment advisers
corresponds to the reporting requirement in Item 1.O. of Part 1A of
Form ADV, which currently requires an investment adviser to check a
box to indicate if it has assets of $1 billion or more. See Form
ADV, Part IA, Item 1.O.; SEC, ``Rules Implementing Amendments to the
Investment Advisers Act of 1940, Investment Advisers Release No. IA-
3221,'' 76 FR 42950 (July 19, 2011). Many commenters to the first
notice of proposed rulemaking indicated that they understood that
the SEC did not intend ``total consolidated assets'' to include non-
proprietary assets, such as client assets under management; others
requested clarification that this understanding is correct. The SEC
is clarifying in the proposed rule that investment advisers should
include only proprietary assets in the calculation--that is, non-
proprietary assets, such as client assets under management would not
be included, regardless of whether they appear on an investment
adviser's balance sheet. The SEC notes that this method is drawn
directly from section 956. See section 956(f) (referencing
``assets'' only).
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The Board's proposed rule would require that savings and loan
holding companies that do not file a regulatory report within the
meaning of section __.2(ee)(3) of the Board's proposed rule report
their average total consolidated assets to the Board on a quarterly
basis. In addition, foreign banking organizations with U.S. operations
would be required to report their total consolidated U.S. assets to the
Board on a quarterly basis. These regulated institutions would be
required to report their average total consolidated assets to the Board
either because they do not file reports of their total consolidated
assets with the Board (in the case of savings and loan holding
companies that do not file a regulatory report with the Board within
the meaning of section __.2(ee)(3) of the Board's proposed rule), or
because the reports filed do not encompass the full range of assets (in
the case of foreign banking organizations with U.S. operations). Asset
information concerning the U.S. operations of foreign banking
organizations is filed on form FRY-7Q, but the information does not
include U.S. assets held pursuant to section 2(h)(2) of the Bank
Holding Company Act. Foreign banking organizations with U.S. operations
would report their average total consolidated U.S. assets including
assets held pursuant to section 2(h)(2) of the Bank Holding Company Act
for purposes of complying with the requirements of section __.2(ee)(3)
of the Board's proposed rule. The Board would propose that reporting
forms be created or modified as necessary for these institutions to
meet these reporting requirements.
The proposed rule does not specify a method for determining the
total consolidated assets of some types of subsidiaries that would be
considered covered institutions under the proposed rule, because those
subsidiaries do not currently submit regular reports of their asset
size to the Agencies. For the subsidiary of a national bank, Federal
savings association, or Federal branch or agency of a foreign bank, the
OCC would rely on a report of the subsidiary's total consolidated
assets prepared by the subsidiary, national bank, Federal savings
association, or Federal branch or agency in a form that is acceptable
to the OCC. Similarly, for a regulated institution subsidiary of a bank
holding company, savings and loan holding company, or foreign banking
organization the Board would rely on a report of the subsidiary's total
consolidated assets prepared by the bank holding company or savings and
loan holding company in a form that is acceptable to the Board.
Control. The definition of control in the proposed rule is similar
to the definition of the same term in the Bank Holding Company Act.\73\
Any company would have control over a bank or any company if: (1) The
company directly or indirectly or acting through one or more other
persons owns, controls, or has power to vote 25 percent or more of any
class of voting securities of the bank or company; (2) the company
controls in any manner the election of a majority of the directors or
trustees of the bank or company; or (3) the appropriate Federal
regulator determines, after notice and opportunity for hearing, that
the company directly or indirectly exercises a controlling influence
over the management or policies of the bank or company.
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\73\ 12 U.S.C. 1841(a)(2).
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Depository institution holding company. The OCC's, the FDIC's, and
the SEC's proposed rules define ``depository institution holding
company'' to mean a top-tier depository institution holding company,
where ``depository institution holding company'' would have the same
meaning as in section 3 of the FDIA.\74\ In a multi-tiered depository
institution holding company, references in the OCC's, FDIC's and SEC's
proposed rules to the ``depository institution holding company'' would
mean the top-tier depository institution holding company of the multi-
tiered holding company only.
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\74\ See 12 U.S.C. 1813(w).
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For example, for the purpose of determining whether a state
nonmember bank that is a subsidiary of a depository institution holding
company and is within a multi-tiered depository institution holding
company structure is a Level 1, Level 2, or Level 3 covered institution
under the FDIC's proposed rule, the state nonmember would look to the
top-tier depository institution holding company's average total
consolidated assets. Thus, in a situation in which a state nonmember
bank with average total consolidated assets of $35 billion is a
subsidiary of a depository institution holding company with average
total consolidated assets of $45 billion that is itself a subsidiary of
a depository institution holding company with $75 billion in average
total consolidated assets, the state nonmember bank would be treated as
a Level 2 covered institution because the top-tier depository
institution holding company has average total consolidated assets of
$75 billion (which is greater than or equal to $50 billion but less
than $250 billion). Similarly, state member banks and national banks
within multi-tiered depository institution holding company structures
would look to the top-tier depository institution holding company's
average total consolidated assets when determining if they are a Level
1, Level 2 or Level 3 covered institution under the Board's and the
OCC's proposed rules.
Subsidiary. For the OCC, the Board, the FDIC, and the SEC, the
proposed rule would define ``subsidiary'' to mean any company which is
owned or controlled directly or indirectly by another company. The
Board proposes to exclude from its definition of ``subsidiary'' any
merchant banking investment that is owned or controlled pursuant to 12
U.S.C. 1843(k)(4)(H) and subpart J of the Board's Regulation Y (12 CFR
part 225) and any company with respect to which the covered institution
acquired ownership or control in the ordinary course of collecting a
debt previously contracted in good faith. Depository institution
holding companies may hold such investments only for limited periods of
time by law. Application of the proposed rule to these institutions
directly would not further the purpose of the proposed rule under
section 956. The holding company and any nonbanking subsidiary holding
these investments would be subject to the proposed rule. For these
reasons, the Board is proposing to exclude from the definition

[[Page 37690]]

of subsidiary companies owned by a holding company as merchant banking
investments or through debt previously contracted in good faith. These
companies would, therefore, not be required to conform their incentive-
based compensation programs to the requirements of the proposed rule.
FHFA's proposed rule would not include a definition of
``subsidiary.'' The Federal Home Loan Banks have no subsidiaries, and
any subsidiaries of the Enterprises as defined by other Agencies under
the proposed rule would be included as affiliates as part of the
definition of Enterprise in the Safety and Soundness Act, which is
referenced in the definition of regulated entity. The NCUA's proposed
rule also would not include a definition of ``subsidiary.'' While in
some cases, CUSOs might be considered subsidiaries of a credit union,
NCUA has determined that this rule would not apply to CUSOs.
2.1. The Agencies invite comment on whether other financial
institutions should be included in the definition of ``covered
institution'' and why.
2.2. The Agencies invite comment on whether any additional
financial institutions should be included in the proposed rule's
definition of subsidiary and why.
2.3. The Agencies invite comment on whether any additional
financial institutions (such as registered investment companies) should
be excluded from the proposed rule's definition of subsidiary and why.
2.4. The Agencies invite comment on the definition of average total
consolidated assets.
2.5. The Agencies invite comment on the proposed rule's approach to
consolidation. Are there any additional advantages to the approach? For
example, the Agencies invite comment on the advantages of the proposed
rule's approach for reinforcing the ability of an institution to
establish and maintain effective risk management and controls for the
entire consolidated organization and enabling holding company
structures to more effectively manage human resources. Are there
advantages to the approach of the proposed rule in helping to reduce
the possibility of evasion of the more specific standards applicable to
certain individuals at Level 1 or Level 2 covered institutions? Are
there any disadvantages to the proposed rule's approach to
consolidation? For example, the Agencies invite comment on any
disadvantages smaller subsidiaries of a larger covered institution may
have by applying the more specific provisions of the proposed rule to
these smaller institutions that would not otherwise apply to them but
for being a subsidiary of a larger institution. Is there another
approach that the proposed rule should take? The Agencies invite
comment on any advantages and disadvantages of the SEC's proposal to
not consolidate subsidiaries of broker-dealers and investment advisers
that are not themselves subsidiaries of depository institution holding
companies. Are the operations, services, and products of broker-dealers
and investment advisers not typically effected through subsidiaries?
Should the SEC adopt an express requirement to treat two or more
affiliated investment advisers or broker-dealers that are separate
legal entities (e.g., investment advisers that are operationally
integrated) as a single investment adviser or broker-dealer for
purposes of the proposed rule's thresholds?
2.6. The Agencies invite comment on whether the three-level
structure would be a workable approach for categorizing covered
institutions by asset size and why.
2.7. The Agencies invite comment on whether the asset thresholds
used in these definitions would divide covered institutions into
appropriate groups based on how they view the competitive marketplace.
If asset thresholds are not the appropriate methodology for determining
which requirements apply, which other alternative methodologies would
be appropriate and why?
2.8. Are there instances where it may be appropriate to modify the
requirements of the proposed rule where there are multiple covered
institutions subsidiaries within a single parent organization based
upon the relative size, complexity, risk profile, or business model,
and use of incentive-based compensation of the covered institution
subsidiaries within the consolidated organization? In what situations
would that be appropriate and why?
2.9. Is the Agencies' assumption that incentive-based compensation
programs are generally designed and administered at the holding company
level for the organization as a whole correct? Why or why not? To what
extent do broker-dealers or investment advisers within a holding
company structure apply the same compensation standards as other
subsidiaries in the parent company?
2.10. Bearing in mind that section 956 by its terms seeks to
address incentive-based compensation arrangements that could lead to
material financial loss to a covered institution, commenters are asked
to provide comments on the proposed method of determining asset size
for investment advisers. Are there instances where it may be
appropriate to determine asset size differently, by for example,
including client assets under management for investment advisers? In
what situations would that be appropriate and why?
2.11. Should the determination of average total consolidated assets
for investment advisers exclude non-proprietary assets that are
included on a balance sheet under accounting rules, such as certain
types of client assets under management required to be included on an
investment adviser's balance sheet? Why or why not?
2.12. Should the determination of average total consolidated assets
be further tailored for certain types of investment advisers, such as
charitable advisers, non-U.S.-domiciled advisers, or insurance
companies and, if so, why and in what manner?
2.13. The Agencies invite comment on the methods for determining
whether foreign banking organizations and Federal branches and agencies
are Level 1, Level 2, or Level 3 covered institutions. Should the same
method be used for both foreign banking organizations and Federal
branches and agencies? Why or why not?
Definitions Pertaining to Covered Persons
Covered person. The proposed rule defines ``covered person'' as any
executive officer, employee, director, or principal shareholder who
receives incentive-based compensation at a covered institution.\75\ The
term ``executive officer'' would include individuals who are senior
executive officers, as defined in the proposed rule, as well as other
individuals designated as executive officers by the covered
institution. As described further below, section __.4 of the proposed
rule would apply requirements and prohibitions on all incentive-based
compensation arrangements for covered persons at covered institutions.
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\75\ Section 956 requires the Agencies to jointly prescribe
regulations or guidelines that prohibit certain incentive-based
compensation arrangements or features of such arrangements that
encourage inappropriate risk by providing an executive officer,
employee, director, or principal shareholder with excessive
compensation, fees, or benefits or that could lead to material
financial loss to the covered financial institution.
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Included in the class of covered persons are senior executive
officers and significant risk-takers, discussed further below. Senior
executive officers and significant risk-takers are covered persons that
may have the ability to expose a covered institution to significant
risk through their positions or actions. Accordingly, the proposed rule
would prohibit the incentive-based

[[Page 37691]]

compensation arrangements for senior executive officers and significant
risk-takers from including certain features that encourage
inappropriate risk, consistent with the approach under sections __.5,
__.9, __.10, and __.11 of the proposed rule of requiring risk-
mitigating features for the incentive-based compensation programs at
larger and more complex covered institutions.
For Federal credit unions, only one director, if any, would be
considered a covered person because, under section 112 of the Federal
Credit Union Act \76\ and NCUA's regulations at 12 CFR 701.33, only one
director may be compensated as an officer of the board of directors.
The insurance and indemnification benefits that are excluded from the
definition of ``compensation'' for purposes of 12 CFR 701.33 would not
cause a non-compensated director of a credit union to be included under
the definition of ``covered person'' because these benefits would not
be ``incentive-based compensation'' under the proposed rule.
---------------------------------------------------------------------------

\76\ 12 U.S.C. 1761a.
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Director. The proposed rule defines ``director'' as a member of the
board of directors of a covered institution. Any member of a covered
institution's governing body would be included within this definition.
Principal shareholder. Section 956 applies to principal
shareholders as well as executive officers, employees, and directors.
The proposed rule defines ``principal shareholder'' as a natural person
who, directly or indirectly, or acting through or in concert with one
or more persons, owns, controls, or has the power to vote 10 percent or
more of any class of voting securities of a covered institution. The 10
percent threshold for identifying principal shareholders is used in a
number of bank regulatory contexts.\77\ The NCUA's proposed rule does
not include this definition because credit unions are not-for-profit
financial cooperatives with member owners. The Agencies recognize that
some other types of covered institutions, for example, mutual savings
associations, mutual savings banks, and some mutual holding companies,
do not have principal shareholders.
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\77\ See, e.g., 12 CFR 215.2(m), 12 CFR 225.2(n)(2), and 12 CFR
225.41(c)(2).
---------------------------------------------------------------------------

2.14. The Agencies invite comment on whether the definition of
``principal shareholder'' reflects a common understanding of who would
be a principal shareholder of a covered institution.
Senior executive officer. The proposed rule defines ``senior
executive officer'' as a covered person who holds the title or, without
regard to title, salary, or compensation, performs the function of one
or more of the following positions at a covered institution for any
period of time in the relevant performance period: President, chief
executive officer (CEO), executive chairman, chief operating officer,
chief financial officer, chief investment officer, chief legal officer,
chief lending officer, chief risk officer, chief compliance officer,
chief audit executive, chief credit officer, chief accounting officer,
or head of a major business line or control function. As described
below, a Level 1 or Level 2 covered institution would be required to
defer a portion of the incentive-based compensation of a senior
executive officer and subject the incentive-based compensation to
forfeiture, downward adjustment, and clawback. The proposed rule would
also limit the extent to which options could be used to meet the
proposed rule's minimum deferral requirements for senior executive
officers. The proposed rule would require a covered institution's board
of directors, or a committee thereof, to approve incentive-based
compensation arrangements for senior executive officers and any
material exceptions or adjustments to incentive-based compensation
policies or arrangements for senior executive officers. Additionally,
Level 1 and Level 2 covered institutions would be required to create
and maintain records listing senior executive officers and to document
forfeiture, downward adjustment, and clawback decisions for senior
executive officers. The proposed rule would limit the extent to which a
Level 1 or Level 2 covered institution may award incentive-based
compensation to a senior executive officer in excess of the target
amount for the incentive-based compensation. Senior executive officers
also would not be eligible to serve on the compensation committee of a
Level 1 or Level 2 covered institution under the proposed rule.
The 2011 Proposed Rule contained a definition of ``executive
officer'' that included the positions of president, CEO, executive
chairman, chief operating officer, chief financial officer, chief
investment officer, chief legal officer, chief lending officer, chief
risk officer, and head of a major business line. It did not include the
positions of chief compliance officer, chief audit executive, chief
credit officer, chief accounting officer, or head of a control
function. One commenter asserted that the term ``executive officer''
should not be defined with reference to specific position, but, rather,
should be identified by the board of directors of a covered
institution. Other commenters asked the Agencies for additional
specificity about the types of executive officers that would be covered
at large and small covered institutions, particularly with respect to
the heads of major business lines. Some commenters encouraged the
Agencies to align the definition of ``executive officer'' with the
Securities Exchange Act of 1934 by focusing on individuals with
significant policymaking functions. In the alternative, some of these
commenters suggested that the definition be revised to conform to the
2010 Federal Banking Agency Guidance.
The definition of ``senior executive officer'' in the proposed rule
retains the list of positions included in the 2011 Proposed Rule and is
consistent with other rules and agency guidance. The list includes the
minimum positions that are considered ``senior executives'' under the
Federal Banking Agency Safety and Soundness Guidelines.\78\ The
Agencies also took into account the positions that would be considered
``officers'' under section 16 of the Securities Exchange Act of
1934.\79\
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\78\ These minimum positions include ``executive officers,''
within the meaning of Regulation O (12 CFR 215.2(e)(1)) and ``named
officers'' within the meaning of the SEC's rules on disclosure of
executive compensation (17 CFR 229.402). In addition to these
minimum positions, the Federal Banking Agency Safety and Soundness
Guidelines also apply to individuals ``who are responsible for
oversight of the organization's firm-wide activities or material
business lines.'' 75 FR at 36407.
\79\ See 17 CFR 240.16a-1.
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In addition to the positions listed in the 2011 Proposed Rule, the
proposed definition of ``senior executive officer'' includes the
positions of chief compliance officer, chief audit executive, chief
credit officer, chief accounting officer, and other heads of a control
function. Individuals in these positions do not generally initiate
activities that generate risk of material financial loss, but they play
an important role in identifying, addressing, and mitigating that risk.
Individuals in these positions have the ability to influence the risk
measures and other information and judgments that a covered institution
uses for risk management, internal control, or financial purposes.\80\
Improperly structured incentive-based compensation arrangements could
create incentives for individuals in these positions to use their
authority in ways that increase, rather than mitigate, risk of material
financial loss. Some larger institutions have designated

[[Page 37692]]

individuals in these positions as ``covered persons'' for purposes of
the 2010 Federal Banking Agency Guidance.
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\80\ See 2010 Federal Banking Agency Guidance, 75 FR at 36411.
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The definition of ``senior executive officer'' also includes a
covered person who performs the function of a senior executive officer
for a covered institution, even if the covered person's formal title
does not reflect that role or the covered person is employed by a
different entity. For example, under the proposed rule, a covered
person who is an employee of a bank holding company and also performs
the functions of a chief financial officer for the subsidiary bank
would, in addition to being a covered person of the bank holding
company, also be a senior executive officer of the bank holding
company's subsidiary bank. This approach would address attempts to
evade being included within the definition of ``senior executive
officer'' by changing an individual's title but not that individual's
responsibilities. In some instances, the determination of senior
executive officers and compliance with relevant requirements of the
proposed rule may be influenced by the covered institution's
organizational structure.\81\ If a covered institution does not have
any covered person who holds the title or performs the function of one
or more of the positions listed in the definition of ``senior executive
officer,'' the proposed rule would not require the covered institution
to designate a covered person to fill such position for purposes of the
proposed rule. Similarly, if a senior executive officer at one covered
institution also holds the title or performs the function of one of
more of the positions listed for a subsidiary that is also a covered
institution, then that individual would be a senior executive officer
for both the parent and the subsidiary covered institutions.
---------------------------------------------------------------------------

\81\ See section __.3(c) of the proposed rule.
---------------------------------------------------------------------------

The list of positions in the proposed definition sets forth the
types of positions whose incumbents would be considered senior
executive officers. The Agencies are proposing this list to aid covered
institutions in identifying their senior executive officers while
allowing the covered institutions some degree of flexibility in
determining which business lines are major business lines.
2.15. The Agencies invite comment on whether the types of positions
identified in the proposed definition of senior executive officer are
appropriate, whether additional positions should be included, whether
any positions should be removed, and why.
2.16. The Agencies invite comment on whether the term ``major
business line'' provides enough information to allow a covered
institution to identify individuals who are heads of major business
lines. Should the proposed rule refer instead to a ``core business
line,'' as defined in FDIC and FRB rules relating to resolution
planning (12 CFR 381.2(d)), to a ``principal business unit, division or
function,'' as described in SEC definitions of the term ``executive
officer'' (17 CFR 240.3b-7), or to business lines that contribute
greater than a specified amount to the covered institution's total
annual revenues or profit? Why?
2.17. Should the Agencies include the chief technology officer
(``CTO''), chief information security officer, or similar titles as
positions explicitly listed in the definition of ``senior executive
officer''? Why or why not? Individuals in these positions play a
significant role in information technology management.\82\ The CTO is
generally responsible for the development and implementation of the
information technology strategy to support the institution's business
strategy in line with its appetite for risk. In addition, these
positions are generally responsible for implementing information
technology architecture, security, and business resilience.
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\82\ See generally Federal Financial Institutions Examination
Council (``FFIEC'') Information Technology Examination Handbook,
available at https://ithandbook.ffiec.gov/it-booklets.aspx.
---------------------------------------------------------------------------

Significant risk-taker. The proposed rule's definition of
``significant risk-taker'' is intended to include individuals who are
not senior executive officers but are in the position to put a Level 1
or Level 2 covered institution at risk of material financial loss so
that the proposed rule's requirements and prohibitions on incentive-
based compensation arrangements apply to such individuals. In order to
ensure that incentive-based compensation arrangements for significant
risk-takers appropriately balance risk and reward, most of the proposed
rule's requirements for Level 1 and Level 2 covered institutions
relating to senior executive officers would also apply to significant
risk-takers to some degree. These requirements include the disclosure
and recordkeeping requirements of section __.5; the deferral,
forfeiture, downward adjustment, and clawback requirements of section
__.7 (including the related limitation on options); and the maximum
incentive-based compensation opportunity limit of section __.8.
The proposed definition of ``significant risk-taker'' incorporates
two tests for determining whether a covered person is a significant
risk-taker. A covered person would be a significant risk-taker if
either test was met. The first test is based on the amounts of annual
base salary and incentive-based compensation of a covered person
relative to other covered persons working for the covered institution
and its affiliate covered institutions (the ``relative compensation
test''). This test is intended to determine whether the individual is
among the top 5 percent (for Level 1 covered institutions) or top 2
percent (for Level 2 covered institutions) of highest compensated
covered persons in the entire consolidated organization, including
affiliated covered institutions. The second test is based on whether
the covered person has authority to commit or expose 0.5 percent or
more of the capital of the covered institution or an affiliate that is
itself a covered institution (the ``exposure test'').\83\
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\83\ In the proposed rule, the Agencies have tailored the
measure of capital to the type of covered institution. For most
covered institutions, the exposure test would be based on common
equity tier 1 capital. For depository institution holding companies,
foreign banking organizations, and affiliates of those institutions
that do not report common equity tier 1 capital, the Board would
work with covered institutions to determine the appropriate measure
of capital. For registered securities brokers or dealers, the
exposure test would be based on tentative net capital. See 17 CFR
240.15c3-1(c)(15). For Federal Home Loan Banks, the exposure test
would be based on regulatory capital. For the Enterprises, the
exposure test would be based on minimum capital. For credit unions,
the exposure test would be based on net worth or total capital. For
simplicity in describing the exposure test in this Supplementary
Information section, common equity tier 1 capital, tentative net
capital, regulatory capital, minimum capital, net worth, and total
capital are referred to generally as ``capital.'' The Agencies
expect that a covered institution that is an investment adviser will
use common equity tier 1 capital or tentative net capital to the
extent it would be a covered institution in another capacity (e.g.,
if the investment adviser also is a depository institution holding
company, a bank, a broker-dealer, or a subsidiary of a depository
institution holding company). For an investment adviser that would
not be a covered institution in any other capacity, the proposed
rule's exposure test would not be measured against the investment
adviser's capital. For a covered person of such an investment
adviser that can commit or expose capital of an affiliated covered
institution, the exposure test would be based on common equity tier
1 capital or tentative net capital of that affiliated covered
institution. For other covered persons of any investment adviser
that would not be a covered institution in any other capacity, no
exposure test is proposed to apply. Comment is requested below
regarding what measure would be appropriate for an exposure test.
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The definition of significant risk-taker applies to only Level 1
and Level 2 covered institutions. The definition of significant risk-
taker does not apply to senior executive officers. Senior

[[Page 37693]]

executive officers of Level 1 and Level 2 covered institutions would be
separately subject to the proposed rule, as discussed earlier in this
Supplemental Information section.
The significant risk-taker definition under either test would be
applicable only to covered persons who received annual base salary and
incentive-based compensation of which at least one-third is incentive-
based compensation (one-third threshold), based on the covered person's
annual base salary paid and incentive-based compensation awarded during
the last calendar year that ended at least 180 days before the
beginning of the performance period for which significant risk-takers
are being identified.\84\ For example, an individual who received
$180,000 in annual base salary during calendar year 2019 and was
awarded incentive-based compensation of $120,000 for performance
periods that ended during calendar year 2019 could be a significant
risk-taker because one-third of the individual's compensation was
incentive-based. Specifically, the individual would be a significant
risk-taker for a performance period beginning on or after June 28, 2020
if the individual also met the relative compensation test or the
exposure test.\85\
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\84\ Incentive-based compensation awarded in a particular
calendar year would include any incentive-based compensation awarded
with respect to a performance period that ended during that calendar
year.
\85\ In this example, incentive-based compensation awarded
($120,000) would be 40 percent of the total $300,000 received in
annual base salary ($180,000) and incentive-based compensation
awarded ($120,000).
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Under the proposed rule, in order for covered persons to be
designated as significant risk-takers, the covered persons would have
to be awarded a level of incentive-based compensation that would be
sufficient to influence their risk-taking behavior. In order to ensure
that significant risk-takers are only those covered persons who have
incentive-based compensation arrangements that could provide incentives
to engage in inappropriate risk-taking, only covered persons who meet
the one-third threshold could be significant risk-takers.
The proposed one-third threshold is consistent with the more
conservative end of the range identified in industry practice.
Institutions in the Board's 2012 LBO Review that would be Level 2
covered institutions under the proposed rule reported that they
generally rewarded their self-identified individual risk-takers with
incentive-based compensation in the range of 8 percent to 90 percent of
total compensation, with an average range of 32 percent to 71 percent.
The proposed threshold of one-third or more falls within the lower end
of that average range.
The one-third threshold would also be consistent with other
standards regarding compensation. Under the Emergency Economic
Stabilization Act of 2008 (as amended by section 7001 of the American
Recovery and Reinvestment Act of 2009), recipients of financial
assistance under Treasury's Troubled Asset Relief Program (``TARP'')
were prohibited from paying or accruing any bonus, retention award, or
incentive compensation except for the payment of long-term restricted
stock if that stock had a value that was not greater than one third of
the total amount of annual compensation of the employee receiving the
stock.\86\ In addition, some international regulators also use a
threshold of one-third incentive-based compensation for determining the
scope of application for certain compensation standards.\87\
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\86\ 12 U.S.C. 5221(b)(3)(D).
\87\ PRA, ``Supervisory Statement LSS8/13, Remuneration
Standards: The Application of Proportionality'' (April 2013), at 11,
available at https://www.bankofengland.co.uk/publications/Documents/other/pra/policy/2013/remunerationstandardslss8-13.pdf.
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The Agencies included the 180-day period in the one-third threshold
of annual base salary and incentive-based compensation because, based
upon the supervisory experience of the Federal Banking Agencies and
FHFA, this period would allow covered institutions an adequate period
of time to calculate the total compensation of their covered persons
and, for purposes of the relative compensation test, the individuals
receiving incentive-based compensation from their affiliate covered
institutions over a full calendar year. The Agencies expect, based on
the experience of exceptional assistance recipients under TARP,\88\
that 180 days would be a reasonable period of time for Level 1 and
Level 2 covered institutions to finalize compensation paid to and
awarded to covered persons and to perform the necessary calculations to
determine which covered persons are significant risk-takers. This time
period would allow covered institutions to make awards following the
end of the performance period, calculate the annual base salary and
incentive-based compensation for all employees in the consolidated
organization, including affiliated covered institutions, and then
implement new compensation arrangements for the significant risk-takers
identified, if necessary.
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\88\ The institutions that accepted ``exceptional assistance''
under TARP were required to submit to the Office of the Special
Master for approval the compensation levels and structures for the
five named executive officers and the next 20 most highly
compensated executive officers (``Top 25'') and the compensation
structures for the next 75 most highly compensated employees. The
requirement for submission of the Top 25 necessitated the collection
of the compensation data for executives worldwide and took
considerable time and effort on the part of the institutions.
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The Agencies recognize that the relative compensation test and the
exposure test, combined with the one-third threshold, may not identify
all covered persons at Level 1 and Level 2 covered institutions who
have the ability to expose a covered institution or its affiliated
covered institutions to material financial loss. Accordingly, paragraph
(2) of the proposed rule's definition of significant risk-taker would
allow covered institutions or the Agencies the flexibility to designate
additional persons as significant risk-takers. An Agency would be able
to designate a covered person as a significant risk-taker if the
covered person has the ability to expose the covered institution to
risks that could lead to material financial loss in relation to the
covered institution's size, capital, or overall risk tolerance. Each
Agency would use its own procedures for making such a designation. Such
procedures generally would include reasonable advance written notice of
the proposed action, including a description of the basis for the
proposed action, and opportunity for the covered person and covered
institution to respond.
Relative Compensation Test
The relative compensation test in paragraphs (1)(i) and (ii) of the
proposed definition of ``significant risk-taker'' would require a
covered institution to determine which covered persons received the
most annual base salary and incentive-based compensation among all
individuals receiving incentive-based compensation from the covered
institution and any affiliates of the covered institution that are also
subject to the proposed rule.\89\ The

[[Page 37694]]

definition contains two percentage thresholds for measuring whether an
individual is a significant risk-taker. For a Level 1 covered
institution, a covered person would be a significant risk-taker if the
person receives annual base salary and incentive-based compensation for
the last calendar year that ended at least 180 days before the
performance period that places the person among the highest 5 percent
of all covered persons in salary and incentive-based compensation
(excluding senior executive officers) of the Level 1 covered
institution and, in the cases of the OCC, the Board, the FDIC, and the
SEC, any section 956 affiliates of the Level 1 covered institution. For
Level 2 covered institutions, the threshold would be 2 percent rather
than 5 percent.
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\89\ The OCC, Board, FDIC, and SEC's proposed rules include a
defined term, ``section 956 affiliate,'' that is intended to
function as shorthand for the types of entities that are considered
``covered institutions'' under the six Agencies' proposed rules. The
term ``section 956 affiliate'' is used only in the definition of
``significant risk-taker,'' and it is not intended to affect the
scope of any Agency's rule or the entities considered ``covered
institutions'' under any Agency's rule. Given the proposed location
of each Agency's proposed rule in the Code of Federal Regulations,
the cross-references used in each of the OCC, Board, FDIC, and SEC's
proposed rule differ slightly. NCUA's proposed rule does not include
a definition of ``section 956 affiliate,'' because credit unions are
not affiliated with the entities that are considered ``covered
institutions'' under the other Agencies' rules. Similarly, FHFA's
proposed rule does not include a definition of ``section 956
affiliate'' because its regulated institutions are not affiliated
with other Agencies' covered institutions.
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For example, if a hypothetical bank holding company were a Level 1
covered institution and had $255 billion in average total consolidated
assets might have a subsidiary national bank with $253 billion in
average total consolidated assets, a mortgage subsidiary with $1.9
billion in average total consolidated assets, and a wealth management
subsidiary with $100 million in average total consolidated assets.\90\
The relative compensation test would analyze the annual base salary and
incentive-based compensation of all covered persons (other than senior
executive officers) who receive incentive-based compensation at the
bank holding company, the subsidiary national bank, and the mortgage
subsidiary, which are all covered institutions with assets greater than
or equal to $1 billion. Individuals at the wealth management subsidiary
would not be included because that subsidiary has less than $1 billion
in average total consolidated assets. Thus, if the bank holding
company, state member bank, and mortgage subsidiary collectively had
150,000 covered persons (excluding senior executive officers), then the
covered institution should identify the 7,500 or 5 percent of covered
persons (other than senior executive officers) who receive the most
annual base salary and incentive-based compensation out of those
150,000 covered persons, and identify as significant risk-takers any of
those 7,500 persons who received annual base salary and incentive-based
compensation for the last calendar year that ended at least 180 days
before the beginning of the performance period of which at least one-
third is incentive-based compensation.\91\ Some of those 7,500 covered
persons might receive incentive-based compensation from the bank
holding company; others might receive incentive-based compensation from
the national bank or the mortgage subsidiary. Each covered person that
satisfies all requirements would be considered a significant risk-taker
of the covered institution from which they receive incentive-based
compensation. This example is provided solely for the purpose of
illustrating the calculation of the number of significant risk-takers
under the relative compensation test as proposed. It does not reflect
any specific institution, nor does it reflect the experience or
judgment of the Agencies of the number of covered persons or
significant risk-takers at any institution that would be a Level 1
covered institution under the proposed rule.
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\90\ Under the proposed rule, all of these subsidiaries in this
example other than the wealth management subsidiary would be subject
to the same requirements as the bank holding company, including the
specific requirements applying to identification of significant
risk-takers. The wealth management subsidiary would not be subject
to the requirements of the proposed rule because it has less than $1
billion in average total consolidated assets.
\91\ The Agencies anticipate that covered institutions that are
within a depository institution holding company structure would work
together to ensure that significant risk-takers are correctly
identified under the relative compensation test.
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Annual base salary and incentive-based compensation would be
measured based on the last calendar year that ended at least 180 days
before the beginning of the performance period for the reasons
discussed above.
The Agencies propose that Level 1 and Level 2 covered institutions
generally should consider a covered person's annual base salary
actually paid during the calendar year. If, for example, a covered
person was a manager during the first half of the year, with an annual
salary of $100,000, and was then promoted to a senior manager with an
annual salary of $150,000 on July 1 of that year, the annual base
salary would be the $50,000 that person received as manager for the
first half of the year plus the $75,000 received as a senior manager
for the second half of the year, for a total of $125,000.
For the purposes of determining significant risk-takers, covered
institutions should consider the incentive-based compensation that was
awarded for any performance period that ended during a particular
calendar year, regardless of when the performance period began. For
example, if a covered person is awarded incentive-based compensation
relating to (i) a plan with a three-year performance period that began
on January 1, 2017, (ii) a plan with a two-year performance period that
began on January 1, 2018, and (iii) a plan with a one-year performance
period that began on January 1, 2019, then all three of these awards
would be included in the calculation of incentive-based compensation
for calendar year 2019 because all three performance periods would end
on December 31, 2019. The amount of previously deferred incentive-based
compensation that vests in a particular year would not affect the
measure of a covered person's incentive-based compensation for purposes
of the relative compensation test.\92\
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\92\ Level 1 and Level 2 covered institutions would also use
this method of calculating a covered person's incentive-based
compensation for a particular calendar year for purposes of
determining (1) whether such person received annual base salary and
incentive-based compensation of which at least one third was
incentive-based compensation and (2) the amount of a covered
person's annual base salary and incentive-based compensation under
the dollar threshold test.
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To reduce the administrative burden of calculating annual base
salary and incentive-based compensation, the calculation would not
include fringe benefits such as the value of medical insurance or the
use of a company car. For purposes of such calculation, any non-cash
compensation, such as stock or options, should be valued as of the date
of the award.
In the Agencies' supervisory experience, the amount of a covered
person's annual base salary and incentive-based compensation can
reasonably be expected to relate to the amount of responsibility that
the covered person has within an organization, and covered persons with
a higher level of responsibility generally either (1) have a greater
ability to expose a covered institution to financial loss or (2)
supervise covered persons who have a greater ability to expose a
covered institution to financial loss. For this reason, the Agencies
are proposing to use the relative compensation test as one basis for
identifying significant risk-takers.
Although a large number of covered persons may be able to expose a
covered institution to a financial loss, the Agencies have limited the
relative compensation test to the most highly compensated individuals
in order to focus on those covered persons whose behavior can directly
or indirectly expose a Level 1 or Level 2 covered institution to a
financial loss that is material. Based on an analysis of public
disclosures of large, international banking organizations \93\ and on
the

[[Page 37695]]

Agencies' own supervision of incentive-based compensation, the top 5
percent most highly compensated covered persons among the covered
institutions in the consolidated structure of Level 1 covered
institutions are the most likely to have the potential to encourage
inappropriate risk-taking by the covered institution because their
compensation is excessive (the first test in section 956) or be the
personnel who are able to expose the organization to risk of material
financial loss (the second test in section 956).
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\93\ Agencies examined information available through various
public reports, including the FSB's annual Compensation Progress
Report. For instance, many international jurisdictions require firms
to identify a population of employees who can expose a firm to
material amounts of risk (sometimes called material risk takers or
key risk takers), who are subject to specific requirements including
deferral. In 2014 the FSB published information indicating that the
average percentage of total global employees identified as risk-
takers under these various jurisdictions' requirements at a sample
of large firms ranged from 0.01 percent of employees of the global
consolidated organization to more than 5 percent. The number varied
between, but also within, individual jurisdictions and institutions
as a result of factors such as specific institutions surveyed, the
size of institution, and the nature of business conducted. See FSB,
Implementing the FSB Principles for Sound Compensation Practices and
their Implementation Standards Third Progress Report (November
2014), at 19, available at https://www.fsb.org/2014/11/fsb-publishes-third-progress-report-on-compensation-practices.
In addition, the Agencies relied to a certain extent on
information disclosed on a legal entity basis as a result of Basel
Pillar 3 remuneration disclosure requirements, for instance those
required under implementing regulations such as Article 450 of the
Capital Requirements Regulation (EU No 575/2013) in the European
Union. See, e.g., Morgan Stanley, Article 450 of CRR Disclosure:
Remuneration Policy (December 31, 2014), available at https://www.morganstanley.com/about-us-ir/pillar3/2014_CRR_450_Disclosure.pdf. Remuneration disclosure requirements
apply to ``significant'' firms. CRD IV defines institutions that are
significant ``in terms of size, internal organisation and nature,
scope and complexity of their activities.'' Under the EBA Guidance
on Sound Remuneration Policies, significant institutions means
institutions referred to in Article 131 of Directive 2013/36/EU
(global systemically important institutions or `G-SIIs,' and other
systemically important institutions or `O-SIIs'), and, as
appropriate, other institutions determined by the competent
authority or national law, based on an assessment of the
institutions' size, internal organization and the nature, the scope
and the complexity of their activities. Some, but not all, national
regulators have provided further guidance on interpretation of that
term, including the United Kingdom's FCA which provides a form of
methodology to determine if a firm is ``significant''--based on
quantitative tests of balance sheet assets, liabilities, annual fee
commission income, client money and client assets.
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The Board and the OCC, as a part of their supervisory efforts,
reviewed a limited sample of banking organizations with total
consolidated assets of $50 billion or more to better understand what
types of positions within these organizations would be captured by
various thresholds for highly compensated employees. In the review, the
Board and the OCC also considered how far below the CEO within the
organizational hierarchy the selected thresholds would reach.
Generally, at banking organizations that would be Level 1 covered
institutions under the proposed rule, a 5 percent threshold would
include positions such as managing directors, directors, senior vice
presidents, relationship and sales managers, mortgage brokers,
financial advisors, and product managers. Such positions generally have
the ability to expose the organization to the risk of material
financial loss. Based on this review, the Agencies believe it is
reasonable to propose a 5 percent threshold under the relative
compensation test for Level 1 covered institutions.
At banking organizations that would be Level 2 covered institutions
under the proposed rule, a 5 percent threshold yielded results that
went much deeper into the organization and identified roles with
individuals who might not individually take significant risks for the
organization. Additional review of a limited sample of these banking
organizations that would be Level 2 covered institutions under the
proposed rule showed that, on average, the institutions in the limited
sample identified approximately 2 percent of their total global
employees as individual employees whose activities may expose the
organization to material amounts of risk, as consistent with the 2010
Federal Banking Agency Guidance. A lower percentage threshold for Level
2 covered institutions relative to Level 1 covered institutions also is
consistent with the observation that larger covered institutions
generally have more complex structures and use incentive-based
compensation more significantly than relatively smaller covered
institutions. Based on this analysis, the Agencies chose to propose a 2
percent threshold for Level 2 covered institutions. A lower percentage
threshold for Level 2 covered institutions relative to Level 1 covered
institutions would reduce the burden on relatively smaller covered
institutions.
Under the proposed rule, if an Agency determines, in accordance
with procedures established by the Agency, that a Level 1 covered
institution's activities, complexity of operations, risk profile, and
compensation practices are similar to those of a Level 2 covered
institution, then the Agency may apply a 2 percent threshold under the
relative compensation test rather than the 5 percent threshold that
would otherwise apply. This provision is intended to allow an Agency
the flexibility to adjust the number of covered persons who are
significant risk-takers with respect to a Level 1 covered institution
if the Agency determines that, notwithstanding the Level 1 covered
institution's average total consolidated assets, its actual activities
and risks are similar to those of a Level 2 covered institution, and
therefore it would be appropriate for the Level 1 covered institution
to have fewer significant risk-takers.
Exposure Test
Under the exposure test, a covered person would be a significant
risk-taker with regard to a Level 1 or Level 2 covered institution if
the individual may commit or expose \94\ 0.5 percent or more of capital
of the covered institution or, and, in the cases of the OCC, the Board,
the FDIC, and the SEC, any section 956 affiliates of the covered
institution, whether or not the individual is employed by that specific
legal entity.
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\94\ An individual may commit or expose capital of a covered
institution or affiliate if the individual has the ability to put
the capital at risk of loss due to market risk or credit risk.
---------------------------------------------------------------------------

The exposure test relates to a covered person's authority to commit
or expose significant amounts of an institution's capital, regardless
of whether or not such exposures or commitments are realized. The
exposure test would relate to a covered person's authority to cause the
covered institution to be subject to credit risk or market risk. The
exposure test would not relate to the ability of a covered person to
expose a covered institution to other types of risk that may be more
difficult to measure or quantify, such as compliance risk.
The measure of capital would relate to a covered person's authority
over the course of the most recent calendar year, in the aggregate, and
would be based on the maximum amount that the person has authority to
commit or expose during the year. For example, a Level 1 or Level 2
covered institution might allocate $10 million to a particular covered
person as an authorized level of lending for a calendar year. For
purposes of the exposure test in the proposed rule, the covered
person's authority to commit or expose would be $10 million. This would
be true even if the individual only made $8 million in loans during the
year or if the covered institution reduced the authorized amount to
$7.5 million at some point during the year. It would also be true even
if the covered person did not have the authority through any single
transaction to lend $10 million, so long as over the course of the year
the covered person could lend up to $10 million in the aggregate. If,
however, in

[[Page 37696]]

the course of the year the covered person received authorization for an
additional $5 million in lending, $15 million would become the
authorization amount for purposes of the exposure test. If a covered
person had no specific maximum amount of lending for the year, but
instead his or her lending was subject to approval on a rolling basis,
then the covered person would be assumed to have an authorized annual
lending amount in excess of the 0.5 percent threshold.
As an additional example, a Level 1 or Level 2 covered institution
could authorize a particular covered person to trade up to $5 million
per day in a calendar year. For purposes of the exposure test, the
covered person's authorized annual lending amount would be $5 million
times the number of trading days in the year (for example, $5 million
times 260 days or $1.3 billion). This would be true even if the covered
person only traded $1 million per day during the year or if the covered
institution reduced the authorized trading amount to $2.5 million per
day at some point during the year. If, however, in the course of the
year the covered person received authorization for an additional $2
million in trading per day, the covered person's authority to commit or
expose capital for purposes of the exposure test would be $1.82 billion
($7 million times 260 days). The Agencies are aware that institutions
may not calculate their exposures in this manner and are requesting
comment upon it, as set forth below.
The exposure test would also include individuals who are voting
members of a committee that has the decision-making authority to commit
or expose 0.5 percent or more of the capital of a covered institution
or of a section 956 affiliate of a covered institution. For example, if
a committee that is comprised of five covered persons has the authority
to make investment decisions with respect to 0.5 percent or more of a
state member bank's capital, then each voting member of such committee
would have the authority to commit or expose 0.5 percent or more of the
state member bank's capital for purposes of the exposure test. However,
individuals who participate in the meetings of such a committee but who
do not have the authority to exercise voting, veto, or similar rights
that lead to the committee's decision would not be included.
The exposure test would also cause a covered person to be
considered a significant risk-taker if he or she can commit or expose
0.5 percent or more of the capital of any section 956 affiliate of the
covered institution by which the covered person is employed. For
example, if a covered person of a nonbank subsidiary of a bank holding
company has the authority to commit 0.5 percent or more of the bank
holding company's capital or the capital of the bank holding company's
subsidiary national bank (and received annual base salary and
incentive-based compensation for the last calendar year that ended at
least 180 days before the beginning of the performance period of which
at least one-third is incentive-based compensation), then the covered
person would be considered a significant risk-taker of the bank holding
company or national bank, whichever is applicable. This would be true
even if the covered person is not employed by the bank holding company
or the bank holding company's subsidiary national bank, and even if the
covered person does not have the authority to commit or expose the
capital of the nonbank subsidiary that employs the covered person.
The exposure test would require a Level 1 or Level 2 covered
institution to consider the authority of an individual to take an
action that could result in significant credit or market risk exposures
to the covered institution. The Agencies are proposing the exposure
test because individuals who have the authority to expose covered
institutions to significant amounts of risk can cause material
financial losses to covered institutions. For example, in proposing the
exposure test, the Agencies were cognizant of the significant losses
caused by actions of individuals, or a trading group, at some of the
largest financial institutions during and after the financial crisis
that began in 2007.\95\
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\95\ See supra note 14.
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The exposure test would identify significant risk-takers based on
the extent of an individual's authority to expose an institution to
market risk or credit risk, measured by reference to 0.5 percent of the
covered institution's regulatory capital. Measuring this authority by
reference to an existing capital standard would provide a uniform and
clearly defined metric to apply among covered persons at Level 1 and
Level 2 covered institutions. The Agencies have selected credit and
market risks as the most relevant types of exposures because the
majority of assets on a covered institution's balance sheet generally
give rise to market or credit risk exposure.
In proposing a threshold of 0.5 percent of relevant capital, the
Agencies considered both the absolute and relative amount of losses
that the threshold would represent for covered institutions, and the
fact that incentive-based compensation programs generally apply to
numerous employees at a covered institution. In the Agencies' view, the
proposed threshold represents a material financial loss within the
meaning of section 956 for any institution and multiple losses at the
same firm incentivized by a single incentive-based compensation program
could impair the firm.
The Agencies considered the cumulative effect of incentive-based
compensation arrangements across a covered institution. The Agencies
recognize that many covered persons who have the authority to expose a
covered institution to risk are subject to similar incentive-based
compensation arrangements. The effect of an incentive-based
compensation arrangement on a covered institution would be the
cumulative effect of the behavior of all covered persons subject to the
incentive-based compensation arrangement. If multiple covered persons
are incented to take inappropriate risks, their combined risk-taking
behavior could lead to a financial loss at the covered institution that
is significantly greater than the financial loss that could be caused
by any one individual.\96\ Although many institutions already have
governance and risk management systems to help ensure the commitment of
significant amounts of capital is subject to appropriate controls, as
noted above, incentive-based compensation arrangements that provide
inappropriate risk-taking incentives can weaken those governance and
risk management systems. These considerations about the cumulative
effect of incentive-based compensation arrangements weigh in favor of a
conservative threshold under the exposure test so that large groups of
covered persons with the authority to commit a covered institution's
capital are not subject to flawed incentive-based compensation
arrangements which would incentivize them to subject the covered
institution to inappropriate risks.
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\96\ See, e.g., the Subcommittee Report.
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The Agencies also considered that in another regulatory context, a
relatively small decrease in a large institution's capital requires
additional safeguards for safety and soundness. Under the capital plan
rule in the Board's Regulation Y, well-capitalized bank holding
companies with average total consolidated assets of $50 billion or more
are subject to prior approval requirements on incremental capital

[[Page 37697]]

distributions if those distributions, as measured over a one-year
period, would exceed pre-approved amounts by more than 1 percent of the
bank holding company's tier 1 capital.\97\ Relative to the capital plan
rule, a lower threshold of capital is appropriate in the context of
incentive-based compensation in light of the potential cumulative
effect of multiple covered persons with incentives to take
inappropriate risks and the possibility that correlated inappropriate
risk-taking incentives could, in the aggregate, significantly erode
capital buffers at Level 1 and Level 2 covered institutions.
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\97\ See 12 CFR 225.8(g). Bank holding companies that are well-
capitalized and that meet other requirements under the rule must
provide the Board with prior notice for incremental capital
distributions, as measured over a one-year period, that represent
more than 1 percent of their tier 1 capital. Id.
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Taking into consideration the cumulative impact of incentive-based
compensation arrangements described above, the Agencies have proposed a
threshold level for the exposure test of 0.5 percent of capital. The
exposure test would be measured on an annual basis to align with the
common practice at many institutions of awarding incentive-based
compensation on an annual basis, taking into account a covered person's
performance and risk-taking over 12 months.
The Agencies also considered international compensation regulations
that also use a 0.5 percent threshold, but on a per transaction
basis.\98\ The Agencies are proposing to apply the threshold on an
aggregate annual basis because a per transaction basis could permit an
individual to evade designation as a significant risk-taker and the
related incentive-based compensation restrictions by keeping his or her
individual transactions below the threshold, but completing multiple
transactions during the course of the year that, in the aggregate, far
exceed the threshold.
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\98\ See, e.g., EBA, ``Regulatory Technical Standards on
Criteria to Identify Categories of Staff Whose Professional
Activities Have a Material Impact on an Institution's Risk Profile
under Article 94(2) of Directive 2013/36/EU'' (December 16, 2013),
available athttps://www.eba.europa.eu/documents/10180/526386/EBA-RTS-2013-11+%28On+identified+staff%29.pdf/c313a671-269b-45be-a748-29e1c772ee0e.
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Exposure Test at Certain Affiliates
Paragraph (3) of the definition of significant risk-taker is
intended to address potential evasion of the exposure test by a Level 1
or Level 2 covered institution that authorizes an employee of one of
its affiliates that is not a covered institution because it has less
than $1 billion in average total consolidated assets or is not
considered a covered institution under one of the six Agencies'
proposed rules, to commit or expose 0.5 percent or more of capital of
the Level 1 or Level 2 covered institution. The Agencies are concerned
that in such a situation, the employee would be functioning as a
significant risk-taker at the affiliated Level 1 or Level 2 covered
institution but would not be subject to the requirements of the
proposed rule that would be applicable to a significant risk-taker at
the affiliated Level 1 or Level 2 covered institution. To address this
circumstance, the proposed rule would treat such employee as a
significant risk-taker with respect to the affiliated Level 1 or Level
2 covered institution for which the employee may commit or expose
capital. That Level 1 or Level 2 covered institution would be required
to ensure that the employee's incentive-based compensation arrangement
complies with the proposed rule.
Dollar Threshold Test
As an alternative to the relative compensation test, the Agencies
also considered using a specific absolute compensation threshold,
measured in dollars, to determine whether an individual is a
significant risk-taker. Under this test, a covered person who receives
annual base salary and incentive-based compensation \99\ in excess of a
specific dollar threshold would be a significant risk-taker, regardless
of how that covered person's annual base salary and incentive-based
compensation compared to others in the consolidated organization (the
``dollar threshold test''). A dollar threshold test would include
adjustments such as for inflation. If the dollar threshold test
replaced the relative compensation test, the definition of
``significant risk-taker'' would still include only covered persons who
received annual base salary and incentive-based compensation of which
at least one-third was incentive-based compensation, based on the
covered person's annual base salary paid and incentive-based
compensation awarded during the last calendar year that ended at least
180 days before the beginning of the performance period.
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\99\ For purposes of the dollar threshold test, the measure of
annual base salary and incentive-based compensation would be
calculated in the same way as the measure for the one-third
threshold discussed above.
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One advantage of a dollar threshold test compared to the relative
compensation test is that it could be less burdensome to implement and
monitor. With a dollar threshold test covered institutions can
determine whether an individual covered person meets the dollar
threshold test of the significant risk-taker definition by reviewing
the compensation of only that single individual. The dollar threshold
test would also allow an institution to implement incentive-based
compensation structures, policies, and procedures with some
foreknowledge of which employees would be covered by them. However,
even with adjustment for inflation, a dollar threshold put in place by
regulation would assume that a certain dollar threshold is an
appropriate level for all Level 1 and Level 2 covered institutions and
covered persons. On the other hand, a dollar threshold could set
expectations so that individual employees would know based on their own
compensation if they are significant risk-takers.
Based on FHFA's supervisory experience analyzing compensation both
at FHFA's regulated entities and at other financial institutions, a
dollar threshold would be an appropriate approach to identify
individuals with the ability to put the covered institution at risk of
material loss. FHFA must prohibit its regulated entities from providing
compensation to any executive officer of the regulated entity that is
not reasonable and comparable with compensation for employment in other
similar businesses (including publicly held financial institutions or
major financial services companies) involving similar duties and
responsibilities.\100\ In order to meet this statutory mandate, FHFA
analyzes, assesses, and compares the compensation paid to employees of
its regulated entities and compensation paid to employees of other
financial institutions of various asset sizes. In performing this
analysis, FHFA has observed that the amount of a covered person's
annual base salary and incentive-based compensation reasonably relates
to the level of responsibility that the covered person has within an
organization. A dollar threshold test, if set at the appropriate level,
would identify covered persons who either (1) have a greater ability to
expose a covered institution to financial loss or (2) supervise covered
persons who have a greater ability to expose a covered institution to
financial loss.
---------------------------------------------------------------------------

\100\ 12 U.S.C. 4518(a).
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One disadvantage of the dollar threshold test is that it may not
appropriately capture all individuals who subject the firm to
significant risks. A dollar threshold put in place by regulation that
is static across all Level 1 and Level 2 covered institutions also is
not sensitive to the compensation

[[Page 37698]]

practices of an individual organization. The relative compensation
test, while not as easy to implement, could be more sensitive to the
compensation structure of an organization because it is based on the
relative compensation of individuals that the organization concludes
should be the mostly highly compensated.
2.18. For purposes of a designation under paragraph (2) of the
definition of significant risk-taker, should the Agencies provide a
specific standard for what would constitute ``material financial loss''
and/or ``overall risk tolerance''? If so, how should these terms be
defined and why?
2.19. The Agencies specifically invite comment on the one-third
threshold in the proposed rule. Is one-third of the total of annual
base salary and incentive-based compensation an appropriate threshold
level of incentive-based compensation that would be sufficient to
influence risk-taking behavior? Is using compensation from the last
calendar year that ended at least 180 days before the beginning of the
performance period for calculating the one-third threshold appropriate?
2.20. The Agencies specifically invite comment on the percentages
of employees proposed to be covered under the relative compensation
test. Are 5 percent and 2 percent reasonable levels? Why or why not?
Would 5 percent and 2 percent include all of the significant risk-
takers or include too many covered persons who are not significant
risk-takers?
2.21. The Agencies specifically invite comment on the time frame
needed to identify significant risk-takers under the relative
compensation test. Is using compensation from the last calendar year
that ended at least 180 days before the beginning of the performance
period appropriate? The Agencies invite comment on whether there is
another measure of total compensation that would be possible to measure
closer in time to the performance period for which a covered person
would be identified as a significant risk-taker.
2.22. The Agencies invite comment on all aspects of the exposure
test, including potential costs and benefits, the appropriate exposure
threshold and capital equivalent, efficacy at identifying those non-
senior executive officers who have the authority to place the capital
of a covered institution at risk, and whether an exposure test is a
useful complement to the relative compensation test. If so, what
specific types of activities or transactions, and at what level of
exposure, should the exposure test cover? The Agencies also invite
comment on whether the exposure test is workable and why. What, if any,
additional details would need to be specified in order to make the
exposure test workable, such as further explanation of the meanings of
``commit'' or ``expose''? In addition to committees, should the
exposure test apply to groups of persons, such as traders on a desk? If
so, how should it be applied?
2.23. With respect to the exposure test, the Agencies specifically
invite comment on the proposed capital commitment levels. Is 0.5
percent of capital of a covered institution a reasonable proxy for
material financial loss, or are there alternative levels or dollar
thresholds that would better achieve the statutory objectives? If
alternative methods would better achieve the statutory objectives, what
are the advantages and disadvantages of those alternatives compared to
the proposed level? For depository institution holding company
organizations with multiple covered institutions, should the capital
commitment level be consistent across all such institutions or should
it vary depending on specified factors and why? For example, should the
levels for covered institutions that are subsidiaries of a parent who
is also a covered institution vary depending on: (1) The size of those
subsidiaries relative to the parent; and/or (2) whether the entity
would be subject to comparable restrictions if it were not affiliated
with the parent? What are the advantages and disadvantages of any such
variation, and what would be the appropriate levels? The Agencies
recognize that certain covered institutions under the Board's, the
OCC's, the FDIC's, and the SEC's proposed rules, such as Federal and
state branches and agencies of foreign banks and investment advisers
that are not also depository institution holding companies, banks, or
broker-dealers or subsidiaries of those institutions, are not otherwise
required to calculate common equity tier 1 capital or tentative net
capital, as applicable. How should the capital commitment level be
determined under the Board's, the OCC's, the FDIC's, and the SEC's
proposed rules for those covered institutions? Is there a capital or
other measure that the Agencies should consider for those covered
institutions that would achieve similar objectives to common equity
tier 1 capital or tentative net capital? If so, what are the advantages
and disadvantages of such a capital or other measure?
2.24. The Agencies invite comment on whether it is appropriate to
limit the exposure test to market risk and credit risk and why. What
other types of risk should be included, if any and how would such
exposures be measured? Should the Agencies prescribe a method for
measurement of market risk and credit risk? Should exposures be
measured as notional amounts or is there a more appropriate measure? If
so, what would it be? Should the exposure test take into account
hedging? How should the exposure test be applied to an individual in a
situation where a firm calculates an exposure limit for a trading desk
comprised of a group of people? Should a de minimis threshold be
introduced for any transaction counted toward the 0.5 percent annual
exposure test?
2.25. Should the exposure test consider the authority of a covered
person to initiate or structure proposed product offerings, even if the
covered person does not have final decision-making authority over such
product offerings? Why or why not? If so, are there specific types of
products with respect to which this approach would be appropriate and
why?
2.26. Should the exposure test measure a covered person's authority
to commit or expose (a) through one transaction or (b) as currently
proposed, through multiple transactions in the aggregate over a period
of time? What would be the benefits and disadvantages of applying the
test on a per-transaction versus aggregate basis over a period of time?
If measured on an aggregate basis, what period of time is appropriate
and why? For example, should paragraph (1)(iii) of the definition of
significant risk-taker read: ``A covered person of a covered
institution who had the authority to commit or expose in any single
transaction during the previous calendar year 0.5 percent or more of
the capital \101\ of the covered institution or of any section 956
affiliate of the covered institution, whether or not the individual is
a covered person of that specific legal entity''? Why or why not?
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\101\ Under this alternative language, each Agency's rule text
would include the relevant capital metrics for its covered
institutions.
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2.27. If the exposure test were based on a single transaction,
would 0.5 percent of capital be the appropriate threshold for
significant risk-taker status? Why or why not? If not, what would be
the appropriate percentage of capital to include in the exposure test
and why?
2.28. Should the Agencies introduce an absolute exposure threshold
in addition to a percentage of capital test if a per-transaction test
was introduced instead of the annual exposure test? Why or why not? For
example, would a threshold formulated as ``the lesser of 0.5 percent of
capital or $100 million''

[[Page 37699]]

help to level the playing field across Level 1 covered institutions and
the smallest Level 2 covered institutions and better ensure that the
right set of activities is being considered by all institutions? The
Agencies' supervisory experience indicates that many large
institutions, for example, require additional scrutiny of significant
transactions, which helps to ensure that the potential risks posed by
large transactions are adequately considered before such transactions
are approved. Would $100 million be the appropriate level at which
additional approval procedures are required before a transaction is
approved, or would a lower threshold be appropriate if an absolute
dollar threshold were combined with the capital equivalent threshold?
2.29. Should the exposure test measure exposures or commitments
actually made, or should the authority to make an exposure or
commitment be sufficient to meet the test and why? For example, should
paragraph (1)(iii) of the definition of significant risk-taker read:
``A covered person of a covered institution who committed or exposed in
the aggregate during the previous calendar year 0.5 percent or more of
the common equity tier 1 capital, or in the case of a registered
securities broker or dealer, 0.5 percent or more of the tentative net
capital, of the covered institution or of any section 956 affiliate of
the covered institution, whether or not the individual is a covered
person of that specific legal entity''?
2.30. Would a dollar threshold test, as described above, achieve
the statutory objectives better than the relative compensation test?
Why or why not? If using a dollar threshold test, and assuming a
mechanism for inflation adjustment, would $1 million be the right
threshold or should it be higher or lower? For example, would a
threshold of $2 million dollars be more appropriate? Why or why not?
How should the threshold be adjusted for inflation? Are there other
adjustments that should be made to ensure the threshold remains
appropriate? What are the advantages and disadvantages of a dollar
threshold test compared to the proposed relative compensation test?
2.31. The Agencies specifically invite comment on replacement of
the relative compensation test in paragraphs (1)(i) and (ii) of the
definition of significant risk-taker with a dollar threshold test, as
follows: ``a covered person of a Level 1 or Level 2 covered institution
who receives annual base salary and incentive-based compensation of $1
million or more in the last calendar year that ended at least 180 days
before the beginning of the performance period.'' Under this
alternative, the remaining language in the definition of ``significant
risk-taker'' would be unchanged.
2.32. The Agencies invite comment on all aspects of a dollar
threshold test, including potential costs and benefits, the appropriate
amount, efficacy at identifying those non-senior executive officers who
have the ability to place the institution at risk, time frame needed to
identify significant risk-takers, and comparison to a relative
compensation test such as the one proposed. Is the last calendar year
that ended at least 180 days before the beginning of the performance
period an appropriate time frame or for the dollar threshold test or
would using compensation from the performance period that ended in the
most recent calendar year be appropriate? The Agencies specifically
invite comment on whether to use an exposure test if a dollar threshold
test replaces the relative compensation test and why.
2.33. The Agencies invite comment on all aspects of the definition
of ``significant risk-taker.'' The Agencies specifically invite comment
on whether the definition should rely solely on the relative
compensation test, solely on the exposure test, or on both tests, as
proposed. What are the advantages and disadvantages of each of these
options?
2.34. In addition to the tests outlined above, are there
alternative tests of, or proxies for, significant risk-taking that
would better achieve the statutory objectives? What are the advantages
and disadvantages of alternative approaches? What are the
implementation burdens of any of the approaches, and how could they be
addressed?
2.35. How many covered persons would likely be identified as
significant risk-takers under the proposed rule? How many covered
persons would likely be identified under only the relative compensation
test with the one-third threshold? How many covered persons would
likely be identified under only the exposure test as measured on an
annual basis with the one-third threshold? How many covered persons
would be identified under only an exposure test formulated on a per
transaction basis with the one-third threshold? How many covered
persons would be identified under only the dollar threshold test,
assuming the dollar threshold is $1 million, with the one-third
threshold? How many covered persons would be identified under each test
individually without a one-third threshold?
Other Definitions
To award. The proposed rule defines ``to award'' as to make a final
determination, conveyed to a covered person, of the amount of
incentive-based compensation payable to the covered person for
performance over a performance period.
The Agencies acknowledge that some covered institutions use the
term ``award'' to refer to the decisions that covered institutions make
about incentive-based compensation structures and performance measure
targets before or soon after the relevant performance period begins.
However, in the interest of clarity and consistency, the proposed rule
uses the phrase ``to award'' only with reference to final
determinations about incentive-based compensation amounts that an
institution makes and communicates to the covered person who could
receive the award under an incentive-based compensation arrangement for
a given performance period.
In most cases, incentive-based compensation will be awarded near
the end of the performance period. Neither the length of the
performance period nor the decision to defer some or all incentive-
based compensation would affect the determination of when incentive-
based compensation is awarded for purposes of the proposed rule. For
example, at the beginning of a one-year performance period, a covered
institution might inform a covered person of the amount of incentive-
based compensation that the covered person could earn at the end of the
performance period if certain measures and other criteria are met. The
covered institution might also inform the covered person that a portion
of the covered person's incentive-based compensation will be deferred
for a four-year period. The covered person's incentive-based
compensation for that performance period--including both the portion
that is deferred and the portion that vests immediately--would be
``awarded'' when the covered institution determines what amount of
incentive-based compensation the covered person has earned based on his
or her performance during the performance period.
For equity-like instruments, such as stock appreciation rights and
options, the date when incentive-based compensation is awarded may be
different than from the date when the instruments vest, are paid out,
or can be exercised. For example, a covered institution could determine
at the end of a performance period that a covered person has earned
options on the basis of performance during that performance

[[Page 37700]]

period, and the covered institution could provide that the covered
person cannot exercise the options for another five years. The options
would be considered to have been ``awarded'' at the end of the
performance period, even if they cannot be exercised for five years.
Under the proposed rule, covered institutions would have the
flexibility to decide how the determination of the amount of incentive-
based compensation would be conveyed to a covered person. For example,
some covered institutions may choose to inform covered persons of their
award amounts in writing or by electronic message. Others may choose to
allow managers to orally inform covered persons of their award amounts.
2.36. The Agencies invite comment on whether the proposed rule's
definition of ``to award'' should include language on when incentive-
based compensation is awarded for purposes of the proposed rule.
Specifically, the Agencies invite comment on whether the definition
should read: ``To award incentive-based compensation means to make a
final determination, conveyed to a covered person, at the end of the
performance period, of the amount of incentive-based compensation
payable to the covered person for performance over that performance
period.'' Why or why not?
Board of directors. The proposed rule defines ``board of
directors'' as the governing body of a covered institution that
oversees the activities of the covered institution, often referred to
as the board of directors or board of managers. Under the Board's
proposed rule, for a foreign banking organization, ``board of
directors'' would mean the relevant oversight body for the
institution's state insured or uninsured branch, agency, or operations,
consistent with the foreign banking organization's overall corporate
and management structure. Under the FDIC's proposed rule, for a state
insured branch of a foreign bank, ``board of directors'' would refer to
the relevant oversight body for the state insured branch consistent
with the foreign bank's overall corporate and management structure.
Under the OCC's proposed rule, for a Federal branch or agency of a
foreign bank, ``board of directors'' would refer to the relevant
oversight body for the Federal branch or agency, consistent with its
overall corporate and management structure. The OCC would work closely
with Federal branches and agencies to determine the appropriate person
or committee to undertake the responsibilities assigned to the
oversight body. NCUA's proposed rule defines ``board of directors'' as
the governing body of a credit union.
Clawback. The term ``clawback'' under the proposed rule refers
specifically to a mechanism that allows a covered institution to
recover from a senior executive officer or significant risk-taker
incentive-based compensation that has vested if the covered institution
determines that the senior executive officer or significant risk-taker
has engaged in fraud or the types of misconduct or intentional
misrepresentation described in section __.7(c) of the proposed rule.
Clawback would not apply to incentive-based compensation that has been
awarded but is not yet vested. As used in the proposed rule, the term
``clawback'' is distinct from the terms ``forfeiture'' and ``downward
adjustment,'' in that clawback provisions allow covered institutions to
recover incentive-based compensation that has already vested. In
contrast, forfeiture applies only after incentive-based compensation is
awarded but before it vests. Downward adjustment occurs only before
incentive-based compensation is awarded.
Compensation, fees, or benefits. The proposed rule defines
``compensation, fees, or benefits'' to mean all direct and indirect
payments, both cash and non-cash, awarded to, granted to, or earned by
or for the benefit of, any covered person in exchange for services
rendered to the covered institution. The form of payment would not
affect whether such payment meets the definition of ``compensation,
fees, or benefits.'' The term would include, among other things,
payments or benefits pursuant to an employment contract, compensation,
pension, or benefit agreements, fee arrangements, perquisites, options,
post-employment benefits, and other compensatory arrangements. The term
is defined broadly under the proposed rule in order to include all
forms of incentive-based compensation.
The term ``compensation, fees, or benefits'' would exclude
reimbursement for reasonable and proper costs incurred by covered
persons in carrying out the covered institution's business.
Control function. The proposed rule defines ``control function'' as
a compliance, risk management, internal audit, legal, human resources,
accounting, financial reporting, or finance role responsible for
identifying, measuring, monitoring, or controlling risk-taking.\102\
The term would include loan review and Bank Secrecy Act roles. Section
__.9(b) of the proposed rule would require a Level 1 or Level 2 covered
institution to provide individuals engaged in control functions with
the authority to influence the risk-taking of the business areas they
monitor and ensure that covered persons engaged in control functions
are compensated in accordance with the achievement of performance
objectives linked to their control functions and independent of the
performance of the business areas they monitor. As described below,
section __.11 of the proposed rule would also require that a Level 1 or
Level 2 covered institution's policies and procedures provide an
appropriate role for control function personnel in the covered
institution's incentive-based compensation program. The heads of
control functions would also be considered senior executive officers
for purposes of the proposed rule, because such employees can
individually affect the risk profile of a covered institution.
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\102\ The term ``control function'' would serve a different
purpose than, and is not intended to affect the interpretation of,
the term ``front line unit,'' as used in the OCC's Heightened
Standards.
---------------------------------------------------------------------------

Although covered persons in control functions generally do not
perform activities designed to generate revenue or reduce expenses,
they may nonetheless have the ability to expose covered institutions to
risk of material financial loss. For example, individuals in human
resources and risk management roles contribute to the design and review
of performance measures used in incentive-based compensation
arrangements, which may allow them to influence the activities of risk-
takers in a covered institution. For that reason, the proposed rule
would treat covered persons who are the heads of control functions as
senior executive officers who would be subject to certain additional
requirements under the proposed rule as described further below.
2.37. The Agencies invite comment on whether and in what
circumstances, the proposed definition of ``control function'' should
include additional individuals and organizational units that (a) do not
engage in activities designed to generate revenue or reduce expenses;
(b) provide operational support or servicing to any organizational unit
or function; or (c) provide technology services.
Deferral. The proposed rule defines ``deferral'' as the delay of
vesting of incentive-based compensation beyond the date on which the
incentive-based compensation is awarded. As discussed below in this
Supplementary Information section, under the proposed

[[Page 37701]]

rule, a Level 1 or Level 2 covered institution would be required to
defer a portion of the incentive-based compensation of senior executive
officers and significant risk-takers. The Agencies would not consider
compensation that has vested, but that the covered person then chooses
to defer, e.g., for tax reasons, to be deferred incentive-based
compensation for purposes of the proposed rule because it would not be
subject to forfeiture.
The Agencies note that the deferral period under the proposed rule
would not include any portion of the performance period, even for
incentive-based compensation plans that have longer performance
periods. Deferral involves a ``look-back'' period that is intended as a
stand-alone interval that follows the performance period and allows
time for ramifications (such as losses or other adverse consequences)
of, and other information about, risk-taking decisions made during the
performance period to become apparent.
If incentive-based compensation is paid in the form of options, the
period of time between when an option vests and when the option can be
exercised would not be considered deferral under the proposed rule. As
with other types of incentive-based compensation, an option would count
toward the deferral requirement only if it has been awarded but has not
yet vested, regardless of when the option could be exercised.\103\
---------------------------------------------------------------------------

\103\ Section __.7(a)(4)(ii) of the proposed rule limits the
portion of the proposed rule's minimum deferral requirements that
can be met in the form of options.
---------------------------------------------------------------------------

2.38. To the extent covered institutions are already deferring
incentive-based compensation, does the proposed definition of deferral
reflect current practice? If not, in what way does it differ?
Deferral period. The proposed rule defines ``deferral period'' as
the period of time between the date a performance period ends and the
last date on which the incentive-based compensation that is awarded for
such performance period vests. A deferral period and a performance
period that both relate to the same incentive-based compensation award
could not occur concurrently. Because sections__.7(a)(1)(iii) and
(a)(2)(iii) of the proposed rule would allow for pro rata vesting of
deferred amounts during a deferral period, some deferred incentive-
based compensation awarded for a performance period could vest before
the end of the deferral period following that performance period. As a
result, the deferral period would be considered to end on the date that
the last tranche of incentive-based compensation awarded for a
performance period vests.
Downward adjustment. The proposed rule defines ``downward
adjustment'' as a reduction of the amount of a covered person's
incentive-based compensation not yet awarded for any performance period
that has already begun, including amounts payable under long-term
incentive plans, in accordance with a forfeiture and downward
adjustment review under section __7(b) of the proposed rule. As
explained above, downward adjustment is distinct from clawback and
forfeiture because downward adjustment affects incentive-based
compensation that has not yet been awarded. It is also distinct from
performance-based adjustments that covered institutions might make in
determining the amount of incentive-based compensation to award to a
covered person, absent or separate from a forfeiture or downward
adjustment review. Depending on the results of a forfeiture and
downward adjustment review under section __.7(b) of the proposed rule,
a covered institution could adjust downward incentive-based
compensation that has not yet been awarded to a senior executive
officer or significant risk-taker such that the senior executive
officer or significant risk-taker is awarded none, or only some, of the
incentive-based compensation that could otherwise have been awarded to
such senior executive officer or significant risk-taker.
Equity-like instrument. The proposed rule defines ``equity-like
instrument'' as (1) equity in the covered institution or of any
affiliate of the covered institution; or (2) a form of compensation (i)
payable at least in part based on the price of the shares or other
equity instruments of the covered institution or of any affiliate of
the covered institution; or (ii) that requires, or may require,
settlement in the shares of the covered institution or any affiliate of
the covered institution. The value of an equity-like instrument would
be related to the value of the covered institution's shares.\104\ The
definition includes three categories. Shares are an example of the
first category, ``equity.'' Examples of the second category, ``a form
of compensation payable at least in part based on the price of the
shares or other equity instruments of the covered institution or any
affiliate of the covered institution,'' include restricted stock units
(RSUs), stock appreciation rights, and other derivative instruments
that settle in cash. Examples of the third category, ``a form of
compensation that requires, or may require, settlement in the shares of
the covered institution or of any affiliate of the covered
institution,'' include options and derivative securities that settle,
either mandatorily or permissively, in shares. An RSU that offers a
choice of settlement in either cash or shares is also an example of
this third category. The definition of equity-like instrument would
include shares in the holding company of a covered institution, or
instruments the value of which is dependent on the value of shares in
the holding company of a covered institution. For example, the
definition would include incentive-based compensation paid in the form
of shares in a bank holding company, even if that incentive-based
compensation were provided by a national bank subsidiary of that bank
holding company. Covered institutions would determine the specific
terms and conditions of the equity-like instruments they award to
covered persons.
---------------------------------------------------------------------------

\104\ The definition of ``equity-like instrument'' in the
proposed rule is similar to ``share-based payment'' in Topic 718 of
the Financial Accounting Standards Board (FASB) Accounting Standards
Codification (formerly FAS 123(R)). Paragraph 718-10-30-20, FASB
Accounting Standards Codification.
---------------------------------------------------------------------------

NCUA's proposed rule does not include the definition of ``equity-
like instrument'' because credit unions do not have these types of
instruments.
2.39. Are there any financial instruments that are used for
incentive-based compensation and have a value that is dependent on the
performance of a covered institution's shares, but are not captured by
the definition of ``equity-like instrument''? If so, what are they, and
should such instruments be added to the definition? Why or why not?
Forfeiture. The proposed rule defines ``forfeiture'' as a reduction
of the amount of deferred incentive-based compensation awarded to a
covered person that has not vested.\105\

[[Page 37702]]

Depending on the results of a forfeiture and downward adjustment review
under section __.7(b) of the proposed rule, a covered institution could
reduce a significant risk-taker or senior executive officer's unvested
incentive-based compensation such that none, or only some, of the
deferred incentive-based compensation vests. As discussed below in this
Supplementary Information section, a Level 1 or Level 2 covered
institution would be required to place at risk of forfeiture all
unvested deferred incentive-based compensation, including amounts that
have been awarded and deferred under long-term incentive plans.
---------------------------------------------------------------------------

\105\ Forfeiture is similar to the concept of ``malus'' common
at some covered institutions. Malus is defined in the CEBS
Guidelines as ``an arrangement that permits the institution to
prevent vesting of all or part of the amount of a deferred
remuneration award in relation to risk outcomes or performance.''
See CEBS Guidelines. The 2011 Proposed Rule did not define the term
``forfeiture,'' but the concept was implicit in the discussion of
adjustments during the deferral period. See 76 FR at 21179,
``Deferred payouts may be altered according to risk outcomes either
formulaically or based on managerial judgment, though extensive use
of judgment might make it more difficult to execute deferral
arrangements in a sufficiently predictable fashion to influence the
risk-taking behavior of a covered person. To be most effective in
ensuring balance, the deferral period should be sufficiently long to
allow for the realization of a substantial portion of the risks from
the covered person's activities, and the measures of loss should be
clearly explained to covered persons and closely tied to their
activities during the relevant performance period.''
---------------------------------------------------------------------------

Incentive-based compensation. The proposed rule defines
``incentive-based compensation'' as any variable compensation, fees, or
benefits that serve as an incentive or reward for performance. The
Agencies propose a broad definition to provide flexibility as forms of
compensation evolve. Compensation earned under an incentive plan,
annual bonuses, and discretionary awards are all examples of
compensation that could be incentive-based compensation. The form of
payment, whether cash, an equity-like instrument, or any other thing of
value, would not affect whether compensation, fees, or benefits meet
the definition of ``incentive-based compensation.''
In response to a similar definition in the 2011 Proposed Rule,
commenters asked for clarification about the components of incentive-
based compensation. The proposed definition clarifies that
compensation, fees, and benefits that are paid for reasons other than
to induce performance would not be included. For example, compensation,
fees, or benefits that are awarded solely for, and the payment of which
is solely tied to, continued employment (e.g., salary or a retention
award that is conditioned solely on continued employment) would not be
considered incentive-based compensation. Likewise, payments to new
employees at the time of hiring (signing or hiring bonuses) that are
not conditioned on performance achievement would not be considered
incentive-based compensation because they generally are paid to induce
a prospective employee to join the institution, not to influence future
performance of such employee.
Similarly, a compensation arrangement that provides payments solely
for achieving or maintaining a professional certification or higher
level of educational achievement would not be considered incentive-
based compensation under the proposed rule. In addition, the Agencies
do not intend for this definition to include compensation arrangements
that are determined based solely on the covered person's level of fixed
compensation and that do not vary based on one or more performance
measures (e.g., employer contributions to a 401(k) retirement savings
plan computed based on a fixed percentage of an employee's salary).
Neither would the proposed definition include dividends paid and
appreciation realized on stock or other equity-like instruments that
are owned outright by a covered person. However, stock or other equity-
like instruments awarded to a covered person under a contract,
arrangement, plan, or benefit would not be considered owned outright
while subject to any vesting or deferral arrangement (regardless of
whether such deferral is mandatory).
2.40. The Agencies invite comment on the proposed definition of
incentive-based compensation. Should the definition be modified to
include additional or fewer forms of compensation and in what way? Is
the definition sufficiently broad to capture all forms of incentive-
based compensation currently used by covered institutions? Why or why
not? If not, what forms of incentive-based compensation should be
included in the definition?
2.41. The Agencies do not expect that most pensions would meet the
proposed rule's definition of ``incentive-based compensation'' because
pensions generally are not conditioned on performance achievement.
However, it may be possible to design a pension that would meet the
proposed rule's definition of ``incentive-based compensation.'' The
Agencies invite comment on whether the proposed rule should contain
express provisions addressing the status of pensions in relation to the
definition of ``incentive-based compensation.'' Why or why not?
Incentive-based compensation arrangement, incentive-based
compensation plan, and incentive-based compensation program. The
proposed rule defines three separate, but related, terms describing how
covered institutions provide incentive-based compensation.\106\ Under
the proposed rule, ``incentive-based compensation arrangement'' would
mean an agreement between a covered institution and a covered person,
under which the covered institution provides incentive-based
compensation to the covered person, including incentive-based
compensation delivered through one or more incentive-based compensation
plans. An individual employment agreement would be an incentive-based
compensation arrangement.
---------------------------------------------------------------------------

\106\ The use of these terms under the proposed rule is
consistent with how the same terms are used in the 2010 Federal
Banking Agency Guidance.
---------------------------------------------------------------------------

``Incentive-based compensation plan'' is defined as a document
setting forth terms and conditions governing the opportunity for and
the delivery of incentive-based compensation payments to one or more
covered persons. An incentive-based compensation plan may cover, among
other things, specific roles or job functions, categories of
individuals, or forms of payment. A covered person may be compensated
under more than one incentive-based compensation plan.
``Incentive-based compensation program'' means a covered
institution's framework for incentive-based compensation that governs
incentive-based compensation practices and establishes related
controls. A covered institution's incentive-based compensation program
would include all of the covered institution's incentive-based
compensation arrangements and incentive-based compensation plans.
Long-term incentive plan. The proposed rule defines ``long-term
incentive plan'' as a plan to provide incentive-based compensation that
is based on a performance period of at least three years. Any
incentive-based compensation awarded to a covered person for a
performance period of less than three years would not be awarded under
a long-term incentive plan, but instead would be considered
``qualifying incentive-based compensation'' as that term is defined
under the proposed rule.\107\
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\107\ In the 2011 Proposed Rule, the Agencies did not define the
term ``long-term incentive plan,'' but the 2011 Proposed Rule
discussed ``longer performance periods'' as one of four methods used
to make compensation more sensitive to risk. 76 FR at 21179 (``Under
this method of making incentive-based compensation risk sensitive,
the time period covered by the performance measures used in
determining a covered person's award is extended (for example, from
one year to two years). Longer performance periods and deferral of
payment are related in that both methods allow awards or payments to
be made after some or all risk outcomes associated with a covered
person's activities are realized or better known.'').
---------------------------------------------------------------------------

Long-term incentive plans are forward-looking plans designed to
reward employees for performance over a multi-year period. These plans
generally provide an award of cash or equity at the end of a
performance period if the employee meets certain individual or
institution-wide performance measures. Because they have longer
performance periods, long-term incentive plans allow more time

[[Page 37703]]

for information about a covered person's performance and risk-taking to
become apparent, and covered institutions can take that information
into account to balance risk and reward. Under current practice, the
performance period for a long-term incentive plan is typically three
years.\108\
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\108\ See Compensation Advisory Partners, ``Large Complex
Banking Organizations: Trends, Practices, and Outlook'' (June 2012),
available at https://www.capartners.com/uploads/news/id90/capartners.com-capflash-issue31.pdf; Pearl Meyer & Partners,
``Trends in Incentive Compensation: How the Federal Reserve is
Influencing Pay'' (2013), available at https://pearlmeyer.com/pearl/media/pearlmeyer/articles/pmp-art-fedreserveinfluencingpay-so-bankdirector-5-14-2013.pdf; Meridian Compensation Partners, LLC,
``Executive Compensation in the Banking Industry: Emerging Trends
and Best Practices, 2014-2015'' (June 22, 2015), available at
https://www.meridiancp.com/wp-content/uploads/Executive-Compensation-in-the-Banking-Industry.pdf; Compensation Advisory
Partners, ``Influence of Federal Reserve on Compensation Design in
Financial Services: An Analysis of Compensation Disclosures of 23
Large Banking Organizations'' (April 24, 2013), available at https://www.capartners.com/uploads/news/id135/capartners.com-capflash-issue45.pdf; ``The 2014 Top 250 Report: Long-term Incentive Grant
Practices for Executives'' (``Cook Report'') (October 2014),
available at https://www.fwcook.com/alert_letters/The_2014_Top_250_Report_Long-Term_Incentive_Grant_Practices_for_Executives.pdf; ``Study of 2013
Short- and Long-term Incentive Design Criterion Among Top 200 S&P
500 Companies'' (December 2014), available at https://www.ajg.com/media/1420659/study-of-2013-short-and-long-term-incentive-design-criterion-among-top-200.pdf.
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2.42. The Agencies invite comment on whether the proposed
definition of ``long-term incentive plan'' is appropriate for purposes
of the proposed rule. Are there incentive-based compensation
arrangements commonly used by financial institutions that would not be
included within the definition of ``long-term incentive plan'' under
the proposed rule but that, given the scope and purposes of section
956, should be included in such definition? If so, what are the
features of such incentive-based compensation arrangements, why should
the definition include such arrangements, and how should the definition
be modified to include such arrangements?
Option. The proposed rule defines an ``option'' as an instrument
through which a covered institution provides a covered person with the
right, but not the obligation, to buy a specified number of shares
representing an ownership stake in a company at a predetermined price
within a set time period or on a date certain, or any similar
instrument, such as a stock appreciation right. Typically, covered
persons must wait for a specified time period to conclude before
obtaining the right to exercise an option.\109\ The definition of
option would also include option-like instruments that mirror some or
all of the features of an option. For example, the proposed rule would
include stock appreciation rights under the definition of option
because the value of a stock appreciation right is based on a stock's
price on a future date. As mentioned above, an option would be
considered an equity-like instrument, as that term is defined in the
proposed rule. NCUA's proposed rule does not include a definition of
``option'' because credit unions do not issue options.
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\109\ As explained above in the definition of ``deferral,'' the
time period after the option vests but before it may be exercised is
not considered part of the deferral period.
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Performance period. The proposed rule defines ``performance
period'' as the period during which the performance of a covered person
is assessed for purposes of determining incentive-based compensation.
The Agencies intend for the proposed rule to provide covered
institutions with flexibility in determining the length and the start
and end dates of their employees' performance periods. For example,
under the proposed rule, a covered institution could choose to have a
performance period that coincided with a calendar year or with the
covered institution's fiscal year (if the calendar year and fiscal year
were different). A covered institution could also choose to have a
performance period of one year for some incentive-based compensation
and a performance period of three years for other incentive-based
compensation.
2.43. Does the proposed rule's definition of ``performance period''
meet the goal of providing covered institutions with flexibility in
determining the length and start and end dates of performance periods?
Why or why not? Would a prescribed performance period, for example,
periods that correspond to calendar years, be preferable? Why or why
not?
Qualifying incentive-based compensation. The proposed rule defines
``qualifying incentive-based compensation'' as the amount of incentive-
based compensation awarded to a covered person for a particular
performance period, excluding amounts awarded to such covered person
for that particular performance period under a long-term incentive
plan. With the exception of long-term incentive plans, all forms of
compensation, fees, and benefits that qualify as ``incentive-based
compensation,'' including annual bonuses, would be included in the
amount of qualifying incentive-based compensation. The deferral
requirements of section __.7(a) of the proposed rule would require a
Level 1 or Level 2 covered institution to defer a specified percentage
of any qualifying incentive-based compensation awarded to a significant
risk-taker or senior executive officer for each performance period.
Regulatory report. Each Agency has included a definition of
``regulatory report'' in its version of the proposed rule that explains
which regulatory reports would be required to be used by each of that
Agency's covered institutions for the purposes of measuring average
total consolidated assets under the proposed rule.
For a national bank, state member bank, state nonmember bank,
federal savings association, and state savings association,
``regulatory report'' would mean the consolidated Reports of Condition
and Income (``Call Report'').\110\ For a U.S. branch or agency of a
foreign bank, ``regulatory report'' would mean the Reports of Assets
and Liabilities of U.S. Branches and Agencies of Foreign Banks--FFIEC
002. For a bank holding company, ``regulatory report'' would mean
Consolidated Financial Statements for Bank Holding Companies (``FR Y-
9C''). For a savings and loan holding company, ``regulatory report''
would mean FR Y-9C; if a savings and loan holding company is not
required to file an FR Y-9C, Quarterly Savings and Loan Holding Company
Report (``FR 2320''), if the savings and loan holding company reports
consolidated assets on the FR 2320. For a savings and loan holding
company that does not file a regulatory report within the meaning of
the preceding sentence, ``regulatory report'' would mean a report of
average total consolidated assets filed with the Board on a quarterly
basis. For an Edge or Agreement Corporation, ``regulatory report''
would mean the Consolidated Report of Condition and Income for Edge and
Agreement Corporations (``FR 2886b''). For the U.S. operations of a
foreign banking organization, ``regulatory report'' would mean a report
of average total consolidated U.S. assets filed with the Board on a
quarterly basis. For subsidiaries of national banks, Federal savings
associations, and Federal branches or agencies of foreign banking
organizations that are not brokers, dealers, persons providing
insurance, investment companies, or investment advisers, ``regulatory
report'' would mean a report of the subsidiary's total consolidated
assets prepared by the subsidiary, national bank, Federal

[[Page 37704]]

savings association, or Federal branch or agency in a form that is
acceptable to the OCC. For a regulated institution that is a subsidiary
of a bank holding company, savings and loan holding company, or a
foreign banking organization, ``regulatory report'' would mean a report
of the subsidiary's total consolidated assets prepared by the bank
holding company, savings and loan holding company, or subsidiary in a
form that is acceptable to the Board.
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\110\ Specifically, the OCC will refer to item RCFD 2170 of
Schedule RC.
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For FHFA's proposed rule, ``regulatory report'' would mean the Call
Report Statement of Condition.
For a natural person credit union, ``regulatory report'' would mean
the 5300 Call Report. For corporate credit unions, ``regulatory
report'' would mean the 5310 Call Report.
For a broker or dealer registered under section 15 of the
Securities Exchange Act of 1934 (15 U.S.C. 78o), ``regulatory report''
would mean the FOCUS Report.\111\ For an investment adviser, as such
term is defined in section 202(a)(11) of the Investment Advisers Act,
and as discussed above, total consolidated assets would be determined
by the investment adviser's total assets (exclusive of non-proprietary
assets) shown on the balance sheet for the adviser's most recent fiscal
year end.\112\
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\111\ 17 CFR 240.17a-5(a); 17 CFR 249.617.
\112\ The proposed rule would not apply the concept of a
regulatory report and the attendant mechanics provided in section
__.3 of the proposed rule to covered institutions that are
investment advisers because such institutions are not currently
required to report the amount of total consolidated assets to any
Federal regulators in their capacities as investment advisers. See
proposed definition of ``average total consolidated assets'' for the
proposed method by which an investment adviser would determine its
asset level for purposes of the proposed rule.
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Vesting. Under the proposed rule, ``vesting'' of incentive-based
compensation means the transfer of ownership \113\ of the incentive-
based compensation to the covered person to whom the incentive-based
compensation was awarded, such that the covered person's right to the
incentive-based compensation is no longer contingent on the occurrence
of any event. Amounts awarded under an incentive-based compensation
arrangement may vest immediately--for example, when the amounts are
paid out to a covered person immediately and are not subject to
deferral and forfeiture. As explained above, before amounts awarded to
a covered person vest, the amounts could also be deferred and at risk
of forfeiture. After amounts awarded to a covered person vest, the
amounts could be subject to clawback, but they would not be at risk of
forfeiture.
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\113\ Compensation awarded to a trust or other entity at the
direction of, or for the benefit of, a covered person would be
treated as compensation awarded to that covered person. If
incentive-based compensation awarded to the entity cannot be reduced
by forfeiture, the amounts would be treated as having vested at the
time of the award.
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As described below in this SUPPLEMENTARY INFORMATION section, for
incentive-based compensation to be counted toward the minimum deferral
amount as discussed in section __.7(a) of the proposed rule, a
sufficient amount of time must elapse between the end of the
performance period and the time when the deferred incentive-based
compensation vests (and is no longer subject to forfeiture). During
that deferral period, the award would be at risk of forfeiture.
If, after the award date, the covered institution had the right to
require forfeiture of the shares or units awarded, then the award would
not be considered vested. If, after the award date, the covered
institution does not have the right to require forfeiture of the shares
or units awarded, then the award would be vested and therefore would
not be able to be counted toward the minimum deferral amount even if
the shares or units have not yet been transferred to the covered
person. For example, a covered institution could award an employee 100
shares of stock appreciation rights that pay out five years after the
award date. In other words, five years after the award date, the
covered institution will pay the employee the difference between the
value of 100 shares of the covered institution's stock on the award
date and the value of 100 shares of the covered institution's stock
five years later. The amount the covered institution pays the employee
could vary based on the value of the institution's shares. If the
covered institution does not have the right to adjust the number of
shares of stock appreciation rights before the payout, the stock
appreciation rights would be considered vested as of the award date
(even if the amount paid out could vary based on the value of the
institution's shares). If, however, the covered institution has the
right to adjust the number of shares of stock appreciation rights until
payout to account for risk outcomes that occur after the award date
(for example, by reducing the number of shares of stock appreciation
rights from 100 to 50 based on a failure to comply with the
institution's risk management policies), the stock appreciation rights
would not be considered vested until payout. Similarly, amounts paid to
a covered person pursuant to a dividend equivalent right would vest
when the number of dividend equivalent rights cannot be adjusted by the
covered institution on the basis of risk outcomes.
2.44. The Agencies invite comment generally on the proposed rule's
definitions.
Relationship Between Defined Terms
The relationship between some of these defined terms can best be
explained chronologically. Under the proposed rule, a covered
institution's incentive-based compensation timeline would be as
follows:
Performance period. A covered person may have incentive-
based compensation targets based on performance measures that would
apply during a performance period. A covered person's performance or
the performance of the covered institution during this period would
influence the amount of incentive-based compensation awarded to the
covered person. Before incentive-based compensation is awarded to a
covered person, it should be subject to risk adjustments to reflect
actual losses, inappropriate risks taken, compliance deficiencies, or
other measures or aspects of financial and non-financial performance,
as described in section __.4(d) of the proposed rule. In addition, at
any time during the performance period, incentive-based compensation
could be subject to downward adjustment, as described in section
__.7(b) of the proposed rule.
Downward adjustment (if needed). Downward adjustment could
occur at any time during a performance period if a Level 1 or Level 2
covered institution conducts a forfeiture and downward adjustment
review under section __.7(b) of the proposed rule and the Level 1 or
Level 2 covered institution determines that incentive-based
compensation not yet awarded for the current performance period should
be reduced. In other words, downward adjustment applies to plans where
the performance period has not yet ended.
Award. At or near the end of a performance period, a
covered institution would evaluate the covered person's or
institution's performance, taking into account adjustments described in
section __.4(d)(3) of the proposed rule, and determine the amount of
incentive-based compensation, if any, to be awarded to the covered
person for that performance period. At that time, the covered
institution would determine what portion of the incentive-based
compensation that is awarded will be deferred, as well as the vesting
schedule for that deferred incentive-based compensation. A Level 1 or
Level 2

[[Page 37705]]

covered institution could reduce the amount of incentive-based
compensation payable to a senior executive officer or significant risk-
taker depending on the outcome of a forfeiture and downward adjustment
review, as described in section __.7(b) of the proposed rule.
Deferral period. The deferral period for incentive-based
compensation awarded for a particular performance period would begin at
the end of such performance period, regardless of when a covered
institution awards incentive-based compensation to a covered person for
that performance period. At any time during a deferral period, a
covered institution could require forfeiture of some or all of the
incentive-based compensation that has been awarded to the covered
person but has not yet vested.
Forfeiture (if needed). Forfeiture could occur at any time
during the deferral period (after incentive-based compensation has been
awarded but before it vests). A Level 1 or Level 2 covered institution
could require forfeiture of unvested deferred incentive-based
compensation payable to a senior executive officer or significant risk-
taker based on the result of a forfeiture and downward adjustment
review, as described in section __.7(b) of the proposed rule. Depending
on the outcome of a forfeiture and downward adjustment review under
section __.7(b) of the proposed rule, a covered institution could
reduce, or eliminate, the unvested deferred incentive-based
compensation of a senior executive officer or significant risk-taker.
Vesting. Vesting could occur annually, on a pro rata
basis, throughout a deferral period. Vesting could also occur at a
slower than pro rata schedule, such as entirely at the end of a
deferral period (vesting entirely at the end of a deferral period is
sometimes called ``cliff vesting''). The deferral period for a
particular performance period would end when all incentive-based
compensation awarded for that performance period has vested. A covered
institution may also evaluate information that has arisen over the
deferral period about financial losses, inappropriate risks taken,
compliance deficiencies, or other measures or aspects of financial and
non-financial performance of the covered person at the time of vesting
to determine if the amount that has been deferred should vest in full
or should be reduced through forfeiture.
Clawback (if needed). Clawback could be used to recover
incentive-based compensation that has already vested. Clawback could be
used after a deferral period has ended, and it also could be used to
recover any portion of incentive-based compensation that vests before
the end of a deferral period. A Level 1 or Level 2 covered institution
would be required to include clawback provisions in incentive-based
compensation arrangements for senior executive officers and significant
risk-takers, as described in section __.7(c) of the proposed rule.
2.45. Is the interplay of the award date, vesting date, performance
period, and deferral period clear? If not, why not?
2.46. Have the Agencies made clear the distinction between the
proposed definitions of clawback, forfeiture, and downward adjustment?
Do these definitions align with current industry practice? If not, in
what way do they differ and what are the implications of such
differences for both the operations of covered institutions and the
effective supervision of compensation practices?

Sec. __.3 Applicability

Section __.3 describes which provisions of the proposed rule would
apply to an institution that is subject to the proposed rule when an
increase or decrease in average total consolidated assets causes it to
become a covered institution, transition to another level, or no longer
meet the definition of covered institution. This process may differ
somewhat depending on whether the institution is a subsidiary of, or
affiliated with, another covered institution.
As discussed above, for an institution that is not an investment
adviser, average total consolidated assets would be determined by
reference to the average of the total consolidated assets reported on
regulatory reports for the four most recent consecutive quarters. The
Agencies are proposing this calculation method because it is also used
to calculate total consolidated assets for purposes of other rules that
have $50 billion thresholds,\114\ and it is therefore expected to
result in lower administrative burden on some institutions--
particularly when those institutions move from Level 3 to Level 2--if
the proposed rule requires total consolidated assets to be calculated
in the same way as existing rules.
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\114\ See, e.g., OCC's Heightened Standards; 12 CFR 46.3; 12 CFR
225.8; 12 CFR 243.2; 12 CFR 252.30; 2 CFR 252.132; 12 CFR 325.202;
12 CFR 381.2.
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As discussed above, average total consolidated assets for a covered
institution that is an investment adviser would be determined by the
investment adviser's total assets (exclusive of non-proprietary assets)
shown on the balance sheet for the adviser's most recent fiscal year
end. The proposed rule would not apply the concept of a regulatory
report and the attendant mechanics provided in section __.3 of the
proposed rule to covered institutions that are investment advisers
because such institutions are not currently required to report the
amount of total consolidated assets to any Federal regulators in their
capacities as investment advisers.
(a) When Average Total Consolidated Assets Increase
Section __.3(a) of the proposed rule describes how the proposed
rule would apply to institutions that are subject to the proposed rule
when average total consolidated assets increase. It generally provides
that an institution that is not a subsidiary of another covered
institution becomes a Level 1, Level 2, or Level 3 covered institution
when its average total consolidated assets increase to an amount that
equals or exceeds $250 billion, $50 billion, or $1 billion,
respectively. For subsidiaries of other covered institutions, the
Agencies would generally look to the average total consolidated assets
of the top-tier parent holding company to determine whether average
total consolidated assets have increased.
Given the unique characteristics of the different types of covered
institutions subject to each Agency's proposed rule, each Agency's
proposed rule contains specific language for subsidiaries that is
consistent with the same general approach. For example, under the
Board's proposed rule, a regulated institution would become a Level 1,
Level 2, or Level 3 covered institution when its average total
consolidated assets or the average total consolidated assets of any of
its affiliates, equals or exceeds $250 billion, $50 billion, or $1
billion, respectively. Under the OCC's proposed rule, a national bank
that is a subsidiary of a bank holding company would become a Level 1,
Level 2, or Level 3 covered institution when the top-tier bank holding
company's average total consolidated assets equals or exceeds $250
billion, $50 billion, or $1 billion, respectively. Because the Federal
Home Loan Banks have no subsidiaries, and subsidiaries of the
Enterprises are included as affiliates as part of the definition of the
Enterprises, FHFA's proposed rule does not include specific language to
address subsidiaries. Because the NCUA's rule does not cover
subsidiaries of credit unions and credit unions are not subsidiaries of
other types of institutions, NCUA's proposed

[[Page 37706]]

rule does not include specific language to address subsidiaries. More
detail on each Agency's proposed approach to subsidiaries is provided
in the above discussion of definitions relating to covered
institutions.
For covered institutions other than investment advisers and the
Federal Home Loan Banks, using a rolling average for asset size, rather
than measuring asset size at a single point in time, should minimize
the frequency with which an institution may fall into or out of a
covered institution level. As explained above, if a covered institution
has fewer than four regulatory reports, the institution would be
required to use the average of its total consolidated assets from its
existing regulatory reports for purposes of determining average total
consolidated assets. If a covered institution has a mix of two or more
different types of regulatory reports covering the relevant period,
those would be averaged for purposes of determining average total
consolidated assets.
Section __.3(a)(2) of the proposed rule provides a transition
period for institutions that were not previously considered covered
institutions and for covered institutions moving from a lower level to
a higher level due to an increase in average total consolidated assets.
Such covered institutions would be required to comply with the
requirements for their new level not later than the first day of the
first calendar quarter that begins at least 540 days after the date on
which they become Level 1, Level 2, or Level 3 covered institutions.
Prior to such date, the institutions would be required to comply with
the requirements of the proposed rule, if any, that were applicable to
them on the day before they became Level 1, Level 2, or Level 3 covered
institutions as a result of the increase in assets. For example, if a
Level 3 covered institution that is not a subsidiary of a depository
institution holding company has average total consolidated assets that
increase to more than $50 billion on December 31, 2015, then such
institution would become a Level 2 covered institution on December 31,
2015. However, the institution would not be required to comply with the
requirements of the proposed rule that are applicable to a Level 2
covered institution until July 1, 2017. Prior to July 1, 2017, (the
compliance date), the institution would remain subject to the
requirements of the proposed rule that are applicable to a Level 3
covered institution. The covered institution's controls, risk
management, and corporate governance also would be required to comply
with the provisions of the proposed rule that are applicable to a Level
2 covered institution no later than July 1, 2017. The Agencies are
proposing this delay between the date when a covered institution's
average total consolidated assets increase and the date when the
covered institution becomes subject to the requirements related to its
new level to provide covered institutions with sufficient time to
comply with the new requirements.
The same general rule would apply to covered institutions that are
subsidiaries (or, in the case of the Board's proposed rule, affiliates)
of other covered institutions. For example, a Level 3 state savings
association that is a subsidiary of a Level 3 savings and loan holding
company, and a Level 3 subsidiary of that state savings association,
would become a Level 2 covered institution on December 31, 2015, if the
average total consolidated assets of the savings and loan holding
company increased to more than $50 billion on December 31, 2015, and
would not be required to comply with the requirements of the proposed
rule that are applicable to a Level 2 covered institution until July 1,
2017.
Section __.3(a)(3) of the proposed rule provides that incentive-
based compensation plans with performance periods that begin before the
compliance date described in section __.3(a)(2) would not be required
to comply with the requirements of the proposed rule that become
applicable to the covered institution on the compliance date as a
result of the change in its status as a Level 1, Level 2, or Level 3
covered institution. Incentive-based compensation plans with a
performance period that begins on or after the compliance date
described in section __.3(a)(2) would be required to comply with the
rules for the covered institution's new level. In the example described
in the previous paragraph, any incentive-based compensation plan with a
performance period that begins before July 1, 2017, would not be
required to comply with the requirements of the proposed rule that are
applicable to a Level 2 covered institution (although any such plan
would be required to comply with the requirements of the proposed rule
that are applicable to a Level 3 covered institution).
The Agencies have included this grandfathering provision so that
covered institutions would not be required to modify incentive-based
compensation plans that are already in place when a covered
institution's average total consolidated assets increase such that it
moves to a higher level. However, incentive-based compensation plans
with performance periods that begin after the compliance date would be
subject to the rules that apply to the covered institution's new level.
In the previous example, any incentive-based compensation plan for a
senior executive officer with a performance period that begins on or
after July 1, 2017, would be required to comply with the requirements
of the proposed rule that are applicable to a Level 2 covered
institution, such as the deferral, forfeiture, downward adjustment, and
clawback requirements contained in section __.7 of the proposed rule.
Because institutions that would be covered institutions under the
proposed rule commonly use long-term incentive plans with overlapping
performance periods or incentive-based compensation plans with
performance periods of one year, the Agencies do not anticipate that
the grandfathering provision would unduly delay the application of the
proposed rule to individual incentive-based compensation arrangements.
3.1. The Agencies invite comment on whether a covered institution's
average total consolidated assets (a rolling average) is appropriate
for determining a covered institution's level when its total
consolidated assets increase. Why or why not? Will 540 days provide
covered institutions with adequate time to adjust incentive-based
compensation programs to comply with different requirements? If not,
why not? In the alternative, is 540 days too long to give covered
institutions time to comply with the requirements of the proposed rule?
Why or why not?
3.2. The Agencies invite comment on whether the date described in
section __.3(a)(2) should instead be the beginning of the first
performance period that begins at least 365 days after the date on
which the regulated institution becomes a Level 1, Level 2, or Level 3
covered institution in order to have the date on which the proposed
rule's corporate governance, policies, and procedures requirements
begin coincide with the date on which the requirements applicable to
plans begin. Why or why not?
(b) When Total Consolidated Assets Decrease
Section __.3(b) of the proposed rule describes how the proposed
rule would apply to an institution when assets decrease. A covered
institution (other than an investment adviser) that is not a subsidiary
of another covered institution would cease to be a Level 1, Level 2, or
Level 3 covered institution

[[Page 37707]]

if its total consolidated assets, as reported on its regulatory
reports, fell below the relevant total consolidated assets threshold
for Level 1, Level 2, or Level 3 covered institutions, respectively,
for four consecutive quarters. The calculation would be effective on
the as-of date of the fourth consecutive regulatory report. For
example, a bank holding company that is a Level 2 covered institution
with total consolidated assets of $55 billion on January 1, 2016, might
report total consolidated assets of $48 billion for the first quarter
of 2016, $49 billion for the second quarter of 2016, $49 billion for
the third quarter of 2016, and $48 billion for the fourth quarter of
2016. On the as-of date of the Y-9C submitted for the fourth quarter of
2016, that bank holding company would become a Level 3 covered
institution because its total consolidated assets were less than $50
billion for four consecutive quarters. In contrast, if that same bank
holding company reported total consolidated assets of $48 billion for
the first quarter of 2016, $49 billion for the second quarter of 2016,
$49 billion for the third quarter of 2016, and $51 billion for the
fourth quarter of 2016, it would still be considered a Level 2 covered
institution on the as-of date of the Y-9C submitted for the fourth
quarter of 2016 because it had total consolidated assets of less than
$50 billion for only 3 consecutive quarters. If the bank holding
company had total consolidated assets of $49 billion in the first
quarter of 2017, it still would not become a Level 3 covered
institution at that time because it would not have four consecutive
quarters of total consolidated assets of less than $50 billion. The
bank holding company would only become a Level 3 covered institution if
it had four consecutive quarters with total consolidated assets of less
than $50 billion after the fourth quarter of 2016.
As with section __.3(a), a Level 1, Level 2, or Level 3 covered
institution that is a subsidiary of another Level 1, Level 2, or Level
3 covered institution would cease to be a Level 1, Level 2, or Level 3
covered institution when the top-tier parent covered institution ceases
to be a Level 1, Level 2, or Level 3 covered institution. As with
section __.3(a), each Agency's proposed rule takes a slightly different
approach that is consistent with the same general principle. For
example, if a broker-dealer with less than $50 billion in average total
consolidated assets is a Level 2 covered institution because its parent
bank holding company has more than $50 billion in average total
consolidated assets, the broker-dealer would become a Level 3 covered
institution if its parent bank holding company had less than $50
billion in total consolidated assets for four consecutive quarters,
thus causing the parent bank holding company itself to become a Level 3
covered institution.
The proposed rule would not require any transition period when a
decrease in a covered institution's total consolidated assets causes it
to become a Level 2 or Level 3 covered institution or to no longer be a
covered institution. The Agencies are not proposing to include a
transition period in this case because the new requirements would be
less stringent than the requirements that were applicable to the
covered institution before its total consolidated assets decreased, and
therefore a transition period should be unnecessary. Instead, the
covered institution would immediately be subject to the provisions of
the proposed rule, if any, that are applicable to it as a result of the
decrease in its total consolidated assets. For example, if as a result
of having four consecutive regulatory reports with total consolidated
assets less than $50 billion, a bank holding company that was
previously a Level 2 covered institution becomes a Level 3 covered
institution as of June 30, 2017, then as of June 30, 2017 that bank
holding company would no longer be subject to the requirements of the
proposed rule that are applicable to Level 2 covered institutions. It
would instead be subject to the requirements of the proposed rule that
are applicable to Level 3 covered institutions.
A covered institution that is an investment adviser would cease to
be a Level 1, Level 2, or Level 3 covered institution effective as of
the most recent fiscal year end in which its total consolidated assets
fell below the relevant asset threshold for Level 1, Level 2, or Level
3 covered institutions, respectively. For example, an investment
adviser that is a Level 1 covered institution during 2015 would cease
to be a Level 1 covered institution effective on December 31, 2015 if
its total assets (exclusive of non-proprietary assets) shown on its
balance sheet for the year ended December 31, 2015 (assuming the
investment adviser had a calendar fiscal year) were less than $250
billion.
3.3. The Agencies invite comment on whether four consecutive
quarters is an appropriate period for determining a covered
institution's level when its total consolidated assets decrease. Why or
why not?
3.4. Should the determination of total consolidated assets for
covered institutions that are investment advisers be by reference to a
periodic report or similar concept? Why or why not? Should there be a
concept of a rolling average for asset size for covered institutions
that are investment advisers and, if so, how should this be structured?
3.5. Should the transition period for an institution that changes
levels or becomes a covered institution due to a merger or acquisition
be different than an institution that changes levels or becomes a
covered institution without a change in corporate structure? If so,
why? If so, what transition period would be appropriate and why?
3.6. The Agencies invite comment on whether covered institutions
transitioning from Level 1 to Level 2 or Level 2 to Level 3 should be
permitted to modify incentive-based compensation plans with performance
periods that began prior to their transition in level in such a way
that would cause the plans not to meet the requirements of the proposed
rule that were applicable to the covered institution at the time when
the performance periods for the plans commenced. Why or why not?
(c) Compliance of Covered Institutions That Are Subsidiaries of Covered
Institutions
Section __.3(c) of the Board's, OCC's, or FDIC's proposed rules
provide that a covered institution that is subject to the Board's,
OCC's, or FDIC's proposed rule, respectively, and that is a subsidiary
of another covered institution may meet any requirement of the proposed
rule if the parent covered institution complies with such requirement
in a way that causes the relevant portion of the incentive-based
compensation program of the subsidiary covered institution to comply
with the requirement. The Board, the OCC, and the FDIC have included
this provision in their proposed rules in order to reduce the
compliance burden on subsidiaries that would be subject to the Board's,
OCC's, and FDIC's proposed rules and in recognition of the fact that
holding companies, national banks, Federal savings associations, state
nonmember banks, and state savings associations may perform certain
functions on behalf of such subsidiaries.
Subsidiary covered institutions subject to the Board's, OCC's, or
FDIC's proposed rule could rely on this provision to comply with, for
example, the corporate governance or policies and procedures
requirements of the proposed rule. For example, if a parent bank
holding company has a compensation committee that performs the
requirements of section __.4(e) of

[[Page 37708]]

the proposed rule with respect to a subsidiary of the parent bank
holding company that is a covered institution under the Board's rule by
(1) conducting oversight of the subsidiary's incentive-based
compensation program, (2) approving incentive-based compensation
arrangements for senior executive officers of the subsidiary (including
any individuals who are senior executive officers of the subsidiary but
not senior executive officers of the parent bank holding company), and
(3) approving any material exceptions or adjustments to incentive-based
compensation policies or arrangements for such senior executive
officers of the subsidiary, then the subsidiary would be deemed to have
complied with the requirements of section __.4(e) of the proposed rule.
Similarly, under the OCC's proposed rule, if an operating subsidiary of
a national bank that is a Level 1 or Level 2 covered institution
subject to the OCC's proposed rule uses the policies and procedures for
its incentive-based compensation program of its parent national bank
that is also a Level 1 or Level 2 covered institution subject to the
OCC's proposed rule, and such policies and procedures satisfy the
requirements of section __.11 of the proposed rule, then the OCC would
consider the subsidiary to have satisfied section __.11 of the proposed
rule. Under the FDIC's proposed rule, if a subsidiary of a state
nonmember bank or state savings association that is a covered
institution subject to the FDIC's proposed rule uses the policies and
procedures for its incentive-based compensation program of its parent
state nonmember bank or state savings association that is a Level 1 or
Level 2 covered institution subject to the FDIC's proposed rule, and
such policies and procedures satisfy the requirements of section __.11
of the proposed rule, then the FDIC would consider the subsidiary to
have satisfied section __.11 of the proposed rule.
Many parent holding companies, particularly larger banking
organizations, design and administer incentive-based compensation
programs and associated policies and procedures. Smaller covered
institutions that operate within a larger holding company structure may
realize efficiencies by incorporating or relying upon their parent
company's incentive-based compensation program or certain components of
the program, to the extent that the program or its components establish
governance, risk management, and recordkeeping frameworks that are
appropriate to the smaller covered institutions and support incentive-
based compensation arrangements that appropriately balance risks to the
smaller covered institution and rewards for its covered persons.
Therefore, it may be less burdensome for covered institution
subsidiaries with risk profiles that are similar to those of their
parent holding companies to use their parent holding companies' program
rather than their own.
The Agencies recognize that the authority of each appropriate
Federal regulator to examine and review compliance with the proposed
rule, along with requiring corrective action when they deem
appropriate, would not be affected by section __.3(c) of the Board's,
OCC's, or FDIC's proposed rule. Each appropriate Federal regulator
would be responsible for examining, reviewing, and enforcing compliance
with the proposed rule by their covered institutions, including any
that are owned or controlled by a depository institution holding
company. For example, in the situation where a parent holding company
controls a subsidiary national bank, state nonmember bank, or broker-
dealer, it would be expected that the board of directors of the
subsidiary will ensure that the subsidiary is in compliance with the
proposed rule. Likewise, the board of directors of a broker-dealer
operating subsidiary of a national bank would be expected to ensure
that the broker-dealer operating subsidiary is in compliance with the
proposed rule.

Sec. __.4 Requirements and Prohibitions Applicable to All Covered
Institutions

Section __.4 sets forth the general requirements that would be
applicable to all covered institutions. Later sections establish more
specific requirements that would be applicable for Level 1 and Level 2
covered institutions.
Under the proposed rule, all covered institutions would be
prohibited from establishing or maintaining incentive-based
compensation arrangements, or any features of any such arrangements,
that encourage inappropriate risks by the covered institution (1) by
providing covered persons with excessive compensation, fees, or
benefits or (2) that could lead to material financial loss to the
covered institution. Section __.4 includes considerations for
determining whether an incentive-based compensation arrangement
provides excessive compensation, fees, or benefits, as required by
section 956(a)(1). Section __.4 also establishes requirements that
would apply to all covered institutions designed to prevent
inappropriate risks that could lead to material financial loss, as
required by section 956(a)(2).\115\ The general standards and
requirements set forth in sections __.4(a), (b), and (c) of the
proposed rule would be consistent with the general standards and
requirements set forth in sections __.5(a) and (b) of the 2011 Proposed
Rule.
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\115\ In addition to the requirements outlined in section __.4,
Level 1 and Level 2 covered institutions would have to meet
additional requirements set forth in section __.5 and sections __.7
through __.11.
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The Agencies do not intend to establish a rigid, one-size-fits-all
approach to the design of incentive-based compensation arrangements.
Thus, under the proposed rule, the structure of incentive-based
compensation arrangements at covered institutions would be expected to
reflect the proposed requirements set forth in section __.4 of the
proposed rule in a manner tailored to the size, complexity, risk
tolerance, and business model of the covered institution. Subject to
supervisory oversight, as applicable, each covered institution would be
responsible for ensuring that its incentive-based compensation
arrangements appropriately balance risk and reward. The methods by
which this is achieved at one covered institution may not be effective
at another, in part because of the importance of integrating incentive-
based compensation arrangements and practices into the covered
institution's own risk-management systems and business model. The
effectiveness of methods may differ across business lines and operating
units as well, so the proposed rule would provide for considerable
flexibility in how individual covered institutions approach the design
and implementation of incentive-based compensation arrangements that
appropriately balance risk and reward.
(a) In General
Section __.4(a) of the proposed rule is derived from the text of
section 956(b) which requires the Agencies to jointly prescribe
regulations or guidelines that prohibit any type of incentive-based
payment arrangement, or any feature of any such arrangement, that the
Agencies determine encourages inappropriate risks by covered
institutions (1) by providing an executive officer, employee, director,
or principal shareholder of the covered institution with excessive
compensation, fees, or benefits or (2) that could lead to material
financial loss to the covered institution.
(b) Excessive Compensation
Section __.4(b) of the proposed rule specifies that compensation,
fees, and

[[Page 37709]]

benefits would be considered excessive for purposes of section
__.4(a)(1) when amounts paid are unreasonable or disproportionate to
the value of the services performed by a covered person, taking into
account all relevant factors. Section 956(c) directs the Agencies to
``ensure that any standards for compensation established under
subsections (a) or (b) are comparable to the standards established
under section [39] of the Federal Deposit Insurance Act (12 U.S.C. 2
[sic] 1831p-1) for insured depository institutions.'' Under the
proposed rule, the factors for determining whether an incentive-based
compensation arrangement provides excessive compensation would be
comparable to the Federal Banking Agency Safety and Soundness
Guidelines that implement the requirements of section 39 of the
FDIA.\116\ The proposed factors would include: (1) The combined value
of all compensation, fees, or benefits provided to the covered person;
(2) the compensation history of the covered person and other
individuals with comparable expertise at the covered institution; (3)
the financial condition of the covered institution; (4) compensation
practices at comparable covered institutions, based upon such factors
as asset size, geographic location, and the complexity of the covered
institution's operations and assets; (5) for post-employment benefits,
the projected total cost and benefit to the covered institution; and
(6) any connection between the covered person and any fraudulent act or
omission, breach of trust or fiduciary duty, or insider abuse with
regard to the covered institution. The inclusion of these factors is
consistent with the requirement under section 956(c) that any standards
for compensation under section 956(a) or (b) must be comparable to the
standards established for insured depository institutions under the
FDIA and that the Agencies must take into consideration the
compensation standards described in section 39(c) of the FDIA.
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\116\ The Federal Banking Agency Safety and Soundness Guidelines
provide: Compensation shall be considered excessive when amounts
paid are unreasonable or disproportionate to the services performed
by an executive officer, employee, director, or principal
shareholder, considering the following: (1) The combined value of
all cash and non-cash benefits provided to the individual; (2) The
compensation history of the individual and other individuals with
comparable expertise at the institution; (3) The financial condition
of the institution; (4) Comparable compensation practices at
comparable institutions, based upon such factors as asset size,
geographic location, and the complexity of the loan portfolio or
other assets; (5) For postemployment benefits, the projected total
cost and benefit to the institution; (6) Any connection between the
individual and any fraudulent act or omission, breach of trust or
fiduciary duty, or insider abuse with regard to the institution; and
(7) Any other factors the Agencies determines to be relevant. See 12
CFR part 30, Appendix A, III.A; 12 CFR part 364, Appendix A, III.A;
12 CFR part 208, Appendix D-1. These factors are drawn directly from
section 39(c)(2) of the FDIA (12 U.S.C. 1831p-1(c)(2)).
---------------------------------------------------------------------------

In response to similar language in the 2011 Proposed Rule, some
commenters indicated that this list of factors should include
additional factors or allow covered institutions to consider other
factors that they deem appropriate. The proposed rule clarifies that
all relevant factors would be taken into consideration, and that the
list of factors in section __.4(b) would not be exclusive.
Commenters on the 2011 Proposed Rule expressed concern that it
would be difficult for some types of institutions, such as
grandfathered unitary savings and loan holding companies with retail
operations, mutual savings associations, mutual savings banks, and
mutual holding companies, to identify comparable covered institutions.
Those commenters also expressed concern that it would be difficult for
these institutions to identify the compensation practices of comparable
institutions that are not public companies or that do not otherwise
make public information about their compensation practices. The
Agencies intend to work closely with these institutions to identify
comparable institutions to help ensure compliance with the proposed
rule.
(c) Material Financial Loss
Section 956(b)(2) of the Act requires the Agencies to adopt
regulations or guidelines that prohibit any type of incentive-based
payment arrangement, or any feature of any such arrangement, that the
Agencies determine encourages inappropriate risks by a covered
financial institution that could lead to material financial loss to the
covered institution. In adopting such regulations or guidelines, the
Agencies are required to ensure that any standards established under
this provision of section 956 are comparable to the standards under
Section 39 of the FDIA, including the compensation standards. However,
section 39 of the FDIA does not include standards for determining
whether compensation arrangements may encourage inappropriate risks
that could lead to material financial loss.\117\ Accordingly, as in the
2011 Proposed Rule, the Agencies have considered the language and
purpose of section 956, existing supervisory guidance that addresses
incentive-based compensation arrangements that may encourage
inappropriate risk-taking,\118\ the FSB Principles and Implementation
Standards, and other relevant material in considering how to implement
this aspect of section 956.
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\117\ Section 39 of the FDIA requires only that the Federal
banking agencies prohibit as an unsafe and unsound practice any
employment contract, compensation or benefit agreement, fee
arrangement, perquisite, stock option plan, postemployment benefit,
or other compensatory arrangement that could lead to a material
financial loss. See 12 U.S.C. 1831p-1(c)(1)(B). The Federal Banking
Agency Safety and Soundness Guidelines satisfy this requirement.
\118\ 2010 Federal Banking Agency Guidance.
---------------------------------------------------------------------------

A commenter argued that the provisions of the 2011 Proposed Rule
relating to incentive-based compensation arrangements that could
encourage inappropriate risks that could lead to material financial
loss were not comparable to the standards established under section 39
of the FDIA. More specifically, the commenter believed that the
requirements of the 2011 Proposed Rule, including the mandatory
deferral requirement, were more ``detailed and prescriptive'' than the
standards established under section 39 of the FDIA.
The Agencies intend that the requirements of the proposed rule
implementing section 956(b)(2) of the Act would be comparable to the
standards established under section 39 of the FDIA. Section 956(b)(2)
of the Act requires that the Agencies prohibit incentive-based
compensation arrangements that encourage inappropriate risks by covered
institutions that could lead to material financial loss, a requirement
that is not discussed in the standards established under section 39 of
the FDIA, which, as discussed above, provide guidelines to determine
when compensation paid to a particular executive officer, employee,
director or principal shareholder would be excessive. In enacting
section 956, Congress referred specifically to the standards
established under section 39 of the FDIA, and was presumably aware that
in the statute there were no such standards articulated that provide
guidance for determining whether compensation arrangements could lead
to a material financial loss. The provisions of the proposed rule
implementing section 956(b)(2) reflect the Agencies' intent to comply
with the statutory mandate under section 956, while ensuring that the
proposed rule is comparable to section 39 of the FDIA, which states
that compensatory arrangements that could lead to a material financial
loss are an unsafe and unsound practice.

[[Page 37710]]

Section __.4(c) of the proposed rule sets forth minimum
requirements for incentive-based compensation arrangements that would
be permissible under the proposed rule, because arrangements without
these attributes could encourage inappropriate risks that could lead to
material financial loss to a covered institution. These requirements
reflect the three principles for sound incentive-based compensation
policies contained in the 2010 Federal Banking Agency Guidance: (1)
Balanced risk-taking incentives; (2) compatibility with effective risk
management and controls; and (3) effective corporate governance.\119\
Similarly, section __.4(c) of the proposed rule provides that an
incentive-based compensation arrangement at a covered institution could
encourage inappropriate risks that could lead to material financial
loss to the covered institution, unless the arrangement: (1)
Appropriately balances risk and reward; (2) is compatible with
effective risk management and controls; and (3) is supported by
effective governance.
---------------------------------------------------------------------------

\119\ See 75 FR 36407-36413.
---------------------------------------------------------------------------

An example of a feature that could encourage inappropriate risks
that could lead to material financial loss would be the use of
performance measures that are closely tied to short-term revenue or
profit of business generated by a covered person, without any
adjustments for the longer-term risks associated with the business
generated. Similarly, if there is no mechanism for factoring risk
outcomes over a longer period of time into compensation decisions,
traders who have incentive-based compensation plans with performance
periods that end at the end of the calendar year, could have an
incentive to take large risks towards the end of the calendar year to
either make up for underperformance earlier in the performance period
or to maximize their year-end profits. The same result could ensue if
the performance measures themselves are poorly designed or can be
manipulated inappropriately by the covered persons receiving incentive-
based compensation.
Incentive-based compensation arrangements typically attempt to
encourage actions that result in greater revenue or profit for a
covered institution. However, short-run revenue or profit can often
diverge sharply from actual long-run profit because risk outcomes may
become clear only over time. Activities that carry higher risk
typically have the potential to yield higher short-term revenue, and a
covered person who is given incentives to increase short-term revenue
or profit, without regard to risk, would likely be attracted to
opportunities to expose the covered institution to more risk that could
lead to material financial loss.
Section __.4(c)(1) of the proposed rule would require all covered
institutions to ensure that incentive-based compensation arrangements
appropriately balance risk and reward. Incentive-based compensation
arrangements achieve balance between risk and financial reward when the
amount of incentive-based compensation ultimately received by a covered
person depends not only on the covered person's performance, but also
on the risks taken in achieving this performance. Conversely, an
incentive-based compensation arrangement that provides financial reward
to a covered person without regard to the amount and type of risk
produced by the covered person's activities would not be considered to
appropriately balance risk and reward under the proposed rule.\120\
Incentive-based compensation arrangements should balance risk and
financial rewards in a manner that does not encourage covered persons
to expose a covered institution to inappropriate risk that could lead
to material financial loss.
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\120\ For example, a covered person who makes a high-risk loan
may generate more revenue in the short run than one who makes a low-
risk loan. Incentive-based compensation arrangements that reward
covered persons solely on the basis of short-term revenue might pay
more to the covered person taking more risk, thereby incentivizing
employees to take more, and sometimes inappropriate, risk. See 2011
FRB Report at 11.
---------------------------------------------------------------------------

The incentives provided by an arrangement depend on how all
features of the arrangement work together. For instance, how
performance measures are combined, whether they take into account both
current and future risks, which criteria govern the use of risk
adjustment before the awarding and vesting of incentive-based
compensation, and what form incentive-based compensation takes (i.e.,
equity-based vehicles or cash-based vehicles) can all affect risk-
taking incentives and generally should be considered when covered
institutions create such arrangements.
The 2010 Federal Banking Agency Guidance outlined four methods that
can be used to make compensation more sensitive to risk--risk
adjustments of awards, deferral of payment, longer performance periods,
and reduced sensitivity to short-term performance.\121\ Consistent with
the 2010 Federal Banking Agency Guidance, under the proposed rule, an
incentive-based compensation arrangement generally would have to take
account of the full range of current and potential risks that a covered
person's activities could pose for a covered institution. Relevant
risks would vary based on the type of covered institution, but could
include credit, market (including interest rate and price), liquidity,
operational, legal, strategic, and compliance risks. Performance and
risk measures generally should align with the broader risk management
objectives of the covered institution and could be incorporated through
use of a formula or through the exercise of judgment. Performance and
risk measures also may play a role in setting amounts of incentive-
based compensation pools (bonus pools), in allocating pools to
individuals' incentive-based compensation, or both. The effectiveness
of different types of adjustments varies with the situation of the
covered person and the covered institution, as well as the thoroughness
with which the measures are implemented.
---------------------------------------------------------------------------

\121\ See 2010 Federal Banking Agency Guidance, 75 FR at 36396.
---------------------------------------------------------------------------

The analysis and methods for ensuring that incentive-based
compensation arrangements appropriately balance risk and reward should
also be tailored to the size, complexity, business strategy, and risk
tolerance of each institution. The manner in which a covered
institution seeks to balance risk and reward in incentive-based
compensation arrangements should account for the differences between
covered persons--including the differences between senior executive
officers and significant risk-takers and other covered persons.
Activities and risks may vary significantly both among covered
institutions and among covered persons within a particular covered
institution. For example, activities, risks, and incentive-based
compensation practices may differ materially among covered institutions
based on, among other things, the scope or complexity of activities
conducted and the business strategies pursued by the institutions.
These differences mean that methods for achieving incentive-based
compensation arrangements that appropriately balance risk and reward at
one institution may not be effective in restraining incentives to
engage in imprudent risk-taking at another institution.
The proposed rule would require that incentive-based compensation
arrangements contain certain features. Section __.4(d) sets out
specific requirements that would be applicable to arrangements for all
covered persons at all covered institutions and that are intended to
result in incentive-based compensation arrangements that

[[Page 37711]]

appropriately balance risk and reward. Sections __.7 and __.8 of the
proposed rule provide more specific requirements that would be
applicable to arrangements at Level 1 and Level 2 covered institutions.
While the proposed rule would require incentive-based compensation
arrangements for senior executive officers and significant risk-takers
at Level 1 and Level 2 covered institutions to have certain features
(such as a certain percentage of the award deferred), those features
alone would not be sufficient to balance risk-taking incentives with
reward. The extent to which additional balancing methods are required
would vary with the size and complexity of a covered institution and
with the nature of a covered person's activities.
Section __.4(c)(2) of the proposed rule provides that an incentive-
based compensation arrangement at a covered institution would encourage
inappropriate risks that could lead to material financial loss to the
covered institution unless the arrangement is compatible with effective
risk management and controls. A covered institution's risk management
processes and internal controls would have to reinforce and support the
development and maintenance of incentive-based compensation
arrangements that appropriately balance risk and reward required under
section __.4(c)(1) of the proposed rule.
One of the reasons risk management is important is that covered
persons may seek to evade the processes established by a covered
institution to achieve incentive-based compensation arrangements that
appropriately balance risk and reward in an effort to increase their
own incentive-based compensation. For example, a covered person might
seek to influence the risk measures or other information or judgments
that are used to make the covered person's incentive-based compensation
sensitive to risk. Such actions may significantly weaken the
effectiveness of a covered institution's incentive-based compensation
arrangements in restricting inappropriate risk-taking and could have a
particularly damaging effect if they result in the manipulation of
measures of risk, information, or judgments that the covered
institution uses for other risk-management, internal control, or
financial purposes. In such cases, the covered person's actions may
weaken not only the balance of the covered institution's incentive-
based compensation arrangements but also the risk-management, internal
controls, and other functions that are supposed to act as a separate
check on risk-taking.
All covered institutions would have to have appropriate controls
surrounding the design, implementation, and monitoring of incentive-
based compensation arrangements to ensure that processes for achieving
incentive-based compensation arrangements that appropriately balance
risk and reward are followed, and to maintain the integrity of their
risk-management and other control functions. The nature of controls
likely would vary by size and complexity of the covered institution as
well as the activities of the covered person. For example, under the
proposed rule, controls surrounding incentive-based compensation
arrangements at smaller covered institutions likely would be less
extensive and less formalized than at larger covered institutions.
Level 1 and Level 2 covered institutions would be more likely to have a
systematic approach to designing and implementing their incentive-based
compensation arrangements, and their incentive-based compensation
programs would more likely be supported by formalized and well-
developed policies, procedures, and systems. Level 3 covered
institutions, on the other hand, might maintain less extensive and
detailed incentive-based compensation programs. Section __.9 of the
proposed rule provides additional, specific requirements that would be
applicable to Level 1 and Level 2 covered institutions designed to
result in incentive-based compensation arrangements at Level 1 and
Level 2 covered institutions that are compatible with effective risk
management and controls.
Incentive-based compensation arrangements also would have to be
supported by an effective governance framework. Section __.4(e) sets
forth more detail on requirements for boards of directors of all
covered institutions that would be designed to result in incentive-
based compensation arrangements that are supported by effective
governance, while section __.10 of the proposed rule provides more
specific requirements that would be applicable to Level 1 and Level 2
covered institutions.
The proposed requirement for effective governance is an important
foundation of incentive-based compensation arrangements that
appropriately balance risk and reward. The involvement of the board of
directors in oversight of the covered institution's overall incentive-
based compensation program should be scaled appropriately to the scope
of the covered institution's incentive-based compensation arrangements
and the number of covered persons who have incentive-based compensation
arrangements.
(d) Performance Measures
The performance measures used in an incentive-based compensation
arrangement have an important effect on the incentives provided to
covered persons and thus affect the potential for the incentive-based
compensation arrangement to encourage inappropriate risk-taking that
could lead to material financial loss. Under section __.4(d) of the
proposed rule, an incentive-based compensation arrangement would not be
considered to appropriately balance risk and reward unless: (1) It
includes financial and non-financial measures of performance that are
relevant to a covered person's role and to the type of business in
which the covered person is engaged and that are appropriately weighted
to reflect risk-taking; (2) it is designed to allow non-financial
measures of performance to override financial measures when
appropriate; and (3) any amounts to be awarded under the arrangement
are subject to adjustment to reflect actual losses, inappropriate risks
taken, compliance deficiencies, or other measures or aspects of
financial and non-financial performance. Each of these requirements is
described more fully below.
First, the arrangements would be required to include both financial
and non-financial measures of performance. Financial measures of
performance generally are measures tied to the attainment of strategic
financial objectives of the covered institution, or one of its
operating units, or to the contributions by covered persons towards
attainment of such objectives, such as measures related to corporate
sales, profit, or revenue targets. Non-financial measures of
performance, on the other hand, could be assessments of a covered
person's risk-taking or compliance with limits on risk-taking. These
may include assessments of compliance with the covered institution's
policies and procedures, adherence to the covered institution's risk
framework and conduct standards, or compliance with applicable laws.
These financial and non-financial measures of performance should
include considerations of risk-taking, and be relevant to a covered
person's role within the covered institution and to the type of
business in which the covered person is engaged. They also should be
appropriately weighted to

[[Page 37712]]

reflect the nature of such risk-taking. The requirement to include both
financial and non-financial measures of performance would apply to
forms of incentive-based compensation that set out performance measure
goals and related amounts near the beginning of a performance period
(such as long-term incentive plans) and to forms that do not
necessarily specify performance measure goals and related amounts in
advance of performance (such as certain bonuses). For example, a senior
executive officer may have his or her performance evaluated based upon
quantitative financial measures, such as return on equity, and on
qualitative, non-financial measures, such as the extent to which the
senior executive officer promoted sound risk management practices or
provided strategic leadership through a difficult merger. The senior
executive officer's performance also may be evaluated on several
qualitative non-financial measures that in some instances span multiple
calendar and performance years.
Incentive-based compensation should support prudent risk-taking,
but should also allow covered institutions to hold covered persons
accountable for inappropriate behavior. Reliable quantitative measures
of risk and risk outcomes, where available, may be particularly useful
in both developing incentive-based compensation arrangements that
appropriately balance risk and reward and assessing the extent to which
incentive-based compensation arrangements properly balance risk and
reward. However, reliable quantitative measures may not be available
for all types of risk or for all activities, and in many cases may not
be sufficient to fully assess the risks that the activities of covered
persons may pose to covered institutions. Poor performance, as assessed
by non-financial measures such as quality of risk management, could
pose significant risks for the covered institution and may itself be a
source of potential material financial loss at a covered institution.
For this reason, non-financial performance measures play an important
role in reinforcing expectations on appropriate risk, control, and
compliance standards and should form a significant part of the
performance assessment process.
Under certain circumstances, it may be appropriate for non-
financial performance measures, which are the primary measures that
relate to risk-taking behavior, to override considerations of financial
performance measures. An override might be appropriate when, for
example, a covered person conducts trades or other transactions that
increase the covered institution's profit but that create an
inappropriate compliance risk for the covered institution. In such a
case, an incentive-based compensation arrangement should allow for the
possibility that the non-financial measure of compliance risk could
override the financial measure of profit when the amount of incentive-
based compensation to be awarded to the covered person is determined.
The effective balance of risks and rewards may involve the use of
both formulaic arrangements and discretion. At most covered
institutions, management retains a significant amount of discretion
when awarding incentive-based compensation. Although the use of
discretion has the ability to reinforce risk balancing, when improperly
utilized, discretionary decisions can undermine the goal of incentive-
based compensation arrangements to appropriately balance risk and
reward. For example, an incentive-based compensation arrangement that
has a longer performance period that could allow risk events to
manifest and for awards to be adjusted to reflect risk could be less
effective if management makes a discretionary award decision that does
not account for, or mitigates, the future impact of those risk
events.\122\
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\122\ For Level 1 and Level 2 covered institutions, section
__.11 of the proposed rule would require policies and procedures
that address the institution's use of discretion.
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Section __.4(d)(3) of the proposed rule would also require that any
amounts to be awarded under an incentive-based compensation arrangement
be subject to adjustment to reflect actual losses, inappropriate risks
taken, compliance deficiencies, or other measures or aspects of
financial and non-financial performance. It is important that
incentive-based compensation arrangements be balanced in design and
implemented so that awards and actual amounts that vest actually vary
based on risks or risk outcomes. If, for example, covered persons are
awarded or paid substantially all of their potential incentive-based
compensation even when they cause a covered institution to take a risk
that is inappropriate given the institution's size, nature of
operations, or risk profile, or cause the covered institution to fail
to comply with legal or regulatory obligations, then covered persons
will have less incentive to avoid activities with substantial risk of
financial loss or non-compliance with legal or regulatory obligations.
(e) Board of Directors
Under section __.4(e) of the proposed rule, the board of directors,
or a committee thereof, would be required to: (1) Conduct oversight of
the covered institution's incentive-based compensation program; (2)
approve incentive-based compensation arrangements for senior executive
officers, including the amounts of all awards and, at the time of
vesting, payouts under such arrangements; and (3) approve any material
exceptions or adjustments to incentive-based compensation policies or
arrangements for senior executive officers.
Section __.4(e)(1) of the proposed rule would require the board of
directors, or a committee thereof, of a covered institution to conduct
oversight of the covered institution's incentive-based compensation
program. Such oversight generally should include overall goals and
purposes. For example, boards of directors, or a committee thereof, of
covered institutions generally should oversee senior management in the
development of an incentive-based compensation program that
incentivizes behaviors consistent with the long-term health of the
covered institution, and provide sufficient detail to enable senior
management to translate the incentive-based compensation program into
objectives, plans, and arrangements for each line of business and
control function. Such oversight also generally should include holding
senior management accountable for effectively executing the covered
institution's incentive-based compensation program and for
communicating expectations regarding acceptable behaviors and business
practices to covered persons. Boards of directors should actively
engage with senior management, including challenging senior
management's incentive-based compensation assessments and
recommendations when warranted.
In addition to the general program oversight requirement set forth
in section __.4(e)(1) of the proposed rule, a board of directors, or a
committee thereof, would also be required by sections __.4(e)(2) and
__.4(e)(3) to approve incentive-based compensation arrangements for
senior executive officers, including the amounts of all awards and
payouts, at the time of vesting, under such arrangements, and to
approve any material exceptions or adjustments to those arrangements.
Although risk-adjusting incentive-based compensation for senior
executive officers responsible for the covered institution's overall
risk posture and

[[Page 37713]]

performance may be challenging given that quantitative measures of
institution-wide risk are difficult to produce and allocating
responsibility among the senior executive team for achieving risk
objectives can be a complex task, the role of senior executive officers
in managing the overall risk-taking activities of an institution is
important. Accordingly the proposed rule would require the board of
directors, or a committee thereof, to approve compensation arrangements
involving senior executive officers. When a board of directors, or a
committee thereof, is considering an award or a payout, it should
consider risks to ensure that the award or payout is consistent with
broader risk management and strategic objectives.
(f) Disclosure and Recordkeeping Requirements and (g) Rule of
Construction
Section __.4(f) of the proposed rule would establish disclosure and
recordkeeping requirements for all covered institutions, as required by
section 956(a)(1).\123\ Under the proposed rule, each covered
institution would be required to create and maintain records that
document the structure of all of the institution's incentive-based
compensation arrangements and demonstrate compliance with the proposed
rule, and to disclose these records to the appropriate Federal
regulator upon request. The proposed rule would require covered
institutions to create such records on an annual basis and to maintain
such records for at least seven years after they are created. The
Agencies recognize that the exact timing for recordkeeping will vary
from institution to institution, but this requirement would ensure that
covered institutions create such records for their incentive-based
compensation arrangements at least once every 12 months. The
requirement to maintain records for at least seven years generally
aligns with the clawback period described in section __.7(c) of the
proposed rule.
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\123\ 12 U.S.C. 5641(a)(1).
---------------------------------------------------------------------------

The proposed rule would require that the records maintained by a
covered institution, at a minimum, include copies of all incentive-
based compensation plans, a list of who is subject to each plan, and a
description of how the covered institution's incentive-based
compensation program is compatible with effective risk management and
controls. These records would be the minimum required information to
determine whether the structure of the covered institution's incentive-
based compensation arrangements provide covered persons with excessive
compensation or could lead to material financial loss to the covered
institution. As specified in section 956(a)(2) and section __.4(g) of
the proposed rule, a covered institution would not be required to
report the actual amount of compensation, fees, or benefits of
individual covered persons as part of this requirement.\124\
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\124\ The Agencies note that covered institutions may be
required to report actual compensation under other provisions of
law. For example, corporate credit unions must disclose compensation
of certain executive officers to their natural person credit union
members under NCUA's corporate credit union rule. 12 CFR 704.19. The
proposed rule would not affect the requirements in 12 CFR 704.19 or
in any other reporting provision under any other law or regulation.
The SEC requires an issuer that is subject to the requirements
of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15
U.S.C. 78m or 78o(d)) to disclose information regarding the
compensation of its principal executive officer, principal financial
officer, and three other most highly compensated executive officers,
as well as its directors, in the issuer's proxy statement, its
annual report on Form 10-K, and registration statements for
offerings of securities. The requirements are generally found in
Item 402 of Regulation S-K (17 CFR 229.402).
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The 2011 Proposed Rule would have implemented section 956(a)(1) by
requiring all covered financial institutions to submit an annual report
to their appropriate Federal regulator, in a format specified by their
appropriate Federal regulator, that described in narrative form the
structure of the covered financial institution's incentive-based
compensation arrangements for covered persons and the policies
governing such arrangements.\125\ Some commenters on the 2011 Proposed
Rule favored annual reporting requirements, while other commenters
opposed any requirement for institutions to make periodic submissions
of information about incentive-based compensation arrangements to
regulators, noting concerns about burden, particularly for smaller
covered financial institutions. A few commenters requested an annual
certification requirement instead of a reporting requirement. While
there is value in receiving reports, the burden of producing them would
potentially be great on smaller covered institutions. Accordingly, the
Agencies determined not to include a requirement for covered
institutions to submit annual narrative reports.
---------------------------------------------------------------------------

\125\ See 2011 Proposed Rule, at 21177. The 2011 Proposed Rule
also would have set forth additional more detailed requirements for
covered financial institutions with total consolidated assets of $50
billion or more.
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Given the variety of covered institutions and asset sizes, the
Agencies are not proposing a specific format or template for the
records that must be maintained by all covered institutions. According
to the Agencies' supervisory experience, as discussed further above,
many covered institutions already maintain information about their
incentive-based compensation programs comparable to the types of
information described above (e.g., in support of public company
filings).
Several commenters on the 2011 Proposed Rule expressed concern
regarding the confidentiality of the reported compensation information.
In light of the nature of the information that would be provided to the
Agencies under section __.4(f) of the proposed rule, and the purposes
for which the Agencies are requiring the information, the Agencies
would view the information disclosed to the Agencies as nonpublic and
expect to maintain the confidentiality of that information, to the
extent permitted by law.\126\ When providing information to one of the
Agencies pursuant to the proposed rule, covered institutions should
request confidential treatment by that Agency.
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\126\ For example, Exemption 4 of the Freedom of Information Act
(``FOIA'') provides an exemption for ``trade secrets and commercial
or financial information obtained from a person and privileged or
confidential.'' 5 U.S.C. 552(b)(4). FOIA Exemption 6 provides an
exemption for information about individuals in ``personnel and
medical files and similar files'' when the disclosure of such
information ``would constitute a clearly unwarranted invasion of
personal privacy.'' 5 U.S.C. 552(b)(6). FOIA Exemption 8 provides an
exemption for matters that are ``contained in or related to
examination, operating, or condition reports prepared by, on behalf
of, or for the use of an agency responsible for the regulation or
supervision of financial institutions.'' 5 U.S.C. 552(b)(8).
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4.1. The Agencies invite comment on the requirements for
performance measures contained in section __.4(d) of the proposed rule.
Are these measures sufficiently tailored to allow for incentive-based
compensation arrangements to appropriately balance risk and reward? If
not, why?
4.2. The Agencies invite comment on whether the terms ``financial
measures of performance'' and ``non-financial measures of performance''
should be defined. If so, what should be included in the defined terms?
4.3. Would preparation of annual records be appropriate or should
another method be used? Would covered institutions find a more specific
list of topics and quantitative information for the content of required
records helpful? Should covered institutions be required to maintain an
inventory of all such records and to maintain such records in a
particular format? If so, why? How would such specific requirements
increase or decrease burden?

[[Page 37714]]

4.4. Should covered institutions only be required to create new
records when incentive-based compensation arrangements or policies
change? Should the records be updated more frequently, such as promptly
upon a material change? What should be considered a ``material
change''?
4.5. Is seven years a sufficient time to maintain the records
required under section __.4(f) of the proposed rule? Why or why not?
4.6. Do covered institutions generally maintain records on
incentive-based compensation arrangements and programs? If so, what
types of records and related information are maintained and in what
format? What are the legal or institutional policy requirements for
maintaining such records?
4.7. For covered institutions that are investment advisers or
broker-dealers, is there particular information that would assist the
SEC in administering the proposed rule? For example, should the SEC
require its reporting entities to report whether they utilize
incentive-based compensation or whether they are Level 1, Level 2 or
Level 3 covered institutions?

Sec. __.5 Additional Disclosure and Recordkeeping Requirements for
Level 1 and Level 2 Covered Institutions

Section __.5 of the proposed rule would establish additional and
more detailed recordkeeping requirements for Level 1 and Level 2
covered institutions.
Under section __.5(a) of the proposed rule, a Level 1 or Level 2
covered institution would be required to create annually, and maintain
for at least seven years, records that document: (1) Its senior
executive officers and significant risk-takers listed by legal entity,
job function, organizational hierarchy, and line of business; (2) the
incentive-based compensation arrangements for senior executive officers
and significant risk-takers, including information on percentage of
incentive-based compensation deferred and form of award; (3) any
forfeiture and downward adjustment or clawback reviews and decisions
for senior executive officers and significant risk-takers; and (4) any
material changes to the covered institution's incentive-based
compensation arrangements and policies.
The proposed recordkeeping and disclosure requirements at Level 1
and Level 2 covered institutions would assist the appropriate Federal
regulator in monitoring whether incentive-based compensation
structures, and any changes to such structures, could result in Level 1
and Level 2 covered institutions maintaining incentive-based
compensation structures that encourage inappropriate risks by providing
excessive compensation, fees, or benefits or could lead to material
financial loss. The more detailed reporting requirement for Level 1 and
Level 2 covered institutions under section __.5(a) of the proposed rule
reflects the information that would assist the appropriate Federal
regulator in most effectively evaluating the covered institution's
compliance with the proposed rule and identifying areas of potential
concern with respect to the structure of the covered institution's
incentive-based compensation arrangements.
For example, the recordkeeping requirement in section __.5(a)(2) of
the proposed rule regarding amounts of incentive-based compensation
deferred and the form of payment of incentive-based compensation for
senior executive officers and significant risk-takers would help
Federal regulators determine compliance with the requirement in section
__.7(a) of the proposed rule for certain amounts of incentive-based
compensation of senior executive officers and significant risk-takers
to be deferred for specific periods of time. Similarly, the
recordkeeping requirement in section __.5(a)(3) of the proposed rule
would require Level 1 and Level 2 covered institutions to document the
rationale for decisions under forfeiture and downward adjustment
reviews and to keep timely and accurate records of the decision. This
documentation would provide information useful to Federal regulators
for determining compliance with the requirements in sections__.7(b) and
(c) of the proposed rule regarding specific forfeiture and clawback
policies at Level 1 and Level 2 covered institutions that are further
discussed below.
The proposed recordkeeping requirements in section __.5(a) of the
proposed rule relate to the proposed substantive requirements in
section __.7 of the proposed rule and would help the appropriate
Federal regulator to closely monitor incentive-based compensation
payments to senior executive officers and significant risk-takers and
to determine whether those payments have been adjusted to reflect risk
outcomes. This approach also would be responsive to comments received
on the 2011 Proposed Rule suggesting that specific qualitative and
quantitative information, instead of a narrative description, be the
basis of a reporting requirement for larger covered institutions.
Section __.5(b) of the proposed rule would require a Level 1 or
Level 2 covered institution to create and maintain records sufficient
to allow for an independent audit of incentive-based compensation
arrangements, policies, and procedures, including those required under
section __.11 of the proposed rule. A standard which reflects the level
of detail required in order to perform an independent audit of
incentive-based compensation would be appropriate given the importance
of regular monitoring of incentive-based compensation programs by
independent control functions. Such a standard also would be consistent
with the monitoring requirements set out in section __.11 of the
proposed rule.
As with the requirements applicable to all covered institutions
under section __.4(f) of the proposed rule, the Agencies are not
proposing to require that a Level 1 or Level 2 covered institution
annually file a report with the appropriate Federal regulator. Instead,
section __.5(c) of the proposed rule would require a Level 1 or Level 2
covered institution to disclose its records to the appropriate Federal
regulator in such form and with such frequency as requested by the
appropriate Federal regulator. The required form and frequency of
recordkeeping may vary among the Agencies and across categories of
covered institutions, although the records described in section __.5(a)
of the proposed rule, along with any other records a covered
institution creates to satisfy the requirements of section __.5(f) of
the proposed rule, would be required to be created at least annually.
Some Agencies may require Level 1 and Level 2 covered institutions to
provide their records on an annual basis, alone or with a standardized
form of report. Level 1 and Level 2 covered institutions should seek
guidance concerning the reporting requirement from their appropriate
Federal regulator.
Generally, the Agencies would expect the volume and detail of
information disclosed by a covered institution under section __.5 of
the proposed rule to be tailored to the nature and complexity of
business activities at the covered institution, and to the scope and
nature of its use of incentive-based compensation arrangements. The
Agencies recognize that smaller covered institutions with less complex
and less extensive incentive-based compensation arrangements likely
would not create or retain records that are as extensive as those that
larger covered institutions with relatively complex programs and
business activities would likely create. The tailored recordkeeping and

[[Page 37715]]

disclosure provisions for Level 1 and Level 2 covered institutions in
the proposed rule are designed to provide the Agencies with streamlined
and well-focused records that would allow the Agencies to promptly and
effectively identify and address any areas of concern.
Similar to the provision of information under section __.4(f) of
the proposed rule, the Agencies expect to treat the information
provided to the Agencies under section __.5 of the proposed rule as
nonpublic and to maintain the confidentiality of that information to
the extent permitted by law.\127\ When providing information to one of
the Agencies pursuant to the proposed rule, covered institutions should
request confidential treatment by that Agency.
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\127\ See supra note 126.
---------------------------------------------------------------------------

5.1. Should the level of detail in records created and maintained
by Level 1 and Level 2 covered institutions vary among institutions
regulated by different Agencies? If so, how? Or would it be helpful to
use a template with a standardized information list?
5.2. In addition to the proposed records, what types of information
should Level 1 and Level 2 covered institutions be required to create
and maintain related to deferral and to forfeiture, downward
adjustment, and clawback reviews?

Sec. __.6 Reservation of Authority for Level 3 Covered Institutions

Section __.6 of the proposed rule would allow the appropriate
Federal regulator to require certain Level 3 covered institutions to
comply with some or all of the more rigorous requirements applicable to
Level 1 and Level 2 covered institutions. Specifically, an Agency would
be able to require a covered institution with average total
consolidated assets greater than or equal to $10 billion and less than
$50 billion to comply with some or all of the more rigorous provisions
of section __.5 and sections __.7 through __.11 of the proposed rule,
if the appropriate Federal regulator determined that the covered
institution's complexity of operations or compensation practices are
consistent with those of a Level 1 or Level 2 covered institution,
based on the covered institution's activities, complexity of
operations, risk profile, or compensation practices. In such cases, the
Agency that is the Level 3 covered institution's appropriate Federal
regulator, in accordance with procedures established by the Agency,
would notify the institution in writing that it must satisfy the
requirements and other standards contained in section __.5 and sections
__.7 through __.11 of the proposed rule. As with the designation of
significant risk-takers discussed above, each Agency's procedures
generally would include reasonable advance written notice of the
proposed action, including a description of the basis for the proposed
action, and opportunity for the covered institution to respond.
As noted previously, the Agencies have determined that it may be
appropriate to apply only basic prohibitions and disclosure
requirements to Level 3 covered institutions, in part because these
institutions generally have less complex operations, incentive-based
compensation practices, and risk profiles than Level 1 and Level 2
covered institutions.\128\ However, the Agencies recognize that there
is a wide spectrum of business models and risk profiles within the $10
to $50 billion range and believe that some Level 3 covered institutions
with between $10 and $50 billion in total consolidated assets may have
incentive-based compensation practices and operational complexity
comparable to those of a Level 1 or Level 2 covered institution. In
such cases, it may be appropriate for the Agencies to provide a process
for determining that such institutions should be held to the more
rigorous standards.
---------------------------------------------------------------------------

\128\ See section 3 of Part II of this Supplementary Information
for more discussions on Level 1, Level 2, and Level 3 covered
institutions.
---------------------------------------------------------------------------

The Agencies are proposing $10 billion as the appropriate threshold
for the low end of this range based upon the general complexity of
covered institutions above this size. The threshold is also used in
other statutory and regulatory requirements. For example, the stress
testing provisions of the Dodd-Frank Act require banking organizations
with total consolidated assets of more than $10 billion to conduct
annual stress tests.\129\ For deposit insurance assessment purposes,
the FDIC distinguishes between small and large banks based on a $10
billion asset size.\130\ For supervisory purposes, the Board defines
community banks by reference to the $10 billion asset size
threshold.\131\
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\129\ 12 U.S.C. 5365(i)(2).
\130\ See 12 CFR 327.8(e) and (f).
\131\ See Federal Reserve SR Letter 12-7, ``Supervisory Guidance
on Stress Testing for Banking Organizations with More Than $10
Billion in Total Consolidated Assets'' (May 14, 2012).
---------------------------------------------------------------------------

The Agencies would consider the activities, complexity of
operations, risk profile, and compensation practices to determine
whether a Level 3 covered institution's operations or compensation
practices warrant application of additional standards pursuant to the
proposed rule. For example, a Level 3 covered institution could have
significant levels of off-balance sheet activities, such as derivatives
that may entail complexities of operations and greater risk than
balance sheet measures would indicate, making the institution's risk
profile more akin to that of a Level 1 or Level 2 covered institution.
Additionally, a Level 3 covered institution might be involved in
particular high-risk business lines, such as lending to distressed
borrowers or investing or trading in illiquid assets, and make
significant use of incentive-based compensation to reward risk-takers.
Still other Level 3 covered institutions might have or be part of a
complex organizational structure, such as operating with multiple legal
entities in multiple foreign jurisdictions.
Section __.6 of the proposed rule would permit the appropriate
Federal regulator of a Level 3 covered institution with total
consolidated assets of between $10 and $50 billion to require the
institution to comply with some or all of the provisions of section
__.5 and sections __.7 through __.11 of the proposed rule. This
approach would allow the Agencies to take a flexible approach in the
proposed rule provisions applicable to all Level 3 covered institutions
while retaining authority to apply more rigorous standards where the
Agencies determine appropriate based on the Level 3 covered
institution's complexity of operations or compensation practices. The
Agencies expect they only would use this authority on an infrequent
basis. This approach has been used in other rules for purposes of
tailoring the application of requirements and providing flexibility to
accommodate the variations in size, complexity, and overall risk
profile of financial institutions.\132\
---------------------------------------------------------------------------

\132\ For example, the OCC, FDIC, and Board's domestic capital
rules include a reservation of authority whereby the agency may
require an institution to hold an amount of regulatory capital
greater than otherwise required under the capital rules. 12 CFR
3.1(d) (OCC); 12 CFR 324.1(d)(1) through (6) (FDIC); 12 CFR 217.1(d)
(Board). The OCC, FDIC, and the Board's Liquidity Coverage Ratio
rule includes a reservation of authority whereby each agency may
impose heightened standards on an institution. 12 CFR 50.2 (OCC); 12
CFR 329.2 (FDIC); 12 CFR 249.2 (Board). The FDIC's stress testing
rules include a reservation of authority to require a $10 billion to
$50 billion covered bank to use reporting templates for larger
banks. 12 CFR 325.201.
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6.1. The Agencies invite general comment on the reservation of
authority in section __.6 of the proposed rule.

[[Page 37716]]

6.2. The Agencies based the $10 billion dollar floor of the
reservation of authority on existing similar reservations of authority
that have been drawn at that level. Did the Agencies set the correct
threshold or should the floor be set lower or higher than $10 billion?
If so, at what level and why?
6.3. Are there certain provisions in section __.5 and sections __.7
through __.11 of the proposed rule that would not be appropriate to
apply to a covered institution with total consolidated assets of $10
billion or more and less than $50 billion regardless of its complexity
of operations or compensation practices? If so, which provisions and
why?
6.4. The Agencies invite comment on the types of notice and
response procedures the Agencies should use in determining that the
reservation of authority should be used. The SEC invites comment on
whether notice and response procedures based on the procedures for a
proceeding initiated upon the SEC's own motion under Advisers Act rule
0-5 would be appropriate for this purpose.
6.5. What specific features of incentive-based compensation
programs or arrangements at a Level 3 covered institution should the
Agencies consider in determining such institution should comply with
some or all of the more rigorous requirements within the rule and why?
What process should be followed in removing such institution from the
more rigorous requirements?

Sec. __.7 Deferral, Forfeiture and Downward Adjustment, and Clawback
Requirements for Level 1 and Level 2 Covered Institutions

As discussed above, allowing covered institutions time to measure
results with the benefit of hindsight allows for a more accurate
assessment of the consequences of risks to which the institution has
been exposed. This approach may be particularly relevant, for example,
where performance is difficult to measure because performance results
and risks take time to observe (e.g., assessing the future repayment
prospects of loans written during the current year).
In order to achieve incentive-based compensation arrangements that
appropriately balance risk and reward, including closer alignment
between the interests of senior executive officers and significant
risk-takers within the covered institution and the longer-term
interests of the covered institution itself, it is important for
information on performance, including information on misconduct and
inappropriate risk-taking, to affect the incentive-based compensation
amounts received by covered persons. Covered institutions may use
deferral, forfeiture and downward adjustment, and clawback to address
information about performance that comes to light after the conclusion
of the performance period, so that incentive-based compensation
arrangements are able to appropriately balance risk and reward. Section
__.7 of the proposed rule would require Level 1 and Level 2 covered
institutions to incorporate these tools into the incentive-based
compensation arrangements of senior executive officers and significant
risk-takers.
Under the proposed rule, an incentive-based compensation
arrangement at a Level 1 or Level 2 covered institution would not be
considered to appropriately balance risk and reward, as would be
required by section __.4(c)(1), unless the deferral, forfeiture,
downward adjustment, and clawback requirements of section __.7 are met.
These requirements would apply to incentive-based compensation
arrangements provided to senior executive officers and significant
risk-takers at Level 1 and Level 2 covered institutions. Institutions
may, of course, take additional steps to address risks that may mature
after the performance period.
The requirements of section __.7 of the proposed rule would apply
to Level 1 and Level 2 covered institutions; that is, to covered
institutions with $50 billion or more in average total consolidated
assets. The requirements of section __.7 would not be applicable to
Level 3 covered institutions.\133\ As discussed above, the Agencies
recognize that larger covered institutions have more complex business
activities and generally rely more on incentive-based compensation
programs, and, therefore, it is appropriate to impose specific
deferral, forfeiture and downward adjustment reviews and clawback
requirements on these institutions. It has been recognized that larger
financial institutions can present greater potential systemic risks.
The Board, for example, has expressed the view that institutions with
more than $250 billion in total consolidated assets are more likely
than other institutions to pose systemic risk to U.S. financial
stability.\134\ Because of these risks that could be created by
excessive risk-taking at the largest covered institutions, additional
safeguards are needed against inappropriate risk-taking at Level 1
covered institutions. For these reasons, the Agencies are proposing a
required minimum deferral percentage and a required minimum deferral
period for Level 1 covered institutions that are greater than those for
Level 2 covered institutions.
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\133\ As explained earlier in this Supplementary Information
section, the appropriate Federal regulator of a Level 3 covered
institution with average total consolidated assets greater than or
equal to $10 billion and less than $50 billion may require the
covered institution to comply with some or all of the provisions of
section __.5 and sections __.7 through __.11 of the proposed rule if
the Agency determines that the complexity of operations or
compensation practices of the Level 3 covered institution are
consistent with those of a Level 1 or 2 covered institution.
\134\ Board, Regulatory Capital Rules: Implementation of Risk-
Based Capital Surcharges for Global Systemically Important Bank
Holding Companies, 80 FR 49082, 49084 (August 14, 2015).
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The requirements of section __.7 of the proposed rule would apply
to incentive-based compensation arrangements for senior executive
officers and significant risk-takers of Level 1 and Level 2 covered
institutions. The decisions of senior executive officers can have a
significant impact on the entire consolidated organization and often
involve substantial strategic or other risks that can be difficult to
measure and model--particularly at larger covered institutions--during
or at the end of the performance period, and therefore can be difficult
to address adequately by risk adjustments in the awarding of incentive-
based compensation.\135\ Supervisory experience and a review of the
academic literature \136\ suggest that incentive-based compensation
arrangements for the most senior decision-makers and risk-takers at the
largest institutions appropriately balance risk and reward when a
significant portion of the incentive-based compensation awarded under
those arrangements is deferred for an adequate amount of time.
---------------------------------------------------------------------------

\135\ This premise was identified in the 2010 Federal Banking
Agency Guidance, 75 FR at 36409, and was highlighted in the 2011 FRB
White Paper. The report reiterated the recommendation that ``[a]
substantial fraction of incentive compensation awards should be
deferred for senior executives of the firm because other methods of
balancing risk taking incentives are less likely to be effective by
themselves for such individuals.'' 2011 FRB White Paper, at 15.
\136\ Gopalan, Milbourn, Song and Thakor, ``Duration of
Executive Compensation'' (December 18, 2012), at 29-30, available at
https://apps.olin.wustl.edu/faculty/thakor/Website%20Papers/Duration%20of%20Executive%20Compensation.pdf.
---------------------------------------------------------------------------

As discussed above, in addition to the institution's senior
executive officers, the significant risk-takers at Level 1 and Level 2
covered institutions may have the ability to expose the institution to
the risk of material financial loss. In order to help ensure that the
incentive-based compensation arrangements for these individuals
appropriately balance risk and reward and do not encourage

[[Page 37717]]

them to engage in inappropriate risk-taking that could lead to material
financial loss, the proposed rule would extend the deferral requirement
to significant risk-takers at Level 1 and Level 2 covered institutions.
Deferral for significant risk-takers as well as executive officers
helps protect against material financial loss at the largest covered
institutions.

Sec. __.7(a) Deferral

As a tool to balance risk and reward, deferral generally consists
of four components: the proportion of incentive-based compensation
required to be deferred, the time horizon of the deferral, the speed at
which deferred incentive-based compensation vests, and adjustment
during the deferral period to reflect risks or inappropriate conduct
that manifest over that period of time.
Section __.7(a) of the proposed rule would require Level 1 and
Level 2 covered institutions, at a minimum, to defer the vesting of a
certain portion of all incentive-based compensation awarded (the
deferral amount) to a senior executive officer or significant risk-
taker for at least a specified period of time (the deferral period).
The minimum required deferral amount and minimum required deferral
period would be determined by the size of the covered institution, by
whether the covered person is a senior executive officer or significant
risk-taker, and by whether the incentive-based compensation was awarded
under a long-term incentive plan or is qualifying incentive-based
compensation. Minimum required deferral amounts range from 40 percent
to 60 percent of the total incentive-based compensation award, and
minimum required deferral periods range from one year to four years, as
detailed below.
Deferred incentive-based compensation of senior executive officers
and significant risk-takers at Level 1 and Level 2 covered institutions
would also be required to meet the following other requirements:
Vesting of deferred amounts may occur no faster than on a
pro rata annual basis beginning on the one-year anniversary of the end
of the performance period;
Unvested deferred amounts may not be increased during the
deferral period;
For most Level 1 and Level 2 covered institutions,
substantial portions of deferred incentive-based compensation must be
paid in the form of both equity-like instruments and deferred cash;
Vesting of unvested deferred amounts may not be
accelerated except in the case of death or disability; \137\ and
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\137\ For covered persons at credit unions, NCUA's rule also
permits acceleration of payment if the covered person must pay
income taxes on the entire amount of an award, including deferred
amounts, at the time of award.
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All unvested deferred amounts must be placed at risk of
forfeiture and subject to a forfeiture and downward adjustment review
pursuant to section __.7(b).
Except for the prohibition against accelerated vesting, the
prohibitions and requirements in section __.7(a) of the proposed rule
would apply to all unvested deferred incentive-based compensation,
regardless of whether the deferral of the incentive-based compensation
was necessary to meet the requirements of the proposed rule. For
example, if a covered institution chooses to defer incentive-based
compensation above the amount required to be deferred under the rule,
the additional amount would be required to be subject to forfeiture. In
another example, if a covered institution would be required to defer a
portion of a particular covered person's incentive-based compensation
for four years, but chooses to defer that compensation for ten years,
the deferral would be subject to forfeiture during the entire ten-year
deferral period. Applying the requirements and prohibitions of section
__.7(a) to all unvested deferred incentive-based compensation is
intended to maximize the balancing effect of deferred incentive-based
compensation, to make administration of the requirements and
prohibitions easier for covered institutions, and to facilitate the
Agencies' supervision for compliance.
Compensation that is not incentive-based compensation and is
deferred only for tax purposes would not be considered ``deferred
incentive-based compensation'' for purposes of the proposed rule.

Sec. __.7(a)(1) and Sec. __.7(a)(2) Minimum Deferral Amounts and
Deferral Periods for Qualifying Incentive-Based Compensation and
Incentive-Based Compensation Awarded Under a Long-Term Incentive Plan

The proposed rule would require a Level 1 covered institution to
defer at least 60 percent of each senior executive officer's qualifying
incentive-based compensation \138\ for at least four years, and at
least 60 percent of each senior executive officer's incentive-based
compensation awarded under a long-term incentive plan for at least two
years beyond the end of that plan's performance period. A Level 1
covered institution would be required to defer at least 50 percent of
each significant risk-taker's qualifying incentive-based compensation
for at least four years, and at least 50 percent of each significant
risk-taker's incentive-based compensation awarded under a long-term
incentive plan for at least two years beyond the end of that plan's
performance period.
---------------------------------------------------------------------------

\138\ As described above, incentive-based compensation that is
not awarded under a long-term incentive plan would be defined as
qualifying incentive-based compensation under the proposed rule.
---------------------------------------------------------------------------

Similarly, the proposed rule would require a Level 2 covered
institution to defer at least 50 percent of each senior executive
officer's qualifying incentive-based compensation for at least three
years, and at least 50 percent of each senior executive officer's
incentive-based compensation awarded under a long-term incentive plan
for at least one year beyond the end of that plan's performance period.
A Level 2 covered institution would be required to defer at least 40
percent of each significant risk-taker's qualifying incentive-based
compensation for at least three years, and at least 40 percent of each
significant risk-taker's incentive-based compensation awarded under a
long-term incentive plan for at least one year beyond the end of that
plan's performance period.
In practice, a Level 1 or Level 2 covered institution typically
evaluates the performance of a senior executive officer or significant
risk-taker during and after the performance period. As the performance
period comes to a close, the covered institution determines an amount
of incentive-based compensation to award the covered person for that
performance period. Senior executive officers and significant risk-
takers may be awarded incentive-based compensation at a given time
under multiple incentive-based compensation plans that have performance
periods that come to a close at that time. Although they end at the
same time, those performance periods may have differing lengths, and
therefore may not completely overlap. For example, long-term incentive
plans, which have a minimum performance period of three years, would
consider performance in at least two years prior to the year the
performance period ends, while annual incentive plans would only
consider performance in the year of the performance period.
For purposes of determining the amount of incentive-based
compensation that would be required to be deferred and the actual
amount that

[[Page 37718]]

would be deferred, a Level 1 or Level 2 covered institution generally
should use the present value of the incentive-based compensation at the
time of the award. In determining the value of awards for this purpose,
Level 1 and Level 2 covered institutions generally should use
reasonable valuation methods consistent with methods used in other
contexts.\139\
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\139\ See, e.g., Topic 718 of the FASB Accounting Standards
Codification (formerly FAS 123(R); Black-Scholes method for valuing
options.
---------------------------------------------------------------------------

Pro Rata Vesting
The requirements of this section would permit the covered
institution to immediately pay, or allow to vest, all of the incentive-
based compensation that is awarded that is not required to be deferred.
All incentive-based compensation that is deferred would be subject to a
deferral period that begins only once the performance period comes to a
close. During this deferral period, indications of inappropriate risk-
taking may arise, leading the covered institution to consider whether
the covered person should not be paid the entire amount originally
awarded.
The incentive-based compensation that would be required by the rule
to be deferred would not be permitted to vest faster than on a pro rata
annual basis beginning no earlier than the first anniversary of the end
of the performance period for which the compensation was awarded. In
other words, a covered institution would be allowed to make deferred
incentive-based compensation eligible for vesting during the deferral
period on a schedule that paid out equal amounts on each anniversary of
the end of the relevant performance period. A covered institution would
also be permitted to make different amounts eligible for vesting each
year, so long as the cumulative total of the deferred incentive-based
compensation that has been made eligible for vesting on each
anniversary of the end of the performance period is not greater than
the cumulative total that would have been eligible for vesting had the
covered institution made equal amounts eligible for vesting each year.
For example, if a Level 1 covered institution is required to defer
$100,000 of a senior executive officer's incentive-based compensation
for four years, the covered institution could choose to make $25,000
available for vesting on each anniversary of the end of the performance
period for which the $100,000 was awarded. The Level 1 covered
institution could also choose to make different amounts available for
vesting at different times during the deferral period, as long as: The
total amount that is made eligible for vesting on the first anniversary
is not more than $25,000; the total amount that has been made eligible
for vesting by the second anniversary is not more than $50,000; and the
total amount that has been made eligible for vesting by the third
anniversary is not more than $75,000. In this example, the Level 1
covered institution would be permitted to make eligible for vesting
$10,000 on the first anniversary, $30,000 on the second anniversary
(bringing the total for the first and second anniversaries to $40,000),
$30,000 on the third anniversary (bringing the total for the first,
second, and third anniversaries to $70,000), and $30,000 on the fourth
anniversary.
A Level 1 or Level 2 covered institution should consider the
vesting schedule at the time of the award, and the present value at
time of award of each form of incentive-based compensation, for the
purposes of determining compliance with this requirement. Level 1 and
Level 2 covered institutions generally should use reasonable valuation
methods consistent with methods used in other contexts in valuing
awards for purposes of this rule.
This approach would provide a covered institution with some
flexibility in administering its specific deferral program. For
example, a covered institution would be permitted to make the full
deferred amount of incentive-based compensation awarded for any given
year eligible for vesting in a lump sum at the conclusion of the
deferral period (i.e., ``cliff vesting''). Alternatively, a covered
institution would be permitted to make deferred amounts eligible for
vesting in equal increments at the end of each year of the deferral
period. Except in the case of acceleration allowed in sections
__.7(a)(1)(iii)(B) and __.7(a)(2)(iii)(B), the proposed rule does not
allow for vesting of amounts required to be deferred (1) faster than on
a pro rata annual basis; or (2) beginning earlier than the first
anniversary of the award date.
The Agencies recognize that some or all of the incentive-based
compensation awarded to a senior executive officer or significant risk-
taker may be forfeited before it vests. For an example of how these
requirements would work in practice, please see Appendix A of this
Supplementary Information section.
This restriction is intended to prevent covered institutions from
defeating the purpose of the deferral requirement by allowing vesting
of most of the required deferral amounts immediately after the award
date. In addition, the proposed approach aligns with both what the
Agencies understand is common practice in the industry and with the
requirements of many foreign supervisors.
Acceleration of Payments
The Agencies propose that the acceleration of vesting and
subsequent payment of incentive-based compensation that is required to
be deferred under this proposed rule generally be prohibited for
covered persons at Level 1 and Level 2 covered institutions. This
restriction would apply to all deferred incentive-based compensation
required to be deferred under the proposed rule, whether it was awarded
as qualifying incentive-based compensation or under a long-term
incentive plan. This prohibition on acceleration would not apply to
compensation that the employee or the employer elects to defer in
excess of the amounts required under the proposed rule or for time
periods that exceed the required deferral periods or in certain other
limited circumstances, such as the death or disability of the covered
person.
NCUA's proposed rule would permit acceleration of payment if
covered persons at credit unions were subject to income taxes on the
entire amount of an incentive-based compensation award even before
deferred amounts vest. Incentive-based compensation for executives of
not-for-profit entities is subject to income taxation under a different
provision of the Internal Revenue Code \140\ than that applicable to
executives of other covered institutions. The result is that credit
union executives' incentive-based compensation awards may be subject to
immediate taxation on the entire award, even deferred amounts.\141\ The
ability to accelerate payment would be a limited exception only
applicable to income tax liability and would only apply to the extent
credit union executives must pay income tax on unvested amounts during
the deferral period. Also, any amounts advanced to pay income tax
liabilities for deferrals must be taken in proportion to the vesting
schedule. For example, a credit union executive may have deferrals of
$200,000 for each of three years ($600,000 total) and a total tax
liability of $240,000 for the deferred amount of an award. The advanced
tax

[[Page 37719]]

payments would result in an annual reduction of $80,000 per deferred
payment, resulting in a new vesting amount of $120,000 for each year of
the deferral period.
---------------------------------------------------------------------------

\140\ 26 U.S.C. 457(f).
\141\ The Agencies understand that the taxation of unvested
deferred awards of covered persons at other covered institutions is
based on other provisions of the Internal Revenue Code. See, e.g.,
26 U.S.C. 409A.
---------------------------------------------------------------------------

Many institutions currently allow for accelerated vesting in the
case of death or disability. Some current incentive-based compensation
arrangements, such as separation agreements, between covered persons
and covered institutions provide for accelerated vesting and payment of
deferred incentive-based compensation that has not yet vested upon the
occurrence of certain events.\142\ Many institutions also currently
provide for the accelerated vesting of deferred incentive-based
compensation awarded to their senior executive officers, particularly
compensation awarded in the form of equity, in connection with a change
in control of the company \143\ (sometimes as part of a ``golden
parachute''). Shareholder proxy firms and some institutional investors
have raised concerns about such golden parachutes,\144\ and golden
parachutes are restricted by law under certain circumstances, including
if an institution is in troubled condition.\145\ Finally, in current
incentive-based compensation arrangements, events triggering
acceleration commonly include leaving the employment of a covered
institution for a new position (either any new position or only certain
new positions, such as employment at a government agency), an
acquisition or change in control of the covered institution, or upon
the death or disability of the employee.\146\
---------------------------------------------------------------------------

\142\ Several commenters argued that the 2011 Proposed Rule's
deferral requirements should not apply upon the death, disability,
retirement, or acceptance of government employment of covered
persons, or a change in control of the covered institution,
effectively arguing for the ability of covered institutions to
accelerate incentive-based compensation under these circumstances.
\143\ See, e.g., Equilar, ``Change-in-Control Equity
Acceleration Triggers'' (March 19, 2014), available at https://www.equilar.com/reports/8-change-in-control-equity-acceleration-triggers.html (Noting that although neither Institutional
Shareholder Services (ISS) nor Glass Lewis state that a single
trigger plan will automatically result in an ``against''
recommendation, both make it clear that they view the single versus
double trigger issue as an important factor in making their
decisions. ISS, in particular, suggests in its policies that double
trigger vesting of equity awards is currently the best market
practice).
\144\ Institutional Shareholders Services, ``2015 U.S.
Compensation Policies, Frequently Asked Questions'' (February 9,
2015) (``ISS Compensation FAQs''), available at https://www.issgovernance.com/file/policy/2015-us-comp-faqs.pdf; and
Institutional Shareholders Services, ``U.S. Corporate Governance
Policy: 2013 Updates'' (November 16, 2012), available at https://www.issgovernance.com/file/files/2013USPolicyUpdates.pdf.
\145\ See 12 U.S.C. 1828(k) and 12 CFR part 359 (generally
applicable to banks and holding companies).
\146\ See, e.g., 2012 James F. Reda & Associates, ``Study of
Executive Termination Provisions Among Top 200 Public Companies
(December 2012), available at www.jfreda.com; Equilar, ``Change-in-
Control Equity Acceleration Triggers'' (March 19, 2014), available
athttps://www.equilar.com/reports/8-change-in-control-equity-acceleration-triggers.html.
---------------------------------------------------------------------------

The Federal Banking Agencies have found that the acceleration of
deferred incentive-based compensation to covered persons is generally
inappropriate because it weakens the balancing effect of deferral and
eliminates the opportunity for forfeiture during the deferral period as
information concerning risks taken during the performance period
becomes known. The acceleration of vesting and payment of deferred
incentive-based compensation in other circumstances, such as when the
covered person voluntarily leaves the institution, could also provide
covered persons with an incentive to retire or leave a covered
institution if the covered person is aware of risks posed by the
covered person's activities that are not yet apparent to or fully
understood by the covered institution. Acceleration of payment could
skew the balance of risk-taking incentives provided to the covered
person if the circumstances under which acceleration is allowed are
within the covered person's control. The proposed rule would prohibit
acceleration of deferred compensation that is required to be deferred
under this proposed rule in most circumstances given the potential to
undermine risk balancing mechanisms.
In contrast, the circumstances under which the Agencies would allow
acceleration of payment, namely death or disability of the covered
person, generally are not subject to the covered person's control, and,
therefore, are less likely to alter the balance of risk-taking
incentives provided to the covered person. In other cases where
acceleration is permitted, effective governance and careful assessment
of potential risks, as well as specific facts and circumstances are
necessary in order to protect against creating precedents that could
undermine more generally the risk balancing effects of deferral.
Therefore, the Agencies have proposed to permit only these limited
exceptions.
Under the proposed rule, the prohibition on acceleration except in
cases of death or disability would apply only to deferred amounts that
are required by the proposed rule so as not to discourage additional
deferral, or affect institutions that opt to defer incentive-based
compensation exceeding the requirements. For example, if an institution
defers compensation until retirement as a retention tool, but the
institution then merges into another company and ceases to exist,
retention may not be a priority. Thus, acceleration would be permitted
for any deferred incentive-based compensation amounts above the amount
required to be deferred or that was deferred longer than the minimum
deferral period to allow those amounts to be paid out closer in time to
the merger.
Similarly, the acceleration of payment NCUA's rule permits if a
covered person of a credit union faces up-front income tax liability on
the deferred amounts of an award is not an event subject to the covered
person's control. This exception will not apply unless the covered
person is actually subject to income taxes on deferred amounts for
which the covered person has not yet received payment, and equalizes
the effect of deferral for covered persons at credit unions and covered
persons at most other covered institutions. This limited exception is
not intended to alter the balance of risk-taking incentives.
Qualifying Incentive-Based Compensation and Incentive-Based
Compensation Awarded Under a Long-Term Incentive Plan
The minimum required deferral amounts would be calculated
separately for qualifying incentive-based compensation and incentive-
based compensation awarded under a long-term incentive plan, and those
amounts would be required to be deferred for different periods of time.
For the purposes of calculating qualifying incentive-based compensation
awarded for any performance period, a covered institution would
aggregate incentive-based compensation awarded under any incentive-
based compensation plan that is not a long-term incentive plan. The
required deferral percentage (40, 50, or 60 percent) would be
multiplied by that total amount to determine the minimum deferral
amount. In a given year, if a senior executive officer or significant
risk-taker is awarded qualifying incentive-based compensation under
multiple plans that have the same performance period (which is less
than three years), the award under each plan would not be required to
meet the minimum deferral requirement, so long as the total amount that
is deferred from all of the amounts awarded under those plans meets the
minimum required percentage of total qualifying incentive-based
compensation relevant to that covered person.

[[Page 37720]]

For example, under the proposal, a significant risk-taker at a
Level 2 covered institution might be awarded $60,000 under a plan with
a one-year performance period that applies to all employees in her line
of business and $40,000 under a plan with a one-year performance period
that applies to all employees of the covered institution. For that
performance period, the significant risk-taker has been awarded a total
of $100,000 in qualifying incentive-based compensation, so she would be
required to defer a total of $40,000. The covered institution could
defer amounts awarded under either plan or under both plans, so long as
the total amount deferred was at least $40,000. For example, the
covered institution could choose to defer $20,000 from the first plan
and $20,000 from the second plan. The covered institution could also
choose to defer nothing awarded under the first plan and the entire
$40,000 awarded under the second plan.
For a full example of how these requirements would work in the
context of a more complete incentive-based compensation arrangement,
please see Appendix A of this preamble.
In contrast, the minimum required deferral percentage would apply
to all incentive-based compensation awarded under each long-term
incentive plan separately. In a given year, if a senior executive
officer or significant risk-taker is awarded incentive-based
compensation under multiple long-term incentive plans that have
performance periods of three years or more, each award under each plan
would be required to meet the minimum deferral requirement.\147\ Based
on supervisory experience, the Federal Banking Agencies have found that
it would be extremely rare for a covered person to be awarded
incentive-based compensation under multiple long-term incentive plans
in one year.
---------------------------------------------------------------------------

\147\ For example, if a Level 1 covered institution awarded a
senior executive officer $100,000 under one long-term incentive plan
and $200,000 under another long-term incentive-plan, the covered
institution would be required to defer at least $60,000 of the
amount awarded under the first long-term incentive plan and at least
$120,000 of the amount awarded under the second long-term incentive
plan. The Level 1 covered institution would not be permitted to meet
the deferral requirements by deferring, for example, $10,000 awarded
under the first long-term incentive plan and $170,000 awarded under
the second long-term incentive plan.
---------------------------------------------------------------------------

The proposed rule would require deferral for the same percentage of
qualifying incentive-based compensation as of incentive-based
compensation awarded under a long-term incentive plan. However, the
proposed rule would require that deferred qualifying incentive-based
compensation meet a longer minimum deferral period than deferred
incentive-based compensation awarded under a long-term incentive plan.
As with the shorter performance period for qualifying incentive-based
compensation, the period over which performance is measured under a
long-term incentive plan is not considered part of the deferral period.
Under the proposed rule, both deferred qualifying incentive-based
compensation and deferred incentive-based compensation awarded under a
long-term incentive plan would be required to meet the vesting
requirements separately. In other words, deferred qualifying incentive-
based compensation would not be permitted to vest faster than on a on a
pro rata annual basis, even if deferred incentive-based compensation
awarded under a long-term incentive plan vested on a slower than pro
rata basis. Each deferred portion is bound by the pro rata requirement.
For an example of how these requirements would work in practice,
please see Appendix A of this Supplementary Information section.
Incentive-based compensation provides an inducement for a covered
person at a covered institution to advance the strategic goals and
interests of the covered institution while enabling the covered person
to share in the success of the covered institution. Incentive-based
compensation may also encourage covered persons to take undesirable or
inappropriate risks, or to sell unsuitable products in the hope of
generating more profit and thereby increasing the amount of incentive-
based compensation received. Covered persons may also be tempted to
manipulate performance results in an attempt to make performance
measurements look better or to understate the actual risks such
activities impose on the covered institution's balance sheet.\148\
Incentive-based compensation should therefore also provide incentives
for prudent risk-taking in the long term and for sound risk management.
---------------------------------------------------------------------------

\148\ For example, towards the end of the performance period,
covered persons who have not yet met the target performance measures
could be tempted to amplify risk taking or take other actions to
meet those targets and receive the maximum incentive-based
compensation. Without deferral, there would be no additional review
applied to the risk-taking activities that were taken during the
defined performance period to achieve those target performance
measures.
---------------------------------------------------------------------------

Deferral of incentive-based compensation awards involves a delay in
the vesting and payout of an award to a covered person beyond the end
of the performance period. The deferral period allows for amounts of
incentive-based compensation to be adjusted for actual losses to the
covered institution or for other aspects of performance that become
clear during the deferral period before those amounts vest or are paid.
These aspects include inappropriate risk-taking and misconduct on the
part of the covered person. More generally, deferral periods that
lengthen the time between the award of incentive-based compensation and
vesting, combined with forfeiture, are important tools for aligning the
interests of risk-takers with the longer-term interests of covered
institutions.\149\ Deferral periods that are sufficiently long to allow
for a substantial portion of the risks from the covered person's
activities to manifest are likely to be most effective in ensuring that
risks and rewards are adequately balanced.\150\
---------------------------------------------------------------------------

\149\ There have been a number of academic papers that argue
that deferred compensation provides incentives for executives to
consider the long-term health of the firm. For example, Eaton and
Rosen (1983) note that delaying compensation is a way of bonding
executives to the firm and providing incentives for them to focus on
long-term performance of the firm. See Eaton and Rosen, ``Agency,
Delayed Compensation, and the Structure of Executive Remuneration,''
38 Journal of Finance 1489, at 1489-1505; see also Park and Sturman,
``How and What You Pay Matters: The Relative Effectiveness of Merit
Pay, Bonus, and Long-Term Incentives on Future Job Performance''
(2012), available at https://scholarship.sha.cornell.edu/cgi/viewcontent.cgi?article=1121&context=articles.
\150\ The length of the deferral period has been a topic of
discussion in the literature. Edmans (2012) argues that deferral
periods of two to three years are too short. He also argues that
deferral should be longer for institutions where the decisions of
the executives have long-term consequences. Bebchuk et al (2010)
argue that deferral provisions alone will not prevent executives
from putting emphasis on short-term prices because executives that
have been in place for many years will have the opportunity to
regularly cash out. They argue that executives should be required to
hold a substantial number of shares and options until retirement.
See also Edmans, Alex, ``How to Fix Executive Compensation,'' The
Wall Street Journal (February 27, 2012); Bebchuk, Lucian, Cohen, and
Spamann, ``The Wages of Failure: Executive Compensation at Bear
Stearns and Lehman 2000-2008,'' 27 Yale Journal on Regulation 257,
257-282 (2010); Bhagat, Sanjai, Bolton and Romano, ``Getting
Incentives Right: Is Deferred Bank Executive Compensation
Sufficient?,'' 31 Yale Journal on Regulation 523 (2014); Bhagat,
Sanjai and Romano, ``Reforming Financial Executives' Compensation
for the Long Term,'' Research Handbook on Executive Pay (2012);
Bebchuk and Fried, ``Paying for Long-Term Performance,'' 158
University of Pennsylvania Law Review, 1915 (2010).
---------------------------------------------------------------------------

Deferral periods allow covered institutions an opportunity to more
accurately judge the nature and scale of risks imposed on covered
institutions' balance sheets by a covered person's performance for
which incentive-based compensation has been awarded, and to better
understand and identify risks that

[[Page 37721]]

result from such activities as they are realized. These include risks
imposed by inappropriate risk-taking or misconduct, and risks that may
manifest as a result of lapses in risk management or risk oversight.
For example, the risks associated with some business lines, such as
certain types of lending, may require many years before they
materialize.
Though it is difficult to set deferral periods that perfectly match
the time it takes risks undertaken by the covered persons of covered
institutions to become known, longer periods allow more time for
incentive-based compensation to be adjusted between the time of award
and the time incentive-based compensation vests.\151\ At the same time,
deferral periods that are inordinately long may reduce the
effectiveness of incentive-based compensation arrangements because
employees more heavily discount the potential impact of such
arrangements. Thus, it is important to strike a reasonable balance
between providing effective incentives and allowing sufficient time to
validate performance measures over a reasonable period of deferral. The
specific deferral periods and amounts proposed in the proposed rule are
also consistent with current practice at many institutions that would
be Level 1 or Level 2 covered institutions, and with compensation
requirements in other countries.\152\ In drafting the requirements in
sections __.7(a)(1) and __.7(a)(2), the Agencies took into account the
comments received regarding similar requirements in the 2011 Proposed
Rule.\153\
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\151\ Some empirical literature has found a link between the
deferral of compensation and firm value, firm performance, risk, and
the manipulation of earnings. Gopalan et al (2014) measure the
duration of executive compensation by accounting for the vesting
schedules in compensation. They argue that the measure is a proxy
for the executives' horizon. They find that longer duration of
compensation is present at less risky institutions and institutions
with better past stock performance. They also find that longer
duration is associated with less manipulation of earnings. Chi and
Johnson (2009) find that longer vesting periods for stocks and
options are related to higher firm value. See Gopalan,
Radhakrishnan, Milbourn, Song and Thakor, ``Duration of Executive
Compensation,'' 59 The Journal of Finance 2777 (2014); Chi, Jianxin,
and Johnson, ``The Value of Vesting Restrictions on Managerial Stock
and Option Holdings'' (March 9, 2009) available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1136298.
\152\ Moody's Investor Service, ``Global Investment Banks:
Reformed Pay Policies Still Pose Risks to Bondholders'' (``Moody's
Report'') (December 9, 2014); McLagan, ``Mandatory Deferrals in
Incentive Programs'' (March 2013), available at https://www.mclagan.com/crb/downloads/McLagan_Mandatory_Deferral_Flash_Survey_Report_3-29-2013.pdf.
\153\ Commenters on the 2011 Proposed Rule expressed differing
views on the proposed deferral requirements and the deferral-related
questions posed by the Agencies. For example, some commenters
expressed the view that the deferral requirements for incentive-
based compensation awards for executive officers were appropriate.
Some commenters argued that deferral would create a longer-term
focus for executives and help to ensure they are not compensated on
the basis of short-term returns that fail to account for long-term
risks. Many commenters also argued that the deferral requirements
should be strengthened by extending the required minimum deferral
period or minimum percentage of incentive compensation deferred. For
example, these commenters urged the Agencies to require a five-year
deferral period, instead of the three-year period that was proposed,
or to disallow ``pro rata'' payments within the proposed three-year
deferral period. These commenters also expressed the view that the
Agencies' proposal to require covered financial institutions to
defer 50 percent of their annual compensation would result in an
insufficient amount of incentive-based compensation being at risk of
potential adjustment, because the risks posed by those executive
officer can take longer to become apparent. Other commenters argued
that all covered institutions subject to this rulemaking should
comply with the deferral requirements regardless of their size.
On the other hand, many commenters recommended that deferral not
be required or argued that, if deferral were to be required, the
three-year and 50 percent deferral minimums provided in the 2011
Proposed Rule were sufficient. Some commenters recommended that the
deferral requirements not be applied to smaller covered
institutions. Some commenters also suggested that unique aspects of
certain types of covered institutions, such as investment advisers
or smaller banks within a larger consolidated organization, should
be considered when imposing deferral and other requirements on
incentive-based compensation arrangements. A number of commenters
suggested that applying a prescriptive deferral requirement,
together with other requirements under the 2011 Proposed Rule, would
make it more difficult for covered institutions to attract and
retain key employees in comparison to the ability of organizations
not subject to such requirements to recruit and retain the same
employees.
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The Agencies have proposed the three- and four-year minimum
deferral periods because these deferral periods, taken together with
the typically one-year performance period, would allow a Level 1 or
Level 2 covered institution four to five years, or the majority of a
traditional business cycle, to identify outcomes associated with a
senior executive officer's or significant risk-taker's performance and
risk-taking activities. The business cycle reflects periods of economic
expansion or recession, which typically underpin the performance of the
financial sector. The Agencies recognize that credit cycles, which
revolve around access to and demand for credit and are influenced by
various economic and financial factors, can be longer.\154\
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\154\ From 1945 to 2009, the average length of the business
cycle in the U.S. was approximately 5.7 years. See The National
Bureau of Economic Research, ``U.S. Business Cycle Expansions and
Contractions, available at https://www.nber.org/cycles/cyclesmain.html. Many researchers have found that credit cycles are
longer than business cycles. For example, Drehmann et al (2012)
estimate an average duration of credit cycles from 10 to 20 years.
See Drehmann, Mathias, Borio and Tsatsaronis, ``Characterising the
Financial Cycle: Don't Lose Sight of the Medium Term!'' Bank for
International Settlements, Working Paper, No. 380 (June 2012),
available at https://www.bis.org/publ/work380.htm. Aikman et al
(2015) found that the credit cycle ranges from eight to 20 years.
See Aikman, Haldane, and Nelson, ``Curbing the Credit Cycle,'' 125
The Economic Journal 1072 (June 2015).
---------------------------------------------------------------------------

However, the Agencies are also concerned with striking the right
balance between allowing covered persons to be fairly compensated and
not encouraging inappropriate risk-taking. The Agencies are concerned
that extending deferral periods for too long may lead to a covered
person placing little or no value on the incentive-based compensation
that only begins to vest far out in the future. This type of
discounting of the value of long-deferred awards may be less effective
as an incentive, positive or negative, and consequently for balancing
the benefit of these types of awards.\155\
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\155\ See Pepper and Gore, ``The Economic Psychology of
Incentives: An International Study of Top Managers,'' 49 Journal of
World Business 289 (2014); PRA, Consultation Paper PRA CP15/14/FCA
CP14/14: Strengthening the alignment of risk and reward: new
remuneration rules (July 2014) available at https://www.bankofengland.co.uk/pra/Documents/publications/cp/2014/cp1514.pdf.
---------------------------------------------------------------------------

As described above, since the Agencies proposed the 2011 Proposed
Rule, the Agencies have gained significant supervisory experience while
encouraging covered institutions to adopt improved incentive-based
compensation practices. The Federal Banking Agencies note in particular
improvements in design of incentive-based compensation arrangements
that help to more appropriately balance risk and reward. Regulatory
requirements for sound incentive-based compensation arrangements at
financial institutions have continued to evolve, including those being
implemented by foreign regulators. Consideration of international
practices and standards is particularly relevant in developing
incentive-based compensation standards for large financial institutions
because they often compete for talented personnel internationally.
Based on supervisory experience, although exact amounts deferred
may vary across employee populations at large covered institutions, the
Federal Banking Agencies have observed that, since the financial crisis
that began in 2007, most deferral periods at financial institutions
range from three to five years, with three years being the most common
deferral period.\156\ Consistent with this observation, the FSB
standards suggest deferral periods ``not less than

[[Page 37722]]

three years,'' and the average deferral period at significant
institutions in FSB member countries is now between three and four
years.\157\ The PRA requires deferral of seven years for senior
managers as defined under the Senior Managers Regime, five years for
risk managers as defined under the EBA regulatory technical standard on
identification of material risk-takers, and three to five years as per
the CRD IV minimum for all other material risk-takers.\158\ CRD IV sets
a minimum deferral period of ``at least three to five years.'' For
senior management, significant institutions \159\ are expected to apply
deferral of ``at least five years.'' \160\ Swiss regulations \161\
require that for members of senior management, persons with relatively
high total remuneration, and persons whose activities have a
significant influence on the risk profile of the firm, the time period
for deferral should last ``at least three years.''
---------------------------------------------------------------------------

\156\ See 2011 FRB White Paper, at 15.
\157\ FSB, Implementing the FSB Principles for Sound
Compensation Practices and their Implementation Standards: Fourth
Progress Report (``2015 FSB Compensation Progress Report'') (2015),
available at https://www.fsb.org/2015/11/fsb-publishes-fourth-progress-report-on-compensation-practices.
\158\ See UK Remuneration Rules. The United Kingdom deferral
standards apply on a group-wide basis and apply to banks, building
societies, and PRA-designated investment firms, but do not currently
cover investment advisors outside of consolidated firms.
\159\ CRD IV defines institutions that are significant ``in
terms of size, internal organisation and nature, scope and
complexity of their activities.'' Under the EBA Guidance on Sound
Remuneration Policies, significant institutions means institutions
referred to in Article 131 of Directive 2013/36/EU (global
systemically important institutions or `G-SIIs,' and other
systemically important institutions or `O-SIIs'), and, as
appropriate, other institutions determined by the competent
authority or national law, based on an assessment of the
institutions' size, internal organisation and the nature, the scope
and the complexity of their activities. Some, but not all, national
regulators have provided further guidance on interpretation of that
term, including the FCA which provides a form of methodology to
determine if a firm is ``significant'' based on quantitative tests
of balance sheet assets, liabilities, annual fee commission income,
client money and client assets.
\160\ See EBA Remuneration Guidelines.
\161\ See FINMA Remuneration Circular 2010.
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The requirements in the proposed rule regarding amounts deferred
are also consistent with observed better practices and the standards
established by foreign regulators. The Board's summary overview of
findings during the early stages of the 2011 FRB White Paper \162\
observed that ``deferral fractions set out in the FSB Principles and
Implementation Standards \163\ are sometimes used as a benchmark (60
percent or more for senior executives, 40 percent or more for other
individual ``material risk takers,'' which are not the same as
``covered employees'') and concluded that deferral fractions were at or
above these benchmarks at both the U.S. banking organizations and
foreign banking organizations that participated in the horizontal
review.
---------------------------------------------------------------------------

\162\ See FRB 2011 Report, at 31.
\163\ Specifically, the FSB Implementation Standards encourage
that ``a substantial portion of variable compensation, such as 40 to
60 percent, should be payable under deferral arrangements over a
period of years'' and that ``proportions should increase
significantly along with the level of seniority and/or
responsibility . . . for the most senior management and the most
highly paid employees, the percentage of variable compensation that
is deferred should be substantially higher, for instance, above 60
percent.''
---------------------------------------------------------------------------

The proportion of incentive-based compensation awards observed to
be deferred at financial institutions during the Board's horizontal
review was substantial. For example, on average senior executives
report more than 60 percent of their incentive-based compensation is
deferred,\164\ and some of the most senior executives had more than 80
percent of their incentive-based compensation deferred with additional
stock retention requirements after deferred stock vests. Most
institutions assigned deferral rates to employees using a fixed
schedule or ``cash/stock table'' under which employees that received
higher incentive-based compensation awards generally were subject to
higher deferral rates, although deferral rates for the most senior
executives were often set separately and were higher than those for
other employees.\165\ The proposed rule's higher deferral rates for
senior executive officers would be consistent with this observed
industry practice of requiring higher deferral rates for the most
senior executives. Additionally, by their very nature, senior executive
officer positions tend to have more responsibility for strategic
decisions and oversight of multiple areas of operations, and these
responsibilities warrant requiring higher percentages of deferral and
longer deferral periods to safeguard against inappropriate risk-taking.
---------------------------------------------------------------------------

\164\ ``Deferral'' for these reports is defined by the
institutions and may include long-term incentive plans without
additional deferral.
\165\ See 2011 FRB White Paper, at 15.
---------------------------------------------------------------------------

This proposed rule is also consistent with standards being
developed internationally. The PRA expects that ``where any employee's
variable remuneration component is [pound]500,000 or more, at least 60
percent should be deferred.'' \166\ European Union regulations require
that ``institutions should set an appropriate portion of remuneration
that should be deferred for a category of identified staff or a single
identified staff member at or above the minimum proportion of 40
percent or respectively 60 percent for particularly high amounts.''
\167\ The EU also publishes a report on Benchmarking of Remuneration
Practices at Union Level and Data on High Earners \168\ that provides
insight into amounts deferred across various lines of business within
significant institutions across the European Union. While amounts
varied by areas of operations, average deferral levels for identified
staff range from 54 percent in retail banking to more than 73 percent
in investment banking.
---------------------------------------------------------------------------

\166\ See PRA, Supervisory Statement SS27/15: Remuneration (June
2015), available at https://www.bankofengland.co.uk/pra/Documents/publications/ss/2015/ss2715.pdf.
\167\ See EBA Remuneration Guidelines.
\168\ See, e.g., EBA, Benchmarking of Remuneration Practices at
Union Level and Data on High Earners, at 39, Figure 46 (September
2015), available at https://www.eba.europa.eu/-/eba-updates-on-remuneration-practices-and-high-earners-data-for-2013-across-the-eu.
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The proposed rule's enhanced requirements for Level 1 institutions
are consistent with international standards. Many regulators apply
compensation standards in a proportional or tiered fashion. The PRA,
for example, classifies three tiers of firms based on asset size and
applies differentiated standards across this population.
Proportionality Level 1 includes firms with greater than [pound]50
billion in consolidated assets; Proportionality Level 2 includes firms
with between [pound]15 billion and [pound]50 billion in consolidated
assets; and Proportionality Level 3 includes firms with less than
[pound]15 billion in consolidated assets. The PRA also recognizes
``significant'' firms. Proportionality Level 3 firms are typically not
subject to provisions on retained shares, deferral, or performance
adjustment.
Under the proposed rule, incentive-based compensation awarded under
a long-term incentive plan would be treated separately and differently
than amounts of incentive-based compensation awarded under annual
performance plans (and other qualifying incentive-based compensation)
for the purposes of the deferral requirements. Deferral of incentive-
based compensation and the use of longer performance periods (which is
the hallmark of a long-term incentive plan) both are useful tools for
balancing risk and reward in incentive-based compensation arrangements
because both allow for the passage of time that allows the covered
institution to have more information about a covered person's risk-
taking activity and its possible outcomes. Both methods allow

[[Page 37723]]

awards or payments to be made after some or all risk outcomes are
realized or better known. However, longer performance periods and
deferral of vesting are distinct risk balancing methods.\169\
---------------------------------------------------------------------------

\169\ The 2011 Proposed Rule expressly recognized this
distinction (``The Proposed Rule identifies four methods that
currently are often used to make compensation more sensitive to
risk. These methods are Risk Adjustment of Awards . . . Deferral of
Payment . . . Longer Performance Periods . . . Reduced Sensitivity
to Short-Term Performance.''). See 76 FR at 21179.
---------------------------------------------------------------------------

As noted above, the Agencies took into account the comments
received regarding similar deferral requirements in the 2011 Proposed
Rule. In response to the proposed deferral requirement in the 2011
Proposed Rule, which did not distinguish between incentive-based
compensation awarded under a long-term incentive plan and other
incentive-based compensation, several commenters argued that the
Agencies should allow incentive-based compensation arrangements that
use longer performance periods, such as a three-year performance
period, to count toward the mandatory deferral requirement. In
particular, some commenters argued that institutions that use longer
performance periods should be allowed to start the deferral period at
the beginning of the performance period. In this way, they argued, a
payment made at the end of a three-year performance period has already
been deferred for three years for the purposes of the deferral
requirement.
As discussed above, deferral allows for time to pass after the
conclusion of the performance period. It introduces a period of time in
between the end of the performance period and vesting of the incentive-
based compensation during which risks may mature without the employee
taking additional risks to affect that earlier award.
Currently, institutions commonly use long-term incentive plans
without subsequent deferral and thus there is no period following the
multi-year performance period that would permit the covered institution
to apply forfeiture or other reductions should it become clear that the
covered person engaged in inappropriate risk-taking. Without deferral,
the incentive-based compensation is awarded and vests at the end of the
multi-year performance period.\170\ In contrast, during the deferral
period, the covered person's incentive-based compensation award is
fixed and the vesting could be affected by information about a covered
person's risk-taking activities during the performance period that
becomes known during the deferral period.
---------------------------------------------------------------------------

\170\ An employee may be incentivized to take additional risks
near the end of the performance period to attempt to compensate for
poor performance early in the period of the long-term incentive
compensation plan. For example, as noted above, towards the end of a
multi-year performance period, covered persons who have not yet met
the target performance measures could be tempted to amplify risk
taking or take other actions to meet those targets and receive the
maximum long-term incentive plan award with no additional review
applied to the risk-taking activities that were taken during the
defined performance period to achieve those target performance
measures.
---------------------------------------------------------------------------

For a long-term incentive plan, the period of time between the
beginning of the performance period and when incentive-based
compensation is awarded is longer than that of an annual plan. However,
the period of time between the end of the performance period and when
incentive-based compensation is awarded is the same for both the long-
term incentive plan and for the annual plan. Consequently, while a
covered institution may have more information about the risk-taking
activities of a covered person that occurred near the beginning of the
performance period for a long-term incentive plan than for an annual
plan, the covered institution would have no more information about
risk-taking activities that occur near the end of the performance
period. The incentive-based compensation awarded under the long-term
incentive plan would be awarded without the benefit of additional
information about risk-taking activities near the end of the
performance period.
Therefore, the proposed rule would treat incentive-based
compensation awarded under a long-term incentive plan similarly to, but
not the same as, qualifying incentive-based compensation for purposes
of the deferral requirement. Under the proposed rule, the incentive-
based compensation awarded under a long-term incentive plan would be
required to be deferred for a shorter amount of time than qualifying
incentive-based compensation, although the period of time elapsing
between the beginning of the performance period and the actual vesting
would be longer. A shorter deferral period would recognize the fact
that the longer performance period of a long-term incentive plan allows
some time for information to surface about risk-taking activities
undertaken at the beginning of the performance period. The longer
performance period allows covered institutions to adjust the amount
awarded under long-term incentive plans for poor performance during the
performance period. Yet, since no additional time would pass between
risk-taking activities at the end of the performance period and the
award date, the proposed rule would allow a shorter deferral period
than would be necessary for qualifying incentive-based compensation.
The percentage of incentive-based compensation awarded that would
be required to be deferred would be the same for incentive-based
compensation awarded under a long-term incentive plan and for
qualifying incentive-based compensation. However, because of the
difference in the minimum required deferral period, the minimum
deferral amounts for qualifying incentive-based compensation and for
incentive-based compensation awarded under a long-term incentive plan
would be required to be calculated separately. In other words, any
amount of qualifying incentive-based compensation that a covered
institution chooses to defer above the minimum required would not
decrease the minimum amount of incentive-based compensation awarded
under a long-term plan that would be required to be deferred, and vice
versa.
For example, a Level 2 covered institution that awards a senior
executive officer $50,000 of qualifying incentive-based compensation
and $20,000 under a long-term incentive plan would be required to defer
at least $25,000 of the qualifying incentive-based compensation and at
least $10,000 of the amounts awarded under the long-term incentive
plan. The Level 2 covered institution would not be permitted to defer,
for example, $35,000 of qualifying incentive-based compensation and no
amounts awarded under the long-term incentive plan, even though that
would result in the deferral of 50 percent of the senior executive
officer's total incentive-based compensation. For a full example of how
these requirements would work in the context of a more complete
incentive-based compensation arrangement, please see Appendix A of this
preamble.
For incentive-based compensation awarded under a long-term
incentive plan, section __.7(a)(2) of the proposed rule would require
that minimum deferral periods for senior executive officers and
significant risk-takers at a Level 1 covered institution extend to two
years after the award date and minimum deferral periods at a Level 2
covered institution extend to one year after the award date. For long-
term incentive plans with performance periods of three years,\171\ this

[[Page 37724]]

requirement would delay the vesting of the last portion of this
incentive-based compensation until five years after the beginning of
the performance period at Level 1 covered institutions and four years
after the beginning of the performance period at Level 2 covered
institutions. Thus, while the deferral period from the award date is
shorter for incentive-based compensation awarded under a long-term
incentive plan, the delay in vesting from the beginning of the
performance period would generally be the same under the most common
qualifying incentive-based compensation and long-term incentive plans.
---------------------------------------------------------------------------

\171\ Many studies of incentive-based compensation at large
institutions have found that long-term incentive plans commonly have
performance periods of three years. See Cook Report; Moody's Report.
---------------------------------------------------------------------------

Under the proposed rule, the incentive-based compensation that
would be required by the rule to be deferred would not be permitted to
vest faster than on a pro rata annual basis beginning no earlier than
the first anniversary of the end of the performance period. This
requirement would apply to both deferred qualifying incentive-based
compensation and deferred incentive-based compensation awarded under a
long-term incentive plan.
The Federal Banking Agencies have also observed that the minimum
required deferral amounts and deferral periods that would be required
under the proposed rule are generally consistent with industry practice
at larger covered institutions that are currently subject to the 2010
Federal Banking Agency Guidance, although the Agencies recognize that
some institutions would need to revise their individual incentive-based
compensation programs and others were not subject to the 2010 Federal
Banking Agency Guidance. In part because the 2010 Federal Banking
Agency Guidance and compensation regulations imposed by international
regulators \172\ currently encourage banking institutions to increase
the proportion of compensation that is deferred to reflect higher
levels of seniority or responsibility, current practice for the largest
international banking institutions reflects substantial levels of
deferral for such individuals. Many of those individuals would be
senior executive officers and significant risk-takers under the
proposed rule. Under current practice, deferral typically ranges from
40 percent for less senior significant risk-takers to more than 60
percent for senior executives.\173\ The Agencies note that current
practice for the largest international banking institutions reflects
average deferral periods of at least three years.\174\
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\172\ Most members of the FSB, for instance, have issued
regulations, or encourage through guidance and supervisory practice,
deferral standards that meet the minimums set forth in the FSB's
Implementation Standards. See 2015 FSB Compensation Progress Report
(concluding ``almost all FSB jurisdictions have now fully
implemented the P&S for banks.''). The FSB standards state that ``a
substantial portion of variable compensation, such as 40 to 60
percent, should be payable under deferral arrangements over a period
of years and these proportions should increase significantly along
with the level of seniority and/or responsibility. The deferral
period should not be less than three years. See FSB Principles and
Implementation Standards.
\173\ FSB member jurisdictions provided data for the purposes of
the 2015 FSB Compensation Progress Report indicating that while the
percentage of variable remuneration deferred varies significantly
between institutions and across categories of staff, for the
surveyed population of senior executives, the percentage of deferred
incentive-based compensation averaged approximately 50 percent. See
2015 FSB Compensation Progress Report.
\174\ See Moody's Report.
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The deferral requirements of the proposed rule for senior executive
officers and significant risk-takers at the largest covered
institutions are also consistent with international standards on
compensation. The European Union's 2013 law on remuneration paid by
financial institutions requires deferral for large firms, among other
requirements.\175\ The PRA and the FCA initially adopted the European
Union's law and requires covered companies to defer 40 to 60 percent of
``senior manager,'' ``risk manager,'' and ``material risk-taker''
compensation. The PRA and FCA recently updated their implementing
regulations to extend deferral periods to seven years for senior
managers and up to five years for certain other persons.\176\ The
proposed deferral requirements are also generally consistent with the
FSB's Principles for Sound Compensation Practices and their related
implementation standards issued in 2009.\177\ Having standards that are
generally consistent across jurisdictions would be important both to
enable institutions subject to multiple regimes to fulfill the
requirements of all applicable regimes, and to ensure that covered
institutions in the United States would be on a level playing field
compared to their non-U.S. peers in the global competition for talent.
---------------------------------------------------------------------------

\175\ In June 2013, the European Union adopted CRD IV, which
sets out requirements on compensation structures, policies, and
practices that applies to all banks and investment firms subject to
the CRD. CRD IV provides that at least 50 percent of total variable
remuneration should consist of equity-linked interests and at least
40 percent of the variable component must be deferred over a period
of three to five years. Directive 2013/36/EU of the European
Parliament and of the Council of 26 June 2013 (effective January 1,
2014).
\176\ See UK Remuneration Rules. In the case of a material risk-
taker who performs a PRA senior management function, the pro rata
vesting requirement applies only from year three onwards (i.e., the
required deferral period is seven years, with no vesting to take
place until three years after award).
\177\ FSB Principles and Implementation Standards.
---------------------------------------------------------------------------

7.1. The Agencies invite comment on the proposed requirements in
sections __.7(a)(1) and (a)(2).
7.2. Are minimum required deferral periods and percentages
appropriate? If not, why not? Should Level 1 and Level 2 covered
institutions be subject to different deferral requirements, as in the
proposed rule, or should they be treated more similarly for this
purpose and why? Should the minimum required deferral period be
extended to, for example, five years or longer in certain cases and
why?
7.3. Is a deferral requirement for senior executive officers and
significant risk-takers at Level 1 and Level 2 covered institutions
appropriate to promote the alignment of employees' incentives with the
risk undertaken by such covered persons? If not, why not? For example,
comment is invited on whether deferral is generally an appropriate
method for achieving incentive-based compensation arrangements that
appropriately balance risk and reward for each type of senior executive
officer and significant risk-taker at these institutions or whether
there are alternative or more effective ways to achieve such balance.
7.4. Commenters are also invited to address the possible impact
that the required minimum deferral provisions for senior executive
officers and significant risk-takers may have on larger covered
institutions and whether any deferral requirements should apply to
senior executive officers at Level 3 institutions.
7.5. A number of commenters to the 2011 Proposed Rule suggested
that applying a prescriptive deferral requirement, together with other
requirements under that proposal, would make it more difficult for
covered institutions to attract and retain key employees in comparison
to the ability of organizations not subject to such requirements to
recruit and retain the same employees. What implications does the
proposed rule have on ``level playing fields'' between covered
institutions and non-covered institutions in setting forth minimum
deferral requirements under the rule?
7.6. The Agencies invite comment on whether longer performance
periods can provide risk balancing benefits similar to those provided
by deferral, such that the shorter deferral periods for incentive-based
compensation awarded under long-term incentive plans in the proposed
rule would be appropriate.
7.7. Would the proposed distinction between the deferral
requirements for

[[Page 37725]]

qualifying incentive-based compensation and incentive-based
compensation awarded under a long-term incentive plan pose practical
difficulties for covered institutions or increase compliance burdens?
Why or why not?
7.8. Would the requirement in the proposed rule that amounts
awarded under long-term incentive plans be deferred result in covered
institutions offering fewer long-term incentive plans? If so, why and
what other compensation plans will be used in place of long-term
incentive plans and what negative or positive consequences might
result?
7.9. Are there additional considerations, such as tax or accounting
considerations, that may affect the ability of Level 1 or Level 2
covered institutions to comply with the proposed deferral requirement
or that the Agencies should consider in connection with this provision
in the final rule? Commenters on the 2011 Proposed Rule noted that
employees of an investment adviser to a private fund hold partnership
interests and that any incentive allocations paid to them are typically
taxed at the time of allocation, regardless of whether these
allocations have been distributed, and consequently, employees of an
investment adviser to a private fund that would have been subject to
the deferral requirement in the 2011 Proposed Rule would have been
required to pay taxes relating to incentive allocations that they were
required to defer. Should the determination of required deferral
amounts under the proposed rule be adjusted in the context of
investment advisers to private funds and, if so, how? Could the tax
liabilities immediately payable on deferred amounts be paid from the
compensation that is not deferred?
7.10. The Agencies invite comment on the circumstances under which
acceleration of payment should be permitted. Should accelerated vesting
be allowed in cases where employees are terminated without cause or
cases where there is a change in control and the covered institution
ceases to exist and why? Are there other situations for which
acceleration should be allowed? If so, how can such situations be
limited to those of necessity?
7.11. The Agencies received comment on the 2011 Proposed Rule that
stated it was common practice for some private fund adviser personnel
to receive payments in order to enable the recipients to make tax
payments on unrealized income as they became due. Should this type of
practice to satisfy tax liabilities, including tax liabilities payable
on unrealized amounts of incentive-based compensation, be permissible
under the proposed rule, including, for example, as a permissible
acceleration of vesting under the proposed rule? Why or why not? Is
this a common industry practice?

Sec. __.7(a)(3) Adjustments of Deferred Qualifying Incentive-Based
Compensation and Deferred Long-Term Incentive Plan Compensation Amounts

Under section __.7(a)(3) of the proposed rule, during the deferral
period, a Level 1 or Level 2 covered institution would not be permitted
to increase a senior executive or significant risk-taker's unvested
deferred incentive-based compensation.\178\ In other words, any
deferred incentive-based compensation, whether it was awarded as
qualifying incentive-based compensation or under a long-term incentive
plan, would be permitted to vest in an amount equal to or less than the
amount awarded, but would not be permitted to increase during the
deferral period.\179\ Deferred incentive-based compensation may be
decreased, for example, under a forfeiture and downward adjustment
review as would be required under section __.7(b) of the proposed rule,
discussed below. It may also be adjusted downward as a result of
performance that falls short of agreed upon performance measure
targets.
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\178\ This requirement is distinct from the prohibition in
section 8(b) of the proposed rule, discussed below.
\179\ Accelerated vesting would be permitted in limited
circumstances under sections __.7(a)(1)(iii)(B) and
__.7(a)(2)(iii)(B), as described above.
---------------------------------------------------------------------------

As discussed in section 8(b), under some incentive-based
compensation plans, covered persons can be awarded amounts in excess of
their target amounts if the covered institution or covered person's
performance exceed performance targets. As explained in the discussion
on section 8(b), this type of upside leverage in incentive-based
compensation plans may encourage covered persons to take inappropriate
risks. Therefore, the proposed rule would limit maximum payouts to
between 125 and 150 percent of the pre-set target. In a similar vein,
the Agencies are concerned that allowing Level 1 and Level 2 covered
institutions to provide for additional increases in amounts that are
awarded but deferred may encourage senior executive officers and
significant risk-takers to take more risk during the deferral period
and thus may not balance risk-taking incentives. This concern is
especially acute when covered institutions require covered persons to
meet more aggressive goals than those established at the beginning of
the performance period in order to ``re-earn'' already awarded, but
deferred incentive-based compensation.
Although increases in the amount awarded, as described above, would
be prohibited by the proposed rule, increases in the value of deferred
incentive-based compensation due solely to a change in share value, a
change in interest rates, or the payment of reasonable interest or a
reasonable rate of return according to terms set out at the award date
would not be considered increases in the amount awarded for purposes of
this restriction. Thus, a Level 1 or Level 2 covered institution would
be permitted to award incentive-based compensation to a senior
executive officer or significant risk-taker in the form of an equity or
debt instrument, and, if that instrument increased in market value or
included a provision to pay a reasonable rate of interest or other
return that was set at the time of the award, the vesting of the full
amount of that instrument would not be in violation of the proposed
rule.
For an example of how these requirements would work in practice,
please see Appendix A of this SUPPLEMENTARY INFORMATION section.
7.12. The Agencies invite comment on the requirement in section
__.7(a)(3).

Sec. __.7(a)(4) Composition of Deferred Qualifying Incentive-Based
Compensation and Deferred Long-Term Incentive Plan Compensation for
Level 1 and Level 2 Covered Institutions

Section __.7(a)(4) of the proposed rule would require that deferred
qualifying incentive-based compensation or deferred incentive-based
compensation awarded under a long-term incentive plan of a senior
executive officer or significant risk-taker at a Level 1 or Level 2
covered institution meet certain composition requirements.
Cash and Equity-Like Instruments
Covered institutions award incentive-based compensation in a number
of forms, including cash-based awards, equity-like instruments, and in
a smaller number of cases, incentive-based compensation in the form of
debt or debt-like instruments such as deferred cash. First, the
proposed rule would require that, at Level 1 and Level 2 covered
institutions \180\ that issue equity

[[Page 37726]]

or are the affiliates of covered institutions that issue equity,
deferred incentive-based compensation for senior executive officers and
significant risk-takers include substantial portions of both deferred
cash and equity-like instruments throughout the deferral period. The
Agencies recognize that the form of incentive-based compensation that a
senior executive officer or significant risk-taker receives can have an
impact on the incentives provided and thus their behavior. In
particular, having incentive-based compensation in the form of equity-
like instruments can align the interests of the senior executive
officers and significant risk-takers with the interests of the covered
institution's shareholders. Thus, the proposed rule would require that
a senior executive officer's or significant risk-taker's deferred
incentive-based compensation include a substantial portion of equity-
like instruments.
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\180\ In the cases of the Board, FDIC and OCC, this requirement
would not apply to a Level 1 and Level 2 covered institution that
does not issue equity itself and is not an affiliate of an
institution that issues equity. Credit unions and certain mutual
savings associations, mutual savings banks, and mutual holding
companies do not issue equity and do not have a parent that issues
equity. For those institutions, imposing this requirement would have
little benefit, as no equity-like instruments would be based off of
the equity of the covered institution or one of its parents. In the
case of FHFA, this requirement would not apply to a Level 1 or Level
2 covered institution that does not issue equity or is not permitted
by FHFA to use equity-like instruments as compensation for senior
executive officers and significant risk-takers.
---------------------------------------------------------------------------

Similarly, having incentive-based compensation in the form of cash
can align the interests of the senior executive officers and
significant risk-takers with the interests of other stakeholders in the
covered institution.\181\ Thus, the proposed rule would require that a
senior executive officer's or significant risk-taker's deferred
incentive-based compensation include a substantial portion of cash.
---------------------------------------------------------------------------

\181\ Generally, in the case of resolution or bankruptcy,
deferred incentive-based compensation in the form of cash would be
treated similarly to other unsecured debt.
---------------------------------------------------------------------------

The value of equity-like instruments received by a covered person
increases or decreases in value based on the value of the equity of the
covered institution, which provides an implicit method of adjusting the
underlying value of compensation as the share price of the covered
institution changes as a result of better or worse operational
performance. Deferred cash may increase in value over time pursuant to
an interest rate, but its value generally does not vary based on the
performance of the covered institution. These two forms of incentive-
based compensation present a covered person with different incentives
for performance, just as a covered institution itself faces different
incentives when issuing debt or equity-like instruments.\182\
---------------------------------------------------------------------------

\182\ Jensen and Meckling (1976) were the first to point out
that the structure of compensation should reflect all of the
stakeholders in the firm--both equity and debt holders, an idea
further explored by Edmans and Liu (2013). Faulkender et al. (2012)
argue that a compensation program that relies too heavily on stock-
based compensation can lead to excessive risk taking, manipulation,
and distract from long-term value creation. Empirical research has
found that equity-based pay increases risk at financial firms
Balanchandarn et al. 2010). See Jensen and Metcking, ``Theory of the
Firm: Managerial Behavior, Agency Costs, and Ownership Structure,''
3 Journal of Financial Economics 305 (July 1, 1976); Edmans and Liu,
``Inside Debt,'' 15 Review of Finance 75 (June 29, 2011);
Faulkender, Kadyrzhanova, Prabhala, and Senbet, ``Executive
Compensation: An Overview of Research on Corporate Practices and
Proposed Reforms,'' 22 Journal of Applied Corporate Finance 107
(2010); and Balachandran, Kogut, and Harnal, ``The Probability of
Default, Excess Risk and Executive Compensation: A Study of
Financial Service Firms from 1995 to 2008,'' working paper (June
2010), available at https://www.insead.edu/facultyresearch/areas/accounting/events/documents/excess_risk_bank_revisedjune21bk.pdf.
---------------------------------------------------------------------------

For purposes of this proposed rule, the Agencies consider
incentive-based compensation paid in equity-like instruments to include
any form of payment in which the final value of the award or payment is
linked to the price of the covered institution's equity, even if such
compensation settles in the form of cash. Deferred cash can be
structured to share many attributes of a debt instrument. For instance,
while equity-like instruments have almost unlimited upside (as the
value of the covered institution's shares increase), deferred cash that
is structured to resemble a debt instrument can be structured so as to
offer limited upside and can be designed with other features that align
more closely with the interests of the covered institution's
debtholders than its shareholders.\183\
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\183\ There has been a recent surge in research on the use of
compensation that has a payoff structure similar to debt, or
``inside debt.'' See, e.g., Wei and Yermack, ``Investor Reactions to
CEOs Inside Debt Incentives,'' 24 Review of Financial Studies 3813
(2011) (finding that bond prices rise, equity prices fall, and the
volatility of both bond and stock prices fall for firms where the
CEO has sizable inside debt and arguing the results indicate that
firms with higher inside debt have lower risk; Cassell, Huang,
Sanchez, and Stuart, ``Seeking Safety: The Relation between CEO
Inside Debt Holding and the Riskiness of Firm Investment and
Financial Policies,'' 103 Journal of Financial Economics 518 (2012)
(finding higher inside debt is associated with lower volatility of
future firm stock returns, research and development expenditures,
and financial leverage, and more diversification and higher asset
liquidity and empirical research finding that debt holders recognize
the benefits of firms including debt-like components in their
compensation structure); Anantharaman, Divya, Fang, and Gong,
``Inside Debt and the Design of Corporate Debt Contracts,'' 60
Management Science 1260 (2013) (finding that higher inside debt is
associated with a lower cost of debt and fewer debt covenants);
Bennett, Guntay and Unal, ``Inside Debt and Bank Default Risk and
Performance During the Crisis,'' FDIC Center for Financial Research
Working Paper No. 2012-3 (finding that banks that had higher inside
debt before the recent financial crisis had lower default risk and
higher performance during the crisis and that banks with higher
inside debt had supervisory ratings that indicate that they had
stronger capital positions, better management, stronger earnings,
and being in a better position to withstand market shocks in the
future); Srivastav, Abhishek, Armitage, and Hagendorff, ``CEO Inside
Debt Holdings and Risk-shifting: Evidence from Bank Payout
Policies,'' 47 Journal of Banking & Finance 41 (2014) (finding that
banks with higher inside debt holdings have a more conservative
dividend payout policy); Chen, Dou, and Wang, ``Executive Inside
Debt Holdings and Creditors' Demand for Pricing and Non-Pricing
Protections,'' working paper (2010) (finding that higher inside debt
is associated with lower interest rates and less restrictive debt
covenants and that in empirical research, specifically on banks,
similar patterns emerge). In addition, the Squam Lake Group has done
significant work on the use of debt based structures. See, e.g.,
Squam Lake Group, ``Aligning Incentives at Systemically Important
Financial Institutions'' (2013) available at https://www.squamlakegroup.org/Squam%20Lake%20Bonus%20Bonds%20Memo%20Mar%2019%202013.pdf. In their
paper ``Enhancing Financial Stability in the Financial Services
Industry: Contribution of Deferred Cash Compensation,'' forthcoming
in the Federal Reserve Bank of New York's Economic Policy Review
(available at https://www.newyorkfed.org/research/epr/),
Hamid Mehran and Joseph Tracy highlight three channels through which
deferred cash compensation can help mitigate risk: Promoting
conservatism, inducing internal monitoring, and creating a liquidity
buffer.
---------------------------------------------------------------------------

Where possible, it is important for the incentive-based
compensation of senior executive officers and significant risk-takers
at Level 1 and Level 2 covered institutions to have some degree of
balance between the amounts of deferred cash and equity-like
instruments received. With the exception of the limitation of use of
options discussed below, the Agencies propose to provide covered
institutions with flexibility in meeting the general balancing
requirement under section __.7(a)(4)(i) and thus have not proposed
specific percentages of deferred incentive-based compensation that must
be paid in each form.
Similar to the rest of section __.7, the requirement in section
__.7(a)(4)(i) would apply to deferred incentive-based compensation of
senior executive officers and significant risk-takers of Level 1 and
Level 2 covered institutions. As discussed above, these covered persons
are the ones most likely to have a material impact on the financial
health and risk-taking of the covered institution. Importantly for this
requirement, these covered persons are also the most likely to be able
to influence the value of the covered institution's equity and debt.
7.13. The Agencies invite comment on the composition requirement
set out in section __.7(a)(4)(i) of the proposed rule.

[[Page 37727]]

7.14. In order to allow Level 1 and Level 2 covered institutions
sufficient flexibility in designing their incentive-based compensation
arrangements, the Agencies are not proposing a specific definition of
``substantial'' for the purposes of this section. Should the Agencies
more precisely define the term ``substantial'' (for example, one-third
or 40 percent) and if so, should the definition vary among covered
institutions and why? Should the term ``substantial'' be interpreted
differently for different types of senior executive officers or
significant risk-takers and why? What other considerations should the
Agencies factor into level of deferred cash and deferred equity
required? Are there particular tax or accounting implications attached
to use of particular forms of incentive-based compensation, such as
those related to debt or equity?
7.15. The Agencies invite comment on whether the use of certain
forms of incentive-based compensation in addition to, or as a
replacement for, deferred cash or deferred equity-like instruments
would strengthen the alignment between incentive-based compensation and
prudent risk-taking.
7.16. The Agencies invite commenters' views on whether the proposed
rule should include a requirement that a certain portion of incentive-
based compensation be structured with debt-like attributes. Do debt
instruments (as opposed to equity-like instruments or deferred cash)
meaningfully influence the behavior of senior executive officers and
significant risk-takers? If so, how? How could the specific attributes
of deferred cash be structured, if at all, to limit the amount of
interest that can be paid? How should such an interest rate be
determined, and how should such instruments be priced? Which attributes
would most closely align use of a debt-like instrument with the
interest of debt holders and promote risk-taking that is not likely to
lead to material financial loss?
Options
Under section __.7(a)(4)(ii), for senior executive officers and
significant risk-takers at Level 1 and Level 2 covered institutions
that receive incentive-based compensation in the form of options, the
total amount of such options that may be used to meet the minimum
deferral amount requirements is limited to, no more than 15 percent of
the amount of total incentive-based compensation awarded for a given
performance period. A Level 1 or Level 2 covered institution would be
permitted to award incentive-based compensation to senior executive
officers and significant risk-takers in the form of options in excess
of this limitation, and could defer such compensation, but the
incentive-based compensation in the form of options in excess of the 15
percent limit would not be counted towards meeting the minimum deferral
requirements for senior executive officers and significant risk-takers
at these covered institutions.
For example, a Level 1 covered institution might award a
significant risk-taker $100,000 in incentive-based compensation at the
end of a performance period: $80,000 in qualifying incentive-based
compensation, of which $25,000 is in options, and $20,000 under a long-
term incentive plan, all of which is delivered in cash. The Level 1
covered institution would be required to defer at least $40,000 of the
qualifying incentive-based compensation and at least $10,000 of the
amount awarded under the long-term incentive plan. Under the draft
proposed rule, the amount that could be composed of options and count
toward the overall deferral requirement would be limited to 15 percent
of the total amount of incentive-based compensation awarded. In this
example, the Level 1 covered institution could count $15,000 in options
(15 percent of $100,000) toward the requirement to defer $40,000 of
qualifying incentive-based compensation. For an example of how these
requirements would work in the context of a more complete incentive-
based compensation arrangement, please see Appendix A of this preamble.
This requirement would thus limit the total amount of incentive-
based compensation in the form of options that could satisfy the
minimum deferral amounts in sections __.7(a)(1)(i) and __.7(a)(1)(ii).
Any incentive-based compensation awarded in the form of options would,
however, be required to be included in calculating the total amount of
incentive-based compensation awarded in a given performance period for
purposes of calculating the minimum deferral amounts at Level 1 and
Level 2 covered institutions as laid out in sections __.7(a)(1)(i) and
__.7(a)(2)(ii).
Options can be a significant and important part of incentive-based
compensation arrangements at many covered institutions. The Agencies
are concerned, however, that overreliance on options as a form of
incentive-based compensation could have negative effects on the
financial health of a covered institution due to options' emphasis on
upside gains and possible lack of responsiveness to downside
risks.\184\
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\184\ In theory, since the payoffs from holding stock options
are positively related to volatility of stock returns, options
create incentives for executives to increase the volatility of share
prices by engaging in riskier activities. See, e.g., Guay, W.R.,
``The Sensitivity of CEO Weather to Equity Risk: An Analysis of the
Magnitude and Determinants,'' 53 Journal of Financial Economics 43
(1999); Cohen, Hall, and Viceira, ``Do Executive Stock Options
Encourage Risk Taking?'' working paper (2000) available at https://www.people.hbs.edu/lviceira/cohallvic3.pdf; Rajgopal and Shvelin,
``Empirical Evidence on the Relation between Stock Option
Compensation and Risk-Taking,'' 33 Journal of Accounting and
Economics 145 (2002); Coles, Daniel, and Naveen, ``Managerial
Incentives and Risk-Taking,'' 79 Journal of Financial Economics 431
(2006); Chen, Steiner, and Whyte, ``Does Stock Option-Based
Executive Compensation Induce Risk-Taking? An Analysis of the
Banking Industry,'' 30 Journal of Banking & Finance 916 (2006);
Mehran, Hamid and Rosenberg, ``The Effect of Employee Stock Options
on Bank Investment Choice, Borrowing and Capital,'' Federal Reserve
Bank of New York Staff Reports No. 305 (2007) available at https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr305.pdf.
Beyond the typical measures of risk, the academic literature has
found a relation between executive stock option holdings and risky
behavior. See, e.g., Denis, Hanouna, and Sarin, ``Is There a Dark
Side to Incentive Compensation?'' 12 Journal of Corporate Finance
467 (2006) (finding that there is a significant positive association
between the likelihood of securities fraud allegations and the
executive stock option incentives); Bergstresser and Phillippon,
``CEO Incentives and Earnings Management,'' 80 Journal of Financial
Economics 511 (2006) (finding that the use of discretionary accruals
to manipulate reported earnings was more pronounced at firms where
CEO's compensation was more closely tied to stock and option
holdings).
---------------------------------------------------------------------------

The risk dynamic for senior executive officers and significant
risk-takers changes when options are awarded because options offer
asymmetric payoffs for stock price performance. Options may generate
very high payments to covered persons when the market price of a
covered institution's shares rises, representing a leveraged return
relative to shareholders. Payment of incentive-based compensation in
the form of options may therefore increase the incentives under some
market conditions for covered persons to take inappropriate risks in
order to increase the covered institution's short-term share price,
possibly without giving appropriate weight to long-term risks.
Moreover, unlike restricted stock, options are limited in how much
they decrease in value when the covered institution's shares decrease
in value.\185\ Thus, options may not be an effective tool for causing a
covered person to adjust his or her behavior to manage downside risk.
For senior executive officers and significant risk-takers, whose
activities can materially impact the firm's stock price, incentive-
based

[[Page 37728]]

compensation based on options may therefore create greater incentive to
take inappropriate risk or provide inadequate disincentive to manage
risk. For these reasons, the Agencies are proposing to limit to 15
percent the amount permitted to be used in meeting the minimum deferral
requirements.
---------------------------------------------------------------------------

\185\ This would be the case if the current market price for a
share is less than or equal to the option's strike price (i.e., the
option is not ``in the money'').
---------------------------------------------------------------------------

In proposing to limit, but not prohibit, the use of options to
fulfill the proposed rule's deferral requirements, the Agencies have
sought to conservatively apply better practice while still allowing for
some flexibility in the design and operation of incentive-based
compensation arrangements. The Agencies note that supervisory
experience at large banking organizations and analysis of compensation
disclosures, as well as the views of some commenters to the 2011
Proposed Rule, indicate that many institutions have recognized the
risks of options as an incentive and have reduced their use of options
in recent years.
The proposed rule's 15 percent limit on options is consistent with
current industry practice, which is moving away from its historical
reliance on options as part of incentive-based compensation. Since the
financial crisis that began in 2007, institutions on their own
initiative and those working with the Board have decreased the use of
options in incentive-based compensation arrangements generally such
that for most organizations options constitute no more than 15 percent
of an institution's total incentive-based compensation. Restricted
stock unit awards have now emerged as the most common form of equity
compensation and are more prevalent than stock options at all employee
levels.\186\ Further, a sample of publicly available disclosures from
large covered institutions shows minimal usage of stock options among
CEOs and other named executive officers; out of a sample of 14 covered
institutions reviewed by the Agencies, only two covered institutions
awarded stock options as part of their incentive-based compensation in
2015. Only one of those two covered institutions awarded options in
excess of 15 percent of total compensation, and the excess was small.
Thus, the proposed rule's limit on options has been set at a level that
would, in the Agencies' views, help mitigate concerns about the use of
options in incentive-based compensation while still allowing
flexibility for covered institutions to use options in a manner that is
consistent with the better practices that have developed following the
recent financial crisis.\187\
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\186\ Bachelder, Joseph E., ``What Has Happened To Stock
Options,'' New York Law Journal (September 19, 2014).
\187\ Rajgopal and Shvelin, ``Empirical Evidence on the Relation
between Stock Option Compensation and Risk-Taking,'' 33 Journal of
Accounting and Economics 145 (2002); Bettis, Bizjak, and Lemmon,
``Exercise Behavior, Valuation, and the Incentive Effects of
Employee Stock Options,'' 76 Journal of Financial Economics 445; ISS
Compensation FAQs.
---------------------------------------------------------------------------

7.17. The Agencies invite comment on the restrictions on the use of
options in incentive-based compensation in the proposed rule. Should
the percent limit be higher or lower and if so, why? Should options be
permitted to be used to meet the deferral requirements of the rule? Why
or why not? Does the use of options by covered institutions create,
reduce, or have no effect on the institution's risk of material
financial loss?
7.18. Does the proposed 15 percent limit appropriately balance the
benefits of using options (such as aligning the recipient's interests
with that of shareholders) and drawbacks of using options (such as
their emphasis on upside gains)? Why or why not? Is the proposed 15
percent limit the appropriate limit, or should it be higher or lower?
If it should be higher or lower, what should the limit be, and why?
7.19. Are there alternative means of addressing the concerns raised
by options as a form of incentive-based compensation other than those
proposed?

Sec. __.7(b) Forfeiture and Downward Adjustment

Section __.7(b) of the proposed rule would require Level 1 and
Level 2 covered institutions to place incentive-based compensation of
senior executive officers and significant risk-takers at risk of
forfeiture and downward adjustment and to subject incentive-based
compensation to a forfeiture and downward adjustment review under a
defined set of circumstances. As described below, a forfeiture and
downward adjustment review would be required to identify senior
executive officers or significant risk-takers responsible for the
events or circumstances triggering the review. It would also be
required to consider certain factors when determining the amount or
portion of a senior executive officer's or significant risk-taker's
incentive-based compensation that should be forfeited or adjusted
downward.
In general, the forfeiture and downward adjustment review
requirements in section __.7(b) would require a Level 1 or Level 2
covered institution to consider reducing some or all of a senior
executive officer's or significant risk-taker's incentive-based
compensation when the covered institution becomes aware of
inappropriate risk-taking or other aspects of behavior that could lead
to material financial loss. The amount of incentive-based compensation
that would be reduced would depend upon the severity of the event, the
impact of the event on the covered institution, and the actions of the
senior executive officer or significant risk-taker in the event. The
covered institution could accomplish this reduction of incentive-based
compensation by reducing the amount of unvested deferred incentive-
based compensation (forfeiture), by reducing the amount of incentive-
based compensation not yet awarded for a performance period that has
begun (downward adjustment), or through a combination of both
forfeiture and downward adjustment. The Agencies have found that the
possibility of a reduction in incentive-based compensation in the
circumstances identified in section __.7(b)(2) of the rule is needed in
order to properly align financial reward with risk-taking by senior
executive officers and significant risk-takers at Level 1 and Level 2
covered institutions.
The possibility of forfeiture and downward adjustment under the
proposed rule would play an important role not only in better aligning
incentive-based compensation payouts with long-run risk outcomes at the
covered institution but also in reducing incentives for senior
executive officers and significant risk-takers to take inappropriate
risk that could lead to material financial loss at the covered
institution. The proposed rule would also require covered institutions,
through policies and procedures,\188\ to formalize the governance and
review processes surrounding such decision-making, and to document the
decisions made.
---------------------------------------------------------------------------

\188\ See sections __.11(b) and __.11(c).
---------------------------------------------------------------------------

While forfeiture and downward adjustment reviews would be required
components of incentive-based compensation arrangements for senior
executive officers and significant risk-takers at Level 1 and Level 2
covered institutions under the proposed rule, and are one way for
covered institutions to take into account information about performance
that becomes known over time, such reviews would not alone be
sufficient to appropriately balance risk and reward, as would be
required under section __.4(c)(1). Incentive-based compensation
arrangements for those

[[Page 37729]]

covered persons would also be required to comply with the specific
requirements of sections __.4(d), __.7(a), __.7(c) and __.8. As
discussed above, to achieve balance between risk and reward, covered
institutions should examine incentive-based compensation arrangements
as a whole, and consider including provisions for risk adjustments
before the award is made, and for adjustments resulting from forfeiture
and downward adjustment review during the deferral period.

Sec. __.7(b)(1) Compensation at Risk

Under the proposed rule, a Level 1 or Level 2 covered institution
would be required to place at risk of forfeiture 100 percent of a
senior executive officer's or significant risk-taker's deferred and
unvested incentive-based compensation, including unvested deferred
amounts awarded under long-term incentive plans. Additionally, a Level
1 or Level 2 covered institution would be required to place at risk of
downward adjustment all of a senior executive officer's or significant
risk-taker's incentive-based compensation that has not yet been
awarded, but that could be awarded for a performance period that is
underway and not yet completed.
Forfeiture and downward adjustment give covered institutions an
appropriate set of tools through which consequences may be imposed on
individual risk-takers when inappropriate risk-taking or misconduct,
such as the events identified in section __.7(b)(2), occur or are
identified. They also help ensure that a sufficient amount of
compensation is at risk. Certain risk management failures and
misconduct can take years to manifest, and forfeiture and downward
adjustment reviews provide covered institutions an opportunity to
adjust the ultimate amount of incentive-based compensation that vests
based on information about risk-taking or misconduct that comes to
light after the performance period. A senior executive officer or
significant risk-taker should not be rewarded for inappropriate risk-
taking or misconduct, regardless of when the covered institution learns
of it.
Some evidence of inappropriate risk taking, risk management
failures and misconduct may not be immediately apparent to the covered
institution. To provide a strong disincentive for senior executive
officers and significant risk-takers to engage in such conduct, which
may lead to material financial loss to the covered institution, the
Agencies are proposing to require that all unvested deferred incentive-
based compensation and all incentive-based compensation eligible to be
awarded for the performance period in which the covered institution
becomes aware of the conduct be available for forfeiture and downward
adjustment under the forfeiture and downward adjustment review. A
covered institution would be required to consider all incentive-based
compensation available, in the form of both unvested deferred
incentive-based compensation and yet-to-be awarded incentive-based
compensation, when considering forfeiture or downward adjustments, even
if the incentive-based compensation does not specifically relate to the
performance in the period in which the relevant event occurred.
For example, a significant risk-taker of a Level 1 covered
institution might engage in misconduct in June 2025, but the Level 1
covered institution might not become aware of the misconduct until
September 2028. The Level 1 covered institution would be required to
consider downward adjustment of any amounts available under any of the
significant risk-taker's incentive-based compensation plans with
performance periods that are still in progress as of September 2028
(for example, an annual plan with a performance period that runs from
January 1, 2028, to December 31, 2028, or a long-term incentive plan
with a performance period that runs from January 1, 2027, to December
31, 2030). The Level 1 covered institution would also be required to
consider forfeiture of any amounts that are deferred, but not yet
vested, as of September 2028 (for example, amounts that were awarded
for a performance period that ran from January 1, 2026, to December 31,
2026, and that have been deferred and do not vest until December 31,
2030). For an additional example of how these requirements would work
in practice, please see Appendix A of this Supplementary Information
section.

Sec. __.7(b)(2) Events Triggering Forfeiture and Downward Adjustment
Review

Section __.7(b) of the proposed rule would require a Level 1 or
Level 2 covered institution to conduct a forfeiture and downward
adjustment review based on certain identified adverse outcomes.
Under section __.7(b), events \189\ that would be required to
trigger a forfeiture and downward adjustment review include: (1) Poor
financial performance attributable to a significant deviation from the
risk parameters set forth in the covered institution's policies and
procedures; (2) inappropriate risk-taking, regardless of the impact on
financial performance; (3) material risk management or control
failures; and (4) non-compliance with statutory, regulatory, or
supervisory standards that results in: Enforcement or legal action
against the covered institution brought by a Federal or state regulator
or agency; or a requirement that the covered institution report a
restatement of a financial statement to correct a material error.
Covered institutions would be permitted to define additional triggers
based on conduct or poor performance. Generally, in the Agencies'
supervisory experience as earlier described, the triggers are
consistent with current practice at the largest financial institutions,
although many covered institutions have triggers that are more granular
in nature than those proposed and cover a wider set of adverse
outcomes. The proposed enumerated adverse outcomes are a set of minimum
standards.
---------------------------------------------------------------------------

\189\ The underlying, or contractual, forfeiture language used
by institutions need not be identical to the triggers enumerated in
this section, provided the covered institution's triggers capture
the full set of outcomes outlined in section 7(b)(2) of the rule.
For example, a trigger at a covered institution that read ``if an
employee improperly or with gross negligence fails to identify,
raise, or assess, in a timely manner and as reasonably expected,
risks and/or concerns with respect to risks material to the
institution or its business activities,'' would be considered
consistent with the minimum parameters set forth in the trigger
identified in section 7(b)(2)(ii) of the rule.
---------------------------------------------------------------------------

As discussed later in this SUPPLEMENTARY INFORMATION section,
covered institutions would be required to provide for the independent
monitoring of all events related to forfeiture and downward
adjustment.\190\ When such monitoring, or other risk surveillance
activity, reveals the occurrence of events triggering forfeiture and
downward adjustment reviews, Level 1 and Level 2 covered institutions
would be required to conduct those reviews in accordance with section
__.7(b). Covered institutions may choose to coordinate the monitoring
for triggering events under section __.9(c)(2) and the forfeiture and
downward adjustment reviews with broader risk surveillance activities.
Such coordinated reviews could take place on a schedule identified by
the covered institution. Schedules may vary among covered institutions,
but they should occur often enough to appropriately monitor risks and
events related to forfeiture and downward adjustment. Larger covered
institutions with more complex operations are likely to need to conduct
more frequent

[[Page 37730]]

reviews to ensure effective risk management.
---------------------------------------------------------------------------

\190\ See section __.9(c)(2).
---------------------------------------------------------------------------

Poor financial performance can indicate that inappropriate risk-
taking has occurred at a covered institution. The Agencies recognize
that not all inappropriate risk-taking does, in fact, lead to poor
financial performance, but given the risks that are posed to the
covered institutions by poorly designed incentive-based compensation
programs and the statutory mandate of section 956, it is appropriate to
prohibit incentive-based compensation arrangements that reward such
inappropriate risk-taking. Therefore, if evidence of past inappropriate
risk-taking becomes known, the proposed rule would require a Level 1 or
Level 2 covered institution to perform a forfeiture and downward
adjustment review in order to assess whether the relevant senior
executive officer's or significant risk-taker's incentive-based
compensation should be affected by the inappropriate risk-taking.
Similarly, material risk management or control failures may allow
for inappropriate risk-taking that may lead to material financial loss
at a covered institution. Because the role of senior executive officers
and significant risk-takers, including those in risk management and
other control functions whose role is to identify, measure, monitor,
and control risk, the material failure by covered persons to properly
perform their responsibilities can be especially likely to put an
institution at risk. Thus, if evidence of past material risk management
or control failures becomes known, the proposed rule would require a
Level 1 or Level 2 covered institution to perform a forfeiture and
downward adjustment review, to assess whether a senior executive
officer or significant risk-taker's incentive-based compensation should
be affected by the risk management or control failure. Examples of risk
management or control failures would include failing to properly
document or report a transaction or failing to properly identify and
control the risks that are associated with a transaction. In each case,
the risk management or control failure, if material, could allow for
inappropriate risk-taking at a covered institution that could lead to
material financial loss.
Finally, a covered institution's non-compliance with statutory,
regulatory, or supervisory standards may also reflect inappropriate
risk-taking that may lead to material financial loss at a covered
institution. The proposed rule would require a forfeiture and downward
adjustment review whenever any such non-compliance (1) results in an
enforcement or legal action against the covered institution brought by
a Federal or state regulator or agency; or (2) requires the covered
institution to restate a financial statement to correct a material
error. The Federal Banking Agencies have found that it is appropriate
for a covered institution to conduct a forfeiture and downward
adjustment review under these circumstances because in many cases a
statutory, regulatory, or supervisory standard may have been put in
place in order to prevent a covered person from taking an inappropriate
risk. In addition, non-compliance with a statute, regulation, or
supervisory standard may also give rise to inappropriate compliance
risk for a covered institution. A forfeiture and downward adjustment
review would allow the institution to assess whether this type of non-
compliance should affect a senior executive officer or significant
risk-taker's incentive-based compensation.

Sec. __.7(b)(3) Senior Executive Officers and Significant Risk-Takers
Affected by Forfeiture and Downward Adjustment

A forfeiture and downward adjustment review would be required to
consider forfeiture and downward adjustment of incentive-based
compensation for a senior executive officer and significant risk-taker
with direct responsibility or responsibility due to the senior
executive officer or significant risk-taker's role or position in the
covered institution's organizational structure, for the events that
would trigger a forfeiture and downward adjustment review as described
in section __.7(b)(2). Covered institutions should consider not only
senior executive officers or significant risk-takers who are directly
responsible for an event that triggers a forfeiture or downward
adjustment review, but also those senior executive officers or
significant risk-takers whose roles and responsibilities include areas
where failures or poor performance contributed to, or failed to
prevent, a triggering event. This requirement would discourage senior
executive officers and significant risk-takers who can influence
outcomes from failing to report or prevent inappropriate risk. A
covered institution conducting a forfeiture and downward adjustment
review may also consider forfeiture for other covered persons at its
discretion.

Sec. __.7(b)(4) Determining Forfeiture and Downward Adjustment Amounts

The proposed rule sets out factors that Level 1 and Level 2 covered
institutions must consider, at a minimum, when making a determination
to reduce incentive-based compensation as a result of a forfeiture or
downward adjustment review. A Level 1 or Level 2 covered institution
would be responsible for determining how much of a reduction in
incentive-based compensation is warranted, consistent with the policies
and procedures it establishes under Sec. __.11(b), and should be able
to support its decisions that such an adjustment was appropriate if
requested by its appropriate Federal regulator. In reducing the amount
of incentive-based compensation, covered institutions may reduce the
dollar amount of deferred cash or cash to be awarded, may lower the
amount of equity-like instruments that have been deferred or were
eligible to be awarded, or some combination thereof. A reduction in the
value of equity-like instruments due to market fluctuations would not
be considered a reduction for purposes of this review.
The proposed minimum factors that would be required to be
considered when determining the amount of incentive-based compensation
to be reduced are: (1) The intent of the senior executive officer or
significant risk-taker to operate outside the risk governance framework
approved by the covered institution's board of directors or to depart
from the covered institution's policies and procedures; (2) the senior
executive officer's or significant risk-taker's level of participation
in, awareness of, and responsibility for, the events triggering the
review; (3) any actions the senior executive officer or significant
risk-taker took or could have taken to prevent the events triggering
the review; (4) the financial and reputational impact of the events
\191\ triggering the review as set forth in section __.7(b)(2) on the
covered institution, the line or sub-line of business, and individuals
involved, as applicable, including the magnitude of any financial loss
and the cost of known or potential subsequent fines, settlements, and
litigation; (5) the causes of the events triggering the review,
including any decision-making

[[Page 37731]]

by other individuals; and (6) any other relevant information, including
past behavior and risk outcomes linked to past behavior attributable to
the senior executive officer or significant risk-taker.
---------------------------------------------------------------------------

\191\ Reputational impact or harm related to the actions of
covered individuals refers to a potential weakening of confidence in
an institution as evidenced by negative reactions from customers,
shareholders, bondholders and other creditors, consumer and
community groups, the press, or the general public. Reputational
impact is a factor currently considered by some institutions in
their existing forfeiture policies. See, e.g., Wells Fargo & Company
2016 Proxy Statement, page 47, available at https://www08.wellsfargomedia.com/assets/pdf/about/investor-relations/annual-reports/2016-proxy-statement.pdf; and Citigroup 2016 Proxy
Statement, page 74, available at https://www.citigroup.com/citi/investor/quarterly/2016/ar16cp.pdf?ieNocache=611.
---------------------------------------------------------------------------

The considerations identified constitute a minimum set of
parameters that would be utilized for exercising the discretion
permissible under the proposed rule while still holding senior
executive officers and significant risk-takers accountable for
inappropriate risk-taking and other behavior that could encourage
inappropriate risk-taking that could lead to risk of material financial
loss at covered institutions. For example, a covered institution might
identify a pattern of misconduct stemming from activities begun three
years before the review that ultimately leads to an enforcement action
and reputational damage to the covered institution. A review of facts
and circumstances, including consideration of the minimum review
parameters set forth in the proposed rule, could reveal that one
individual knowingly removed transaction identifiers in order to
facilitate a trade or trades with a counterparty on whom regulators had
applied Bank Secrecy Act or Anti-Monetary Laundering sanctions. Several
of the senior executive officer's or significant risk-taker's peers
might have been aware of this pattern of behavior but did not report it
to their managers. Under the proposed rule, the individual who
knowingly removed the identifiers would, in most cases, be subject to a
greater reduction in incentive-based compensation than those who were
aware of but not participants in the misconduct. However, those peers
that were aware of the misconduct, managers supervising the covered
person directly involved in the misconduct, and control staff who
should have detected but failed to detect the behavior would be
considered for a reduction, depending on their role in the
organization, and assuming the peers are now senior executive officers
or significant risk-takers.
The Agencies do not intend for these proposed factors to be
exhaustive and covered institutions should consider additional factors
where appropriate. In addition, covered institutions generally should
impact incentive-based compensation as a result of forfeiture and
downward adjustment reviews to reflect the severity of the event that
triggered the review and the level of an individual's involvement.
Covered institutions should be able to demonstrate to the appropriate
Federal regulator that the impact on incentive-based compensation was
appropriate given the particular set of facts and circumstances.
7.20. The Agencies invite comment on the forfeiture and downward
adjustment requirements of the proposed rule.
7.21. Should the rule limit the events that require a Level 1 or
Level 2 covered institution to consider forfeiture and downward
adjustment to adverse outcomes that occurred within a certain time
period? If so, why and what would be an appropriate time period? For
example, should the events triggering forfeiture and downward
adjustment reviews be limited to those events that occurred within the
previous seven years?
7.22. Should the rule limit forfeiture and downward adjustment
reviews to reducing only the incentive-based compensation that is
related to the performance period in which the triggering event(s)
occurred? Why or why not? Is it appropriate to subject unvested or
unawarded incentive-based compensation to the risk of forfeiture or
downward adjustment, respectively, if the incentive-based compensation
does not specifically relate to the performance in the period in which
the relevant event occurred or manifested? Why or why not?
7.23. Should the rule place all unvested deferred incentive-based
compensation, including amounts voluntarily deferred by Level 1 and
Level 2 covered institutions or senior executive officers or
significant risk-takers, at risk of forfeiture? Should only that
unvested deferred incentive-based compensation that is required to be
deferred under section __.7(a) be at risk of forfeiture? Why or why
not?
7.24. Are the events triggering a review that are identified in
section __.7(b)(2) comprehensive and appropriate? If not, why not?
Should the Agencies add ``repeated supervisory actions'' as a
forfeiture or downward adjustment review trigger and why? Should the
Agencies add ``final enforcement or legal action'' instead of the
proposed ``enforcement or legal action'' and why?
7.25. Is the list of factors that a Level 1 or Level 2 covered
institution must consider, at a minimum, in determining the amount of
incentive-based compensation to be forfeited or downward adjusted by a
covered institution appropriate? If not, why not? Are any of the
factors proposed unnecessary? Should additional factors be included?
7.26. Are the proposed parameters for forfeiture and downward
adjustment review sufficient to provide an appropriate governance
framework for making forfeiture decisions while still permitting
adequate discretion for covered institutions to take into account
specific facts and circumstances when making determinations related to
a wide variety of possible outcomes? Why or why not?
7.27. Should the rule include a presumption of some amount of
forfeiture for particularly severe adverse outcomes and why? If so,
what should be the amount and what would those outcomes be?
7.28. What protections should covered institutions employ when
making forfeiture and downward adjustment determinations?
7.29. In order to determine when forfeiture and downward adjustment
should occur, should Level 1 and Level 2 covered institutions be
required to establish a formal process that both looks for the
occurrence of trigger events and fulfills the requirements of the
forfeiture and downward adjustment reviews under the proposed rule? If
not, why not? Should covered institutions be required as part of the
forfeiture and downward adjustment review process to establish formal
review committees including representatives of control functions and a
specific timetable for such reviews? Should the answer to this question
depend on the size of the institution considered?

Sec. __.7(c) Clawback

As used in the proposed rule, the term ``clawback'' means a
mechanism by which a covered institution can recover vested incentive-
based compensation from a covered person. The proposed rule would
require Level 1 and Level 2 covered institutions to include clawback
provisions in incentive-based compensation arrangements for senior
executive officers and significant risk-takers that, at a minimum,
would allow for the recovery of up to 100 percent of vested incentive-
based compensation from a current or former senior executive officer or
significant risk-taker for seven years following the date on which such
compensation vests. Under section __.7(c) of the proposed rule, all
vested incentive-based compensation for senior executive officers and
significant risk-takers, whether it had been deferred before vesting or
paid out immediately upon award, would be required to be subject to
clawback for a period of no less than seven years following the date on
which such incentive-based compensation vests. Clawback would be
exercised under an identified set of circumstances. These circumstances
include situations where a senior executive officer or significant
risk-taker engaged in: (1) Misconduct that resulted in significant
financial or

[[Page 37732]]

reputational harm \192\ to the covered institution; (2) fraud; or (3)
intentional misrepresentation of information used to determine the
senior executive officer's or significant risk-taker's incentive-based
compensation.\193\ The clawback provisions would apply to all vested
incentive-based compensation, whether that incentive-based compensation
had been deferred or paid out immediately when awarded. If a Level 1 or
Level 2 covered institution discovers that a senior executive officer
or significant risk-taker was involved in one of the triggering
circumstances during a past performance period, the institution would
potentially be able to recover from that senior executive officer or
significant risk-taker incentive-based compensation that was awarded
for that performance period and has already vested. A covered
institution could require clawback irrespective of whether the senior
executive officer or significant risk-taker was currently employed by
the covered institution.
---------------------------------------------------------------------------

\192\ As described in the above note 191, reputational impact or
harm of an event related to the actions of covered individuals
refers to a potential weakening of confidence in an institution as
evidenced by negative reactions from customers, shareholders,
bondholders and other creditors, consumer and community groups, the
press, or the general public.
\193\ As with other provisions in this proposed rule, the
clawback requirement would not apply to incentive-based compensation
plans and arrangements in place at the time the proposed rule is
final because those plans and arrangements would be grandfathered.
---------------------------------------------------------------------------

The proposed set of triggering circumstances would constitute a
minimum set of outcomes for which covered institutions would be
required to consider recovery of vested incentive-based compensation.
Covered institutions would retain flexibility to include other
circumstances or outcomes that would trigger additional use of such
provisions.
In addition, while the proposed rule would require the inclusion of
clawback provisions in incentive-based compensation arrangements, the
proposed rule would not require that Level 1 or Level 2 covered
institutions exercise the clawback provision, and the proposed rule
does not prescribe the process that covered institutions should use to
recover vested incentive-based compensation. Facts, circumstances, and
all relevant information should determine whether and to what extent it
is reasonable for a Level 1 or Level 2 covered institution to seek
recovery of any or all vested incentive-based compensation.
The Agencies recognize that clawback provisions may provide another
effective tool for Level 1 and Level 2 covered institutions to deter
inappropriate risk-taking because it lengthens the time horizons of
incentive-based compensation.\194\ The Agencies are proposing that
vested incentive-based compensation be subject to clawback for up to
seven years. The Agencies are proposing seven years as the length of
the review period because it is slightly longer than the length of the
average business cycle in the United States and is close to the lower
end of the range of average credit cycles.\195\ Also, the Agencies
observe that seven years is consistent with some international
standards.\196\
---------------------------------------------------------------------------

\194\ See, e.g., Faulkender, Kadyrzhanova, Prabhala, and Senbet,
``Executive Compensation: An Overview of Research on Corporate
Practices and Proposed Reforms,'' 22 Journal of Applied Corporate
Finance 107 (2010) (arguing that clawbacks guard against
compensating executives for luck rather than long-term performance);
Babenko, Bennett, Bizjak and Coles, ``Clawback Provisions,'' working
paper (2015) available at https://wpcarey.asu.edu/sites/default/files/uploads/department-finance/clawbackprovisions.pdf (finding
that the use of clawback provisions are associated with lower
institution risk); Chen, Greene, and Owers, ``The Costs and Benefits
of Clawback Provisions in CEO Compensation,'' 4 Review of Corporate
Finance Studies 108 (2015) (finding that the use of clawback
provisions are associated with higher reporting quality).
\195\ See supra note 154.
\196\ See, e.g., PRA, ``Policy Statement PS7/14: Clawback''
(July 2014), available at https://www.bankofengland.co.uk/pra/Documents/publications/ps/2014/ps714.pdf.
---------------------------------------------------------------------------

By proposing seven years as the length of the review period, the
Agencies intend to encourage institutions to fairly compensate covered
persons and incentivize appropriate risk-taking, while also recognizing
that recovering amounts that have already been paid is more difficult
than reducing compensation that has not yet been paid. The Agencies are
concerned that a clawback period that is too short or one that is too
long, or even infinite, could result in the covered person ignoring or
discounting the effect of the clawback period and accordingly, could be
less effective in balancing risk-taking. Additionally, a very long or
even infinite clawback period may be difficult to implement.
While the Agencies did not propose a clawback requirement in the
2011 Proposed Rule, mandatory clawback provisions are not a new
concept. Commenters to the 2011 Proposed Rule advocated that the
Agencies adopt measures to allow shareholders (and others) to recover
incentive-based compensation already paid to covered persons. As
discussed above, clawback provisions are now increasingly common at the
largest financial institutions. The largest (and mostly publicly
traded) covered institutions are already subject to a number of
overlapping clawback regimes as a result of statutory
requirements.\197\ Over the past several years, many financial
institutions have further refined such mechanisms.\198\ Most often,
clawbacks allow banking institutions to recoup incentive-based
compensation in cases of financial restatement, misconduct, or poor
financial outcomes. A number of covered institutions have gone beyond
these minimum parameters to include situations where poor risk
management has led to financial or reputational damage to the
firm.\199\ The Agencies were cognizant of these developments in
proposing the clawback provision in section __.7(c).
---------------------------------------------------------------------------

\197\ See, e.g., section 304 of the Sarbanes-Oxley Act of 2002,
15 U.S.C. 7243; section 111 of the Emergency Economic Stabilization
Act of 2008, 12 U.S.C. 5221; section 210(s) of the Dodd-Frank Act,
12 U.S.C. 5390(s); section 954 of the Dodd-Frank Act, 15 U.S.C. 78j-
4(b).
\198\ See, e.g., PricewaterhouseCoopers, ``Executive
Compensation: Clawbacks, 2014 Proxy Disclosure Study'' (January
2015), available at https://www.pwc.com/us/en/hr-management/publications/assets/pwc-executive-compensation-clawbacks-2014.pdf;
Compensation Advisory Partners, ``2014 Proxy Season: Changing
Practices in Executive Compensation: Clawback, Hedging, and Pledging
Policies'' (December 17, 2014), available at https://www.capartners.com/uploads/news/id204/capartners.com-capflash-issue62.pdf.
\199\ See, e.g., JPMorgan Chase & Company 2015 Proxy Statement,
page 56, available at https://files.shareholder.com/downloads/ONE/1425504805x0x820065/4c79f471-36d9-47d4-a0b3-7886b0914c92/JPMC-2015-ProxyStatementl.pdf (where vested compensation is subject to
clawback if, among other things, ``the employee engaged in conduct
detrimental to the Firm that causes material financial or
reputational harm to the Firm'').
---------------------------------------------------------------------------

The Agencies propose the three triggers referenced above for
several reasons. First, a number of the specified triggers reflect
better practice at covered institutions today.\200\ The factors
triggering clawback are based on existing clawback requirements that
appear in some covered institutions' incentive-based compensation
arrangements. Second, while many of the clawback regulatory regimes
currently in place focus only on accounting restatements or material
misstatements of financial results, the proposed triggers focus more
broadly on risk-related outcomes that are more likely to contribute
meaningfully to the balance of incentive-based compensation
arrangements. Third, the proposed rule would extend coverage of

[[Page 37733]]

clawback mechanisms to include additional senior executive officers or
significant risk-takers whose inappropriate risk-taking may not result
in an accounting restatement, but would inflict harm on the covered
institution nonetheless.
---------------------------------------------------------------------------

\200\ See, e.g., notes 198 and 199. See also Dawn Kopecki, ``JP
Morgan's Drew Forfeits 2 Years' Pay as Managers Ousted,'' Bloomberg
Business (July 13, 2012); Dolia Estevez, ``Pay Slash to Citigroup's
Top Mexican Executive Called `Humiliating,' '' Forbes (March 13,
2014); Eyk Henning, ``Deutsche Bank Cuts Co-CEOs' Compensation,''
Wall Street Journal (March 20, 2015).
---------------------------------------------------------------------------

This provision would go beyond, but not conflict with, clawback
provisions in other areas of law.\201\ For example, covered
institutions that issue securities also may be subject to clawback
requirements pursuant to statutes administered by the SEC:
---------------------------------------------------------------------------

\201\ See, e.g., section 304 of the Sarbanes-Oxley Act of 2002,
15 U.S.C. 7243; section 111 of the Emergency Economic Stabilization
Act of 2008, 12 U.S.C. 5221; section 210(s) of the Dodd-Frank Act,
12 U.S.C. 5390(s); section 954 of the Dodd-Frank Act, 15 U.S.C. 78j-
4(b).
---------------------------------------------------------------------------

[cir] Section 304 of the Sarbanes-Oxley Act of 2002 \202\ provides
that if an issuer is required to prepare an accounting restatement due
to the material noncompliance of the issuer, as a result of misconduct,
with any financial reporting requirements under the securities laws,
the CEO and chief financial officer of the issuer shall reimburse the
issuer for (i) any bonus or other incentive-based or equity-based
compensation received by that person from the issuer during the 12-
month period following the first public issuance or filing with the SEC
(whichever first occurs) of the financial document embodying such
financial reporting requirement and (ii) any profits realized from the
sale of securities of the issuer during that 12-month period.
---------------------------------------------------------------------------

\202\ 15 U.S.C. 7243.
---------------------------------------------------------------------------

[cir] Section 954 of the Dodd-Frank Act added Section 10D to the
Securities Exchange Act of 1934.\203\ Specifically, Section 10D(a) of
the Securities Exchange Act requires the SEC to adopt rules directing
the national securities exchanges \204\ and the national securities
associations \205\ to prohibit the listing of any security of an issuer
that is not in compliance with the requirements of Section 10D(b).
Section 10D(b) requires the SEC to adopt rules directing the exchanges
to establish listing standards to require each issuer to develop and
implement a policy providing: (1) For the disclosure of the issuer's
policy on incentive-based compensation that is based on financial
information required to be reported under the securities laws; and (2)
that, in the event that the issuer is required to prepare an accounting
restatement due to the issuer's material noncompliance with any
financial reporting requirement under the securities laws, the issuer
will recover from any of the issuer's current or former executive
officers who received incentive-based compensation (including stock
options awarded as compensation) during the three-year period preceding
the date the issuer is required to prepare the accounting restatement,
based on the erroneous data, in excess of what would have been paid to
the executive officer under the accounting restatement.
---------------------------------------------------------------------------

\203\ 15 U.S.C. 78a et seq.
\204\ A ``national securities exchange'' is an exchange
registered as such under section 6 of the Exchange Act (15 U.S.C.
78f). There are currently 18 exchanges registered under Section 6(a)
of the Exchange Act: BATS Exchange, BATS Y-Exchange, BOX Options
Exchange, C2 Options Exchange, Chicago Board Options Exchange,
Chicago Stock Exchange, EDGA Exchange, EDGX Exchange, International
Securities Exchange (``ISE''), ISE Gemini, Miami International
Securities Exchange, NASDAQ OMX BX, NASDAQ OMX PHLX, The NASDAQ
Stock Market, National Stock Exchange, New York Stock Exchange
(``NYSE''), NYSE Arca and NYSE MKT.
\205\ A ``national securities association'' is an association of
brokers and dealers registered as such under Section 15A of the
Exchange Act (15 U.S.C. 78o-3). The Financial Industry Regulatory
Authority (``FINRA'') is the only association registered with the
SEC under section 15A(a) of the Exchange Act, but FINRA does not
list securities.
---------------------------------------------------------------------------

The SEC has proposed rules to implement the requirements of
Exchange Act Section 10D.\206\
---------------------------------------------------------------------------

\206\ Listing Standards for Recovery of Erroneously Awarded
Compensation, Release No. 33-9861 (July 1, 2015), 80 FR 41144 (July
14, 2015).
---------------------------------------------------------------------------

7.30. The Agencies invite comment on the clawback requirements of
the proposed rule.
7.31. Is a clawback requirement appropriate in achieving the goals
of section 956? If not, why not?
7.32. Is the seven-year period appropriate? Why or why not?
7.33. Are there state contract or employment law requirements that
would conflict with this proposed requirement? Are there challenges
that would be posed by overlapping Federal clawback regimes? Why or why
not?
7.34. Do the triggers discussed above effectively achieve the goals
of section 956? Should the triggers be based on those contained in
section 954 of the Dodd-Frank Act?
7.35. Should the Agencies provide additional guidance on the types
of behavior that would constitute misconduct for purposes of section
__.7(c)(1)?
7.36. Should the rule include a presumption of some amount of
clawback for particularly severe adverse outcomes? Why or why not? If
so, what should be the amount and what would those outcomes be?

Sec. __.8 Additional Prohibitions for Level 1 and Level 2 Covered
Institutions

Section __.8 of the proposed rule would establish additional
prohibitions for Level 1 and Level 2 covered institutions to address
practices that, in the view of the Agencies, could encourage
inappropriate risks that could lead to material financial loss at
covered institutions. The Agencies' views are based in part on
supervisory experiences in reviewing and supervising incentive-based
compensation at some covered institutions, as described earlier in this
Supplemental Information section. Under the proposed rule, an
incentive-based compensation arrangement at a Level 1 or Level 2
covered institution would be considered to appropriately balance risk
and reward, as required by section __.4(c)(1) of the proposed rule,
only if the covered institution complies with the prohibitions of
section __.8.

Sec. __.8(a) Hedging

Section __.8(a) of the proposed rule would prohibit Level 1 and
Level 2 covered institutions from purchasing hedging instruments or
similar instruments on behalf of covered persons to hedge or offset any
decrease in the value of the covered person's incentive-based
compensation. This prohibition would apply to all covered persons at a
Level 1 or Level 2 covered institution, not just senior executive
officers and significant risk-takers. Personal hedging strategies may
undermine the effect of risk-balancing mechanisms such as deferral,
downward adjustment and forfeiture, or may otherwise negatively affect
the goals of these risk-balancing mechanisms and their overall efficacy
in inhibiting inappropriate risk-taking.\207\ For example, a financial
instrument, such as a derivative security that increases in value as
the price of a covered institution's equity decreases would offset the
intended balancing effect of awarding incentive-based compensation in
the form of equity, the value of which is linked to the performance of
the covered institution.
---------------------------------------------------------------------------

\207\ This prohibition would not limit a covered institutions
ability to hedge its own exposure in deferred compensation
obligations, which the Board, the OCC, and the FDIC continue to view
as prudent practice. (see, e.g., Federal Reserve SR Letter 04-19
(Dec. 7, 2004); OCC Bulletin 2004-56 (Dec. 7, 2004); FDIC FIL-127-
2004 (Dec. 7, 2004); OCC Interpretive Letter No. 878 (Dec. 22,
1999).
---------------------------------------------------------------------------

Similarly, a hedging arrangement with a third party, under which
the third party would make direct or indirect payments to a covered
person that are linked to or commensurate with the amounts by which a
covered person's incentive-based compensation is reduced by forfeiture,
would protect the covered person against declines in the value of
incentive-based compensation.

[[Page 37734]]

In order for incentive-based compensation to provide the appropriate
incentive effects, covered persons should not be shielded from exposure
to the negative financial impact of taking inappropriate risks or other
aspects of their performance at the covered institution.
In the 2011 Proposed Rule, the Agencies stated that they were aware
that covered persons who received incentive-based compensation in the
form of equity might wish to use personal hedging strategies as a way
to assure the value of deferred equity compensation.\208\ The Agencies
expressed concern that such hedging during deferral periods could
diminish the alignment between risk and financial rewards that deferral
arrangements might otherwise achieve.\209\ After considering
supervisory experiences in reviewing incentive-based compensation at
some covered institutions and the purposes of section 956 and related
provisions of the Dodd-Frank Act, the Agencies are proposing a
prohibition on covered institutions purchasing hedging and similar
instruments on behalf of a covered person as a practical approach to
eliminate the possibility that hedging during deferral periods could
diminish the alignment between risk and financial rewards that deferral
arrangements might otherwise achieve.
---------------------------------------------------------------------------

\208\ See 76 FR at 21183.
\209\ The Agencies note that one commenter to the 2011 Proposed
Rule supported limits on hedging.
---------------------------------------------------------------------------

8.1. The Agencies invite comment on whether this restriction on
Level 1 and Level 2 covered institutions prohibiting the purchase of a
hedging instrument or similar instrument on behalf of covered persons
is appropriate to implement section 956 of the Dodd-Frank Act.
8.2. Are there additional requirements that should be imposed on
covered institutions with respect to hedging of the exposure of covered
persons under incentive-based compensation arrangements?
8.3. Should the proposed rule include a prohibition on the purchase
of a hedging instrument or similar instrument on behalf of covered
persons at Level 3 institutions?

Sec. __.8(b) Maximum Incentive-Based Compensation Opportunity

Section __.8(b) of the proposed rule would limit the amount by
which the actual incentive-based compensation awarded to a senior
executive officer or significant risk-taker could exceed the target
amounts for performance measure goals established at the beginning of
the performance period. It is the understanding of the Agencies that,
under current practice, covered institutions generally establish
performance measure goals for their covered persons at the beginning
of, or early in, a performance period. At that time, under some
incentive-based compensation plans, those covered institutions
establish target amounts of incentive-based compensation that the
covered persons can expect to be awarded if they meet the established
performance measure goals. Some covered institutions also set out the
additional amounts of incentive-based compensation, in excess of the
target amounts, that covered persons can expect to be awarded if they
or the covered institution exceed the performance measure goals.
Incentive-based compensation plans commonly set out maximum awards of
150 to 200 percent of the pre-set target amounts.\210\
---------------------------------------------------------------------------

\210\ See, e.g., Arthur Gallagher & Co., ``Study of 2013 Short-
and Long-Term Incentive Design Criterion Among Top 200 S&P 500
Companies'' (December 5, 2014), available at https://www.ajg.com/media/1420659/study-of-2013-short-and-long-term-incentive-design-criterion-among-top-200.pdf.
---------------------------------------------------------------------------

The proposed rule would prohibit a Level 1 or Level 2 covered
institution from awarding incentive-based compensation to a senior
executive officer in excess of 125 percent of the target amount for
that incentive-based compensation. For a significant risk-taker the
limit would be 150 percent of the target amount for that incentive-
based compensation. This limitation would apply on a plan-by-plan
basis, and, therefore, would apply to long-term incentive plans
separately from other incentive-based compensation plans.
For example, a Level 1 covered institution might provide an
incentive-based compensation plan for its senior executive officers
that links the amount awarded to a senior executive officer to the
covered institution's four-year average return on assets (ROA). The
plan could establish a target award amount of $100,000 and a target
four-year average ROA of 75 basis points. That is, if the covered
institution's four-year average ROA was 75 basis points, a senior
executive officer would receive $100,000. The plan could also provide
that senior executive officers would earn nothing (zero percent of
target) under the plan if ROA was less than 50 basis points; $60,000
(60 percent of target) if ROA was 65 basis points; and $125,000 (125
percent of target) if ROA was 100 basis points. Under the proposed
rule, the plan would not be permitted to provide, for example, $130,000
(130 percent of target) if ROA was 100 basis points or $150,000 (150
percent of target) if ROA was 110 basis points.
The Agencies are proposing these limits, in part, because they are
consistent with the current industry practice at large banking
organizations. Moreover, high levels of upside leverage (e.g., 200
percent to 300 percent above the target amount) could lead to senior
executive officers and significant risk-takers taking inappropriate
risks to maximize the opportunity to double or triple their incentive-
based compensation. Recognizing the potential for inappropriate risk-
taking with such high levels of leverage, the Federal Banking Agencies
have worked with large banking organizations to reduce leverage levels
to a range of 125 percent to 150 percent. Such a range continues to
provide for flexibility in the design and operation of incentive-based
compensation arrangements in covered institutions while it addresses
the potential for inappropriate risk-taking where leverage
opportunities are large or uncapped. For a full example of how these
requirements would work in practice, please see Appendix A of this
Supplementary Information section.
The proposed rule would set different maximums for senior executive
officers and for significant risk-takers because senior executive
officers and significant risk-takers have the potential to expose
covered institutions to different types and levels of risk, and may be
motivated by different types and amounts of incentive-based
compensation. The Agencies intend the different limitations to reflect
the differences between the risks posed by senior executive officers
and significant risk-takers.
The Agencies emphasize that the proposed limits on a covered
employee's maximum incentive-based compensation opportunity would not
equate to a ceiling on overall incentive-based compensation. Such
limits would represent only a constraint on the percentage by which
incentive-based compensation could exceed the target amount, and is
aimed at prohibiting the use of particular features of incentive-based
compensation arrangements which can contribute to inappropriate risk-
taking.
8.4. The Agencies invite comment on whether the proposed rule
should establish different limitations for senior executive officers
and significant risk-takers, or whether the proposed rule should impose
the same percentage limitation on senior executive officers and
significant risk-takers.
8.5. The Agencies also seek comment on whether setting a limit on
the amount that compensation can grow from the time the target is
established

[[Page 37735]]

until an award occurs would achieve the goals of section 956.
8.6. The Agencies invite comment on the appropriateness of the
limitation, i.e., 125 percent and 150 percent for senior executive
officers and significant risk-takers, respectively. Should the
limitations be set higher or lower and, if so, why?
8.7. Should the proposed rule apply this limitation on maximum
incentive-based compensation opportunity to Level 3 institutions?

Sec. __.8(c) Relative Performance Measures

Under section __.8(c) of the proposed rule, a Level 1 or Level 2
covered institution would be prohibited from using incentive-based
compensation performance measures based solely on industry peer
performance comparisons. This prohibition would apply to incentive-
based compensation arrangements for all covered persons at a Level 1 or
Level 2 covered institution, not just senior executive officers and
significant risk-takers.
As discussed above, covered institutions generally establish
performance measures for covered persons at the beginning of, or early
in, a performance period. For these types of plans, the performance
measures (sometimes known as performance metrics) are the basis upon
which a covered institution determines the related amounts of
incentive-based compensation to be awarded to covered persons. These
performance measures can be absolute, meaning they are based on the
performance of the covered person or the covered institution without
reference to the performance of other covered persons or covered
institutions. In contrast, a relative performance measure is a
performance measure that compares a covered institution's performance
to that of so called ``peer institutions'' or an industry average. The
composition of peer groups is generally decided by the individual
covered institution. An example of an absolute performance measure is
total shareholder return (TSR). An example of a relative performance
measure is the rank of the covered institution's TSR among the TSRs of
institutions in a pre-established peer group.
The Agencies have observed that incentive-based compensation
arrangements based solely on industry peer performance comparisons (a
type of relative performance measure) can cause covered persons to take
inappropriate risks that could lead to material financial loss.\211\
For example, if a covered institution falls behind its industry peers,
it may use performance measures--and set goals for those measures--that
lead to inappropriate risk-taking by covered persons in order to
perform better than its industry peers. Also, the performance of a
covered institution can be strong relative to its peers, but poor on an
absolute basis (e.g., every institution in the peer group is performing
poorly, but the covered institution is the best of the group).
Consequently, if incentive-based compensation arrangements were based
only on relative performance measures, they would, in that
circumstance, reward covered employees for performance that is poor on
an absolute level but still better than that of the covered
institution's peer group. Similarly, in cases where only relative
performance measures are used and performance is poor, performance-
based vesting may still occur when peer performance is also poor. Using
a combination of relative and absolute performance measures as part of
the performance evaluation process can help maintain balance between
financial rewards and potential risks in such situations.
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\211\ Gong, Li, and Shin, ``Relative Performance Evaluation and
Related Peer Groups in Executive Compensation Contracts,'' 86 The
Accounting Review 1007 (May 2011).
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Additionally, covered persons do not know what level of performance
is necessary to meet or exceed target peer group rankings, as rankings
will become known only at the end of the performance period. As a
result, covered employees may be strongly incentivized to achieve
exceptional levels of performance by taking inappropriate risks to
increase the likelihood that the covered institution will meet or
exceed the peer group ranking in order to maximize their incentive-
based compensation.
Further, comparing an institution's performance to a peer group can
be misleading because the members of the peer group are likely to have
different business models, product mixes, operations in different
geographical locations, cost structures, or other attributes that make
comparisons between institutions inexact.
Relative performance measures, including industry peer performance
measures, may be useful when used in combination with absolute
performance measures. Thus, under the proposed rule, a covered
institution would be permitted to use relative performance measures in
combination with absolute performance measures, but not in isolation.
For instance, a covered institution would not be in compliance with the
proposed rule if the performance of the CEO were assessed solely on the
basis of total shareholder return relative to a peer group. However, if
the performance of the CEO were assessed on the basis of institution-
specific performance measures, such as earnings per share and return on
tangible common equity, along with the same relative TSR the covered
institution would comply with section __.8(c) of the proposed rule
(assuming the CEO's incentive-based compensation arrangement met the
other requirements of the rule, such as an appropriate balance of risk
and reward).
8.8. The Agencies invite comment on whether the restricting on the
use of relative performance measures for covered persons at Level 1 and
Level 2 covered institutions in section __.8(d) of the proposed rule is
appropriate in deterring behavior that could put the covered
institution at risk of material financial loss. Should this restriction
be limited to a specific group of covered persons and why? What are the
relative performance measures being used in industry?
8.9. Should the proposed rule apply this restriction on the use of
relative performance measures to Level 3 institutions?

Sec. __.8(d) Volume-Driven Incentive-Based Compensation

Section __.8(d) of the proposed rule would prohibit Level 1 and
Level 2 covered institutions from providing incentive-based
compensation to a covered person that is based solely on transaction or
revenue volume without regard to transaction quality or the compliance
of the covered person with sound risk management. Under the proposed
rule, transaction or revenue volume could be used as a factor in
incentive-based compensation arrangements, but only in combination with
other factors designed to cause covered persons to account for the
risks of their activities. This prohibition would apply to incentive-
based compensation arrangements for all covered persons at a Level 1 or
Level 2 covered institution, not just senior executive officers and
significant risk-takers.
Incentive-based compensation arrangements that do not account for
the risks covered persons can take to achieve performance measures do
not appropriately balance risk and reward, as section __.4(c)(1) of the
proposed rule would require. An arrangement that provides incentive-
based compensation

[[Page 37736]]

to a covered person based solely on transaction or revenue volume,
without regard to other factors, would not adequately account for the
risks to which the transaction in question could expose the covered
institution. For instance, an incentive-based compensation arrangement
that rewarded mortgage originators based solely on the volume of loans
approved, without any subsequent adjustment for the quality of the
loans originated (such as adjustments for early payment default or
problems with representations and warranties) would not adequately
balance risk and financial rewards.
An incentive-based compensation arrangement with performance
measures based solely on transaction or revenue volume could
incentivize covered persons to generate as many transactions or as much
revenue as possible without appropriate attention to resulting risks.
Such arrangements were noted in MLRs and similar reports where
compensation had been cited as a contributing factor to a financial
institution's failure during the recent financial crisis.\212\ In
addition, many studies about the causes of the recent financial crisis
discuss how volume-driven incentive-based compensation lead to
inappropriate risk-taking and caused material financial loss to
financial institutions.\213\
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\212\ In accordance with section 38(k) of the FDIA, 12 U.S.C.
1831o(k), MLRs are conducted by the Inspectors General of the
appropriate Federal banking agency following the failure of insured
depository institutions.
See, e.g., Office of Inspector General for the Department of
Treasury, ``Material Loss Review of Indymac Bank, FSB,'' OIG-09-032
(February 26, 2009), available at https://www.treasury.gov/about/organizational-structure/ig/Documents/oig09032.pdf; Offices of
Inspector General for the Federal Deposit Insurance Corporation and
the Department of Treasury, ``Evaluation of Federal Regulatory
Oversight of Washington Mutual Bank,'' EVAL-10-002 (April 9, 2010),
available at https://www.fdicig.gov/reports10/10-002EV.pdf.
\213\ See, e.g., Financial Crisis Inquiry Commission, ``The
Financial Crisis Inquiry Report'' (January 2011), available at
https://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full.pdf.
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8.10. The Agencies invite comment on whether there are
circumstances under which consideration of transaction or revenue
volume as a sole performance measure goal, without consideration of
risk, can be appropriate in incentive-based compensation arrangements
for Level 1 or Level 2 covered institutions.
8.11. Should the proposed rule apply this restriction on the use of
volume-driven incentive-based compensation arrangements to Level 3
institutions?

Sec. __.9 Risk Management and Controls Requirements for Level 1 and
Level 2 Covered Institutions

Prior to the financial crisis that began in 2007, institutions
rarely involved risk management in either the design or monitoring of
incentive-based compensation arrangements. Federal Banking Agency
reviews of compensation practices have shown that one important
development in the intervening years has been the increasing
integration of control functions in compensation design and decision-
making. For instance, control functions are increasingly relied on to
ensure that risk is properly considered in incentive-based compensation
programs. At the largest covered institutions, the role of the board of
directors in oversight of compensation programs (including the
oversight of supporting risk management processes) has also expanded.
Section __.9 of the proposed rule would establish additional risk
management and controls requirements at Level 1 and Level 2 covered
institutions. Without effective risk management and controls, larger
covered institutions could establish incentive-based compensation
arrangements that, in the view of the Agencies,\214\ could encourage
inappropriate risks that could lead to material financial loss at
covered institutions. Under the proposed rule, an incentive-based
compensation arrangement at a Level 1 or Level 2 covered institution
would be considered to be compatible with effective risk management and
controls, as required by section __.4(c)(2) of the proposed rule, only
if the covered institution also complies with the requirements of
section __.9. In proposing section __.9, the Agencies are also
cognizant of comments received on the 2011 Proposed Rule.\215\ In order
to facilitate consistent adoption of the practices that contribute to
incentive-based compensation arrangements that appropriately balance
risk and reward, the Agencies are proposing that the practices set
forth in section __.9 be required for all Level 1 and Level 2 covered
institutions.
---------------------------------------------------------------------------

\214\ This view is based in part on supervisory experiences in
reviewing and supervising incentive-based compensation at some
covered institutions.
\215\ The 2011 Proposed Rule would have required incentive-based
compensation arrangements to be compatible with effective risk
management and controls. A number of commenters offered views on the
proposed requirements, and some raised concerns. Some commenters
emphasized the importance of sound risk management practices in the
area of incentive-based compensation. However, a number of
commenters also questioned whether the determination of an
``appropriate'' role for risk management personnel should be left to
the discretion of individual institutions. In light of these
comments, the proposed rule is designed to strike a reasonable
balance between requiring an appropriate role for risk management
and allowing institutions the ability to tailor their risk
management practices to their business model. The proposed rule does
not include prescriptive standards. Instead, it would allow Level 1
and Level 2 covered institutions to retain flexibility to determine
the specific role that risk management and control functions should
play in incentive-based compensation processes, while still allowing
for appropriate oversight of incentive-based compensation
arrangements.
---------------------------------------------------------------------------

Section __.9(a) of the proposed rule would establish minimum
requirements for a risk management framework at a Level 1 or Level 2
covered institution by requiring that such framework: (1) Be
independent of any lines of business; (2) include an independent
compliance program that provides for internal controls, testing,
monitoring, and training with written policies and procedures
consistent with section __.11 of the proposed rule; and (3) be
commensurate with the size and complexity of the covered institution's
operations.
Generally, section __.9(a) would require that Level 1 and Level 2
covered institutions have a systematic approach to designing and
implementing their incentive-based compensation arrangements and
incentive-based compensation programs supported by independent risk
management frameworks with written policies and procedures, and
developed systems. These frameworks would include processes and systems
for identifying and reporting deficiencies; establishing managerial and
employee responsibility; and ensuring the independence of control
functions. To be effective, an independent risk management framework
should have sufficient stature, authority, resources and access to the
board of directors.
Level 1 and Level 2 covered institutions would be required to
develop, as part of their broader risk management framework, an
independent compliance program for incentive-based compensation. The
Federal Banking Agencies have found that an independent compliance
program leads to more robust oversight of incentive-based compensation
programs, helps to avoid undue influence by lines of business, and
facilitates supervision. Agencies would expect such a compliance
program to have formal policies and procedures to support compliance
with the proposed rule and to help to ensure that risk is effectively
taken into account in both design and decision-making processes related
to incentive-based

[[Page 37737]]

compensation. The requirements for such policies and procedures are set
forth in section __.11 of the proposed rule.
The requirements of the proposed rule would encourage Level 1 and
Level 2 covered institutions to develop well-targeted internal controls
that work within the covered institution's broader risk management
framework to support balanced risk-taking. Independent control
functions should regularly monitor and test the covered institution's
incentive-based compensation program and its arrangements to validate
their effectiveness. Training would generally include communication to
employees of the covered institution's compliance risk management
standards and policies and procedures, and communication to managers on
expectations regarding risk adjustment and documentation.
The Agencies note that independent compliance programs consistent
with these proposed requirements are already in place at a significant
number of larger covered institutions, in part due to supervisory
efforts such as the Board's ongoing horizontal review of incentive-
based compensation,\216\ Enhanced Prudential Standards from section 165
of the Dodd-Frank Act,\217\ and the OCC's Heightened Standards.\218\
For example, control function employees monitor compliance with
policies and procedures and help to ensure robust documentation of
compensation decisions, including those relating to forfeiture and
risk-adjustment processes. Institutions have also improved
communication to managers and employees about how risk adjustment
should work and have developed processes to review the application of
related guidance in order to ensure better consideration of risk in
compensation decisions. The Agencies are proposing to require similar
compliance programs at covered institutions not subject to the
supervisory efforts described above, as well as to reinforce the
practices of covered institutions that already have such compliance
programs in place.
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\216\ See 2011 FRB White Paper.
\217\ See 12 CFR part 252.
\218\ See 12 CFR part 30, appendix D.
---------------------------------------------------------------------------

Section __.9(b) of the proposed rule would require Level 1 and
Level 2 covered institutions to provide individuals engaged in control
functions with the authority to influence the risk-taking of the
business areas they monitor and to ensure covered persons engaged in
control functions are compensated in accordance with the achievement of
performance objectives linked to their control functions and
independent of the performance of the business areas they oversee.
These protections are intended to mitigate potential conflicts of
interest that might undermine the role covered persons engaged in
control functions play in supporting incentive-based compensation
arrangements that appropriately balance risk and reward.
Under section__.9(c) of the proposed rule, Level 1 and Level 2
covered institutions would be required to provide for independent
monitoring of: (1) Incentive-based compensation plans to identify
whether those plans appropriately balance risk and reward; (2) events
relating to forfeiture and downward adjustment reviews and decisions
related thereto; and (3) compliance of the incentive-based compensation
program with the covered institution's policies and procedures.
To be considered independent under the proposed rule, the group or
person at the covered institution responsible for monitoring the areas
described above generally should have a reporting line to senior
management or the board that is separate from the covered persons whom
the group or person is responsible for monitoring. Some covered
institutions may use internal audit to perform the independent
monitoring that would be required under this section.\219\ The type of
independent monitoring conducted to fulfill the requirements of section
__.9(c) generally should be appropriate to the size and complexity of
the covered institution and its use of incentive-based compensation.
For example, a Level 1 covered institution might be expected to use a
different scope and type of data and analysis to monitor its incentive-
based compensation program than a Level 2 covered institution.
Likewise, a covered institution that offers incentive-based
compensation to only a few employees may require a less formal
monitoring process than a covered institution that offers many types of
incentive-based compensation to many of its employees.
---------------------------------------------------------------------------

\219\ At OCC-supervised institutions, the independent monitoring
required under section __.9(c) would be carried out by internal
audit.
---------------------------------------------------------------------------

Section __.9(c)(1) of the proposed rule would require covered
institutions to periodically review all incentive-based compensation
plans to assess whether those plans provide incentives that
appropriately balance risk and reward. Monitoring the incentives
embedded in plans, rather than the individual arrangements that rely on
those plans, provides an opportunity to identify incentives for
imprudent risk-taking. It also reduces burden on covered institutions
in a reasonable way in light of the proposed rule's additional
protections against excessive risk-taking which operate at the level of
incentive-based compensation arrangements. Supervisory experience
indicates that many covered institutions already periodically perform
such a review, and the Agencies consider it a better practice. Level 1
and Level 2 covered institutions should have procedures for collecting
information about the effects of their incentive-based compensation
arrangements on employee risk-taking, and have systems and processes
for using this information to adjust incentive-based compensation
arrangements in order to eliminate or reduce unintended incentives for
inappropriate risk-taking.
Under Section __.9(c)(2), covered institutions would be required to
provide for the independent monitoring of all events related to
forfeiture and downward adjustment. With regard to forfeiture and
downward adjustment decisions, covered institutions would be expected
to regularly monitor the events that could trigger a forfeiture and
downward adjustment review. Many covered institutions also regularly
conduct independent monitoring and testing activities, or broad-based
risk reviews, that could reveal instances of inappropriate risk-taking.
The policies and procedures established under section __.11(b) would be
expected to specify that covered institutions would evaluate whether
inappropriate risk-taking identified in the course of any independent
monitoring and testing activities triggered a forfeiture and downward
adjustment review. The frequency of reviews may vary depending on the
size and complexity of, and the level of risks at, the covered
institution, but they should occur often enough to reasonably monitor
risks and events related to the forfeiture and downward adjustment
triggers.\220\ When these reviews uncover events that trigger
forfeiture and downward adjustment reviews, Level 1 and Level 2 covered
institutions would be required to complete such a review, consistent
with the requirements of section __.7(b). They would also be required
to monitor adherence to policies and procedures that support effective
balancing of risk and rewards. Many covered institutions currently
perform forfeiture reviews in the context of broader and more regular
risk reviews to ensure that the forfeiture review process appropriately
captures all risk-taking activity. The Agencies view this

[[Page 37738]]

approach as better practice, as decisions about appropriate adjustment
of compensation in such circumstances are only one desired outcome. For
instance, identification of risk events generally should lead not only
to consideration of compensation adjustments, but also to analysis of
whether there are weaknesses in broader controls or risk management
oversight that need to be addressed. In their supervisory experience,
the Federal Banking Agencies have found that tying forfeiture reviews
to broader risk reviews is a better practice.
---------------------------------------------------------------------------

\220\ See section __.7(b)(2).
---------------------------------------------------------------------------

Section __.9(c)(3) of the proposed rule would require covered
institutions to provide for independent compliance monitoring of the
institution's incentive-based compensation program with policies and
procedures. To be considered independent under the proposed rule, the
group or person at the covered institution monitoring compliance should
have a separate reporting line to senior management or to the board of
directors from the business line or group being monitored, but may be
conducted by groups within the covered institution. For example,
internal audit could review whether award disbursement and vesting
policies were adhered to and whether documentation of such decisions
was sufficient to support independent review. Such independence will
help ensure that the monitoring is unbiased and identifies appropriate
issues.
The Agencies have taken the position that Level 1 and Level 2
covered institutions should regularly review whether the design and
implementation of their incentive-based compensation arrangements
deliver appropriate risk-taking incentives. Independent monitoring
should enable covered institutions to correct deficiencies and make
necessary improvements in a timely fashion based on the results of
those reviews.\221\
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\221\ The 2010 Federal Banking Agency Guidance mentions several
practices that can contribute to the effectiveness of such activity,
including internal reviews and audits of compliance with policies
and procedures, and monitoring of results relative to expectations.
For instance, internal audit should assess the effectiveness of the
compliance risk management program by performing regular independent
reviews and evaluating whether internal controls, policies, and
processes that limit incentive-based compensation risk are effective
and appropriate for the covered institution's activities and
associated risks.
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9.1 Some Level 1 and Level 2 covered institutions are subject to
separate risk management and controls requirements under other
statutory or regulatory regimes. For example, OCC-supervised Level 1
and Level 2 covered institution are subject to the OCC's Heightened
Standards. Is it clear to commenters how the risk management and
controls requirements under the proposed rule would interact, if at
all, with requirements under other statutory or regulatory regimes?

Sec. __.10 Governance Requirements for Level 1 and Level 2 Covered
Institutions

Section __.10 of the proposed rule contains specific governance
requirements that would apply to Level 1 and Level 2 covered
institutions. Under the proposed rule, an incentive-based compensation
arrangement at a Level 1 or Level 2 covered institution would be
considered to be supported by effective governance, as required by
section __.4(c)(3) of the proposed rule, only if the covered
institution also complies with the requirements of section __.10.
As discussed earlier in this Supplementary Information section, the
supervisory experience of the Federal Banking Agencies at large
consolidated financial institutions is that effective oversight by a
covered institution's board of directors, including review and approval
by the board of the overall goals and purposes of the covered
institution's incentive-based compensation program, is essential to the
attainment of incentive-based compensation arrangements that do not
encourage inappropriate risks that could lead to material financial
loss to the covered institution.
Accordingly, section __.10(a) of the proposed rule would require
that a Level 1 or Level 2 covered institution establish a compensation
committee, composed solely of directors who are not senior executive
officers, to assist the board in carrying out its responsibilities
related to incentive-based compensation.\222\ Having an independent
compensation committee is consistent with the emphasis the Agencies
place on the need for incentive-based compensation arrangements to be
compatible with effective risk management and controls and supported by
effective governance. In response to the 2011 Proposed Rule, some
commenters expressed a view that an independent compensation committee
composed solely of non-management directors would have helped to avoid
potential conflicts of interest and more appropriate consideration of
management proposals, particularly proposed awards and payouts for
senior executive officers.
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\222\ As described above, under the Board's and FDIC's proposed
rules, for a foreign banking organization, ``board of directors''
would mean the relevant oversight body for the institution's U.S.
branch, agency, or operations, consistent with the foreign banking
organization's overall corporate and management structure. The Board
and FDIC will work with foreign banking organizations to determine
the appropriate persons to carry out the required functions of a
compensation committee under the proposed rule. Likewise, under the
OCC's proposed rule, for a Federal branch or agency of a foreign
bank, ``board of directors'' would mean the relevant oversight body
for the Federal branch or agency, consistent with its overall
corporate and management structure. The OCC would work closely with
Federal branches and agencies to determine the person or committee
to undertake the responsibilities assigned to the oversight body.
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Section __.10(b) of the proposed rule would require that
compensation committees at Level 1 and Level 2 covered institutions
obtain input and assessments from various parties. For example, the
compensation committees would be required to obtain input on the
effectiveness of risk measures and adjustments used to balance risk and
reward in incentive-based compensation arrangements from the risk and
audit committees of the covered institution's board of directors, or
groups performing similar functions, and from the covered institution's
risk management function. The proposed requirements would help protect
covered institutions against inappropriate risk-taking that could lead
to material financial loss by leveraging the expertise and experience
of these parties.
In their review of the incentive-based compensation practices of
many of the largest covered institutions, the Federal Banking Agencies
have noted that the compensation, risk, and audit committees of the
boards of directors collaborate and seek advice from risk management
and other control functions before making decisions. Many of these
covered institutions have members of the compensation committee that
are also members of the risk and audit committees. Some covered
institutions rely on regular meetings between the compensation and risk
committees, while others rely on more ad hoc communications. Human
resources, risk management, finance, and audit committees work with
compensation committees to ensure that compensation systems attain
multiple objectives, including appropriate risk-taking.\223\
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\223\ See generally 2011 FRB White Paper; FSB, ``FSB 2015
Workshop on Compensation Practices'' (April 14, 2015), available at
https://www.fsb.org/wp-content/uploads/Summary-of-the-April-2015-FSB-workshop-on-compensation-practices.pdf.
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Section __.10(b)(2) of the proposed rule would require the
compensation committees to obtain from management, on an annual or more
frequent basis, a written assessment of the covered institution's
incentive-based compensation program and related compliance and control
processes. The

[[Page 37739]]

report should assess the extent to which the program and processes
provide risk-taking incentives that are consistent with the covered
institution's risk profile. Management would be required to develop the
assessment with input from the covered institutions' risk and audit
committees, or groups performing similar functions, and from
individuals in risk management and audit functions. In addition to the
written assessment submitted by management, section __.10(b)(3) of the
proposed rule would require the compensation committee to obtain
another written assessment on the same matter, submitted on an annual
or more frequent basis, by the internal audit or risk management
function of the covered institution. This written assessment would be
developed independently of the covered institution's management.
The Agencies are proposing that the independent compensation
committee of the board of directors to be the recipient of such input
and written assessments.
Developing incentive-based compensation arrangements that provide
balanced risk-taking incentives and monitoring arrangements to ensure
they achieve balance requires an understanding of the full spectrum of
risks (including compliance risks) and potential risk outcomes
associated with the activities of covered persons. For this reason,
risk-management and other control functions generally should each have
an appropriate role in the covered institution's processes, not only
for designing incentive-based compensation arrangements, but also for
assessing their effectiveness in providing risk-taking incentives that
are consistent with the risk profile of the institution. The proposed
rule sets forth two separate effectiveness assessments: (1) An
assessment under the auspices of management, but reliant on risk
management and audit functions, as well as the audit and risk
committees of the board, and (2) an assessment conducted by the
internal audit or risk management function of the covered institution,
independent of management.
In support of the first requirement, a covered institution's
management has a full understanding of both the entirety of the covered
institution's activities and a detailed understanding of its incentive-
based compensation program, including both the performance that the
covered institution intends to reward and the risks to which covered
persons can expose the covered institution. An understanding of the
full compensation program (including the effectiveness of risk measures
across various lines of business, the measurement of actual risk
outcomes, and the analysis of risk-taking and risk outcomes relative to
incentive-based compensation payments) requires a large degree of
technical expertise. It also requires an understanding of the wider
strategic and risk management frameworks in place at the covered
institution (including the various objectives that compensation
programs seek to balance, such as recruiting and retention goals and
prudent risk management). While the board of directors at a covered
institution is ultimately responsible for the balance of incentive-
based compensation arrangements, and for an incentive-based
compensation program that incentivizes behaviors consistent with the
long-term health of the organization, the board should generally hold
senior management accountable for effectively executing the covered
institution's incentive-based compensation program, and for modifying
it when weaknesses are identified.
In addition, some Level 1 and Level 2 covered institutions use
automated systems to monitor the effectiveness of incentive-based
compensation arrangements in balancing risk-taking incentives,
especially systems that support capture of relevant data in databases
that support monitoring and analysis. Management plays a role in all of
these activities and is well-positioned to oversee an analysis that
considers such a wide variety of inputs. In order to ensure that
considerations of risk-taking are included in such an exercise, an
active role for independent control functions is critical in such a
review as well as input from the risk and audit committees of the board
of directors, or groups performing similar functions. Periodic
presentations by the chief risk officer or other risk management staff
to the board of directors can help complement the annual effectiveness
review.
In addition, the proposed rule includes a requirement that internal
audit or risk management submit a written assessment of the
effectiveness of a Level 1 or Level 2 covered institution's incentive-
based compensation program and related control processes in providing
risk-taking incentives that are consistent with the risk profile of the
covered institution. Regular internal reviews and audits of compliance
with policies and procedures are important to helping implement the
incentive-based compensation system as intended by those employees
involved in incentive-based compensation decision-making. Internal
audit and risk management are well-positioned to provide an independent
perspective on a covered institution's incentive-based compensation
program and related control processes. The Federal Banking Agencies
have observed that compensation committees benefit from an independent
analysis of the effectiveness of their covered institutions' incentive-
based compensation programs.\224\
---------------------------------------------------------------------------

\224\ For example, the 2010 Federal Banking Agency Guidance
notes that a banking organization's risk-management processes and
internal controls should reinforce and support the development and
maintenance of balanced incentive compensation arrangements.
---------------------------------------------------------------------------

The proposed requirement takes into consideration comments received
on the policies and procedures standards embodied in the 2011 Proposed
Rule that would have required the covered financial institution's board
of directors, or a committee thereof, to receive data and analysis from
management and other sources sufficient to allow the board, or
committee thereof, to assess whether the overall design and performance
of the institution's incentive-based compensation arrangements were
consistent with section 956. Many commenters on the 2011 Proposed Rule
expressed concern that the proposed requirements in the 2011 Proposed
Rule would have inappropriately expanded the traditional ``oversight''
role of the board and would have required the board to exercise
judgment in areas that traditionally have been--and, in the view of
some commenters, are best left to--the expertise and prerogative of
management. Commenters suggested that the proposed requirement instead
place responsibility on management to conduct a formal assessment of
the effectiveness of the covered institution's incentive-based
compensation program and related compliance and control processes. The
Agencies agree that management should be responsible for conducting
such an assessment and section __.10(b)(2) of the proposed rule would
thus place this responsibility on management, while requiring input
from risk and audit committees, or groups performing similar functions,
and from the covered institutions' risk management and audit functions.
Under the proposed rule, the board's primary focus would be oversight
of incentive-based compensation program and arrangements, while
management would be expected to implement a program consistent with the
vision of the board.
10.1. The Agencies invite comment on this provision generally and
whether the written assessments required under sections __.10(b)(2) and
__.10(b)(3)

[[Page 37740]]

of the proposed rule should be provided to the compensation committee
on an annual basis or at more or less frequent intervals?
10.2. Are both reports required under Sec. __.10(b)(2) and (3)
necessary to aid the compensation committee in carrying out its
responsibilities under the proposed rule? Would one or the other be
more helpful? Why or why not?

Sec. __.11 Policies and Procedures Requirements for Level 1 and Level
2 Covered Institutions

Section __.11 of the proposed rule would require Level 1 and Level
2 covered institutions to develop and implement certain minimum
policies and procedures relating to their incentive-based compensation
programs. Requiring covered institutions to develop and follow policies
and procedures related to incentive-based compensation would help both
covered institutions and regulators identify the incentive-based
compensation risks to which covered institutions are exposed, and how
these risks are managed so as not to incentivize inappropriate risk-
taking by covered persons that could lead to material financial loss to
the covered institution. The Agencies are not proposing to require
specific policies and procedures of Level 3 covered institutions
because these institutions are generally less complex and the impact to
the financial system by risks taken at these covered institutions is
not as significant as risks taken by covered persons at the larger,
more complex covered institutions. In addition, by not requiring
additional policies and procedures, Agencies intend to reduce burden on
smaller covered institutions. In contrast, the larger Level 1 and Level
2 covered institutions generally will have more complex organizations
that tend to conduct a wide range of business activities and therefore
will need robust policies and procedures as part of their compliance
programs.\225\ Therefore, under section __.11 of the proposed rule,
Level 3 covered institutions would not be subject to any specific
requirements in this area, while Level 1 and Level 2 covered
institutions would be required to develop and implement specific
policies and procedures for their incentive-based compensation
programs.
---------------------------------------------------------------------------

\225\ See Federal Reserve SR Letter 08-08, ``Compliance Risk
Management Programs and Oversight at Large Banking Organizations
with Complex Compliance Profiles'' (October 16, 2008).
---------------------------------------------------------------------------

Section __.11 of the proposed rule would identify certain areas
that the policies and procedures of Level 1 and Level 2 covered
institutions would, at a minimum, have to address. The list is not
exhaustive. Instead, it is meant to indicate the policies and
procedures that would, at a minimum, be necessary to carry out the
requirements in other sections of the proposed rule.
The development and implementation of the policies and procedures
under section __.11 of the proposed rule would help to ensure and
monitor compliance with the requirements set forth in section 956 and
the other requirements in the proposed rule because the policies and
procedures would set clear expectations for covered persons and allow
the Agencies to better understand how a covered institution's
incentive-based compensation program operates. Section __.11(a) of the
proposed rule would contain the general requirement that the policies
and procedures be consistent with the prohibitions and requirements
under the proposed rule. Other parts of section __.11 of the proposed
rule would help to ensure and monitor compliance with specific portions
of the proposed rule.
Under section __.11(b) of the proposed rule, a Level 1 or Level 2
covered institution would have to develop and implement policies and
procedures that specify the substantive and procedural criteria for the
application of forfeiture and clawback, including the process for
determining the amount of incentive-based compensation to be clawed
back. These policies and procedures would provide covered persons with
notice of the circumstances that would lead to forfeiture and clawback
at their covered institutions, including any circumstances identified
by the covered institution in addition to those required under the
proposed rule. They would also help ensure consistent application of
forfeiture and clawback by establishing a common set of expectations.
Policies and procedures should make clear the triggers that will
result in consideration of forfeiture, downward adjustment, and
clawback; should indicate what individuals or committees are
responsible for identifying, escalating and resolving these issues in
such cases; should ensure that control functions contribute relevant
information and participate in any decisions; and should set out a
clear process for determining responsibility for the events triggering
the forfeiture and downward adjustment review including provisions
requiring appropriate input from covered employees under consideration
for forfeiture or clawback.
The proposed rule also would require that Level 1 and Level 2
covered institutions' policies and procedures require the maintenance
of documentation of final forfeiture, downward adjustment, and clawback
decisions under section __.11(c) of the proposed rule. Documentation
would allow control functions and the Agencies to evaluate compliance
with the requirements of section __.7 of the proposed rule. The
Agencies are proposing this requirement because they have found that it
is critical that forfeiture and downward adjustment reviews at covered
institutions be supported by effective governance to ensure
consistency, fairness and robustness of all related decision-making.
Section __.11(d) of the proposed rule would include a requirement
for policies and procedures of Level 1 and Level 2 covered institutions
that would specify the substantive and procedural criteria for
acceleration of payments of deferred incentive-based compensation to a
covered person consistent with sections __.7(a)(1)(iii)(B) and
__.7(a)(2)(iii)(B) of the proposed rule. Under section __.7 of the
proposed rule, acceleration of vesting of incentive-based compensation
that is required to be deferred under such section would only be
permitted in the case of death or disability. A Level 1 or Level 2
covered institution would have to have policies and procedures that
describe how disability would be evaluated for purposes of determining
whether to accelerate payments of deferred incentive-based
compensation.
Section __.11(e) would require Level 1 and Level 2 covered
institutions to have policies and procedures that identify and describe
the role of any employees, committees, or groups authorized to make
incentive-based compensation decisions, including when discretion is
authorized. A Level 1 or Level 2 covered institution's policies and
procedures would also have to describe how discretion is expected to be
exercised in order to appropriately balance risk and reward and how the
incentive-based compensation arrangements will be monitored under
sections __.11(f) and (h) of the proposed rule, respectively.
Related to the requirements regarding disclosure under sections
__.4(f) and __.5 of the proposed rule, under section __.11(g), a Level
1 or Level 2 covered institution would need to have policies and
procedures that require the covered institution to maintain
documentation of the establishment, implementation, modification, and
monitoring of incentive-based

[[Page 37741]]

compensation arrangements sufficient to support the covered
institution's decisions. Section __.11(i) would require the policies
and procedures to specify the substantive and procedural requirements
of the independent compliance program, consistent with section
__.9(a)(2). And section __.11(j) would require policies and procedures
that address the appropriate roles for risk management, risk oversight,
and other control function personnel in the covered institution's
processes for (1) designing incentive-based compensation arrangements
and determining awards, deferral amounts, deferral periods, forfeiture,
downward adjustment, clawback, and vesting, and (2) assessing the
effectiveness of incentive-based compensation arrangements in
restraining inappropriate risk-taking.
The Agencies anticipate that some Level 1 and Level 2 covered
institutions that have international operations might choose to adopt
enterprise-wide incentive-based compensation policies and procedures.
The Agencies recognize that such policies and procedures, when utilized
by various subsidiary institutions, may need to be further modified to
reflect local regulation and the requirements of home country
regulators in the case of international institutions and tailored to a
certain extent by line of business, legal entity, or business model.
11.1. The Agencies invite general comment on the proposed policies
and procedures requirements for Level 1 and Level 2 covered
institutions under section __.11 of the proposed rule.

Sec. __.12 Indirect Actions

Section __.12 of the proposed rule would prohibit a covered
institution from doing indirectly what it cannot do directly under the
proposed rule. Section __.12 would apply all of the proposed rule's
requirements and prohibitions to actions taken by covered institutions
indirectly or through or by any other person. Section __.12 is
substantially the same as section __.7 of the 2011 Proposed Rule. The
Agencies did not receive any comments on section __.7 of the 2011
Proposed Rule.
By subjecting such indirect actions by covered institutions to all
of the proposed rule's requirements and prohibitions, section __.12
would implement the directive in section 956(b) to adopt rules that
prohibit any type of incentive-based payment arrangement, or any
feature of any such arrangement, that the Agencies determine encourages
inappropriate risks by covered institutions (1) by providing excessive
compensation, fees, or benefits or (2) that could lead to material
financial loss. The Agencies are concerned that a covered institution
may take indirect actions in order to avoid application of the proposed
rule's requirements and prohibitions. For example, a covered
institution could attempt to make substantial numbers of its covered
persons independent contractors for the purpose of avoiding application
of the proposed rule's requirements and prohibitions. A covered
institution could also attempt to make substantial numbers of its
covered persons employees of another entity for the purpose of avoiding
application of the proposed rule's requirements and prohibitions. If
left unchecked, such indirect actions could encourage inappropriate
risk-taking by providing covered persons with excessive compensation or
could lead to material financial loss at a covered institution.
The Agencies, however, do not intend to disrupt indirect actions,
including independent contractor or employment relationships, not
undertaken for the purpose of avoiding application of the proposed
rule's requirements and prohibitions. Thus, the Agencies would apply
the proposed rule regardless of how covered institutions classify their
actions, while also recognizing that covered institutions may
legitimately engage in activities that are outside the scope of section
956 and the proposed rule.\226\
---------------------------------------------------------------------------

\226\ The Agencies note, however, that section 956 of the Dodd-
Frank Act does not, and the proposed rule would not, limit the
authority of the Agencies under other provisions of applicable law
and regulations.
---------------------------------------------------------------------------

NCUA's proposed rule also would clarify that covered credit unions
may not use CUSOs to avoid the requirements of the proposed rule, such
as by using CUSOs to maintain non-compliant incentive-based
compensation arrangements on behalf of senior executive officers or
significant risk-takers of Federally insured credit unions.
12.1. Commenters are invited to address all aspects of section
__.12, including any examples of other indirect actions that the
Agencies should consider.

Sec. __.13 Enforcement

By its terms, section 956 applies to any depository institution and
any depository institution holding company (as those terms are defined
in section 3 of the FDIA), any broker-dealer registered under section
15 of the Securities Exchange Act, any credit union, any investment
adviser (as that term is defined in the Investment Advisers Act of
1940), the Federal National Mortgage Association, and the Federal Home
Loan Mortgage Corporation. Section 956 also applies to any other
financial institution that the appropriate Federal regulators jointly
by rule determine should be treated as a covered financial institution
for purposes of section 956.
Section 956(d) also specifically sets forth the enforcement
mechanism for rules adopted under that section. The statute provides
that section 956 and the implementing rules shall be enforced under
section 505 of the Gramm-Leach-Bliley Act and that a violation of
section 956 or the regulations under section 956 will be treated as a
violation of subtitle A of Title V of the Gramm-Leach-Bliley Act.
Section 505 of the Gramm-Leach-Bliley Act provides for enforcement
under section 1818 of title 12, by the appropriate Federal banking
agency, as defined in section 1813(q) of title 12,\227\ in the case of
national banks, Federal branches and Federal agencies of foreign banks,
and any subsidiaries of such entities (except brokers, dealers, persons
providing insurance, investment companies, and investment advisers);
member banks of the Federal Reserve System (other than national banks),
branches and agencies of foreign banks (other than Federal branches,
Federal agencies, and insured State branches of foreign banks),
commercial lending companies owned or controlled by foreign banks,
organizations operating under section 25 or 25A of the Federal Reserve
Act [12 U.S.C. 601 et seq., 611 et seq.], and bank holding companies
and their nonbank subsidiaries or affiliates (except brokers, dealers,
persons providing insurance, investment companies, and investment
advisers); as well as banks insured by the FDIC (other than members of
the Federal Reserve System), insured State branches of foreign banks,
and any subsidiaries of such entities (except brokers, dealers, persons
providing insurance, investment companies, and investment advisers);
and savings associations the deposits of which are insured by the FDIC,
and any subsidiaries of such savings associations (except brokers,
dealers, persons providing insurance, investment companies, and
investment advisers).
---------------------------------------------------------------------------

\227\ For purposes of section 1813(q), the appropriate Federal
banking agency for institutions listed in paragraphs (A) and (D) is
the OCC; for institutions listed in paragraphs (B), the Board; and
for institutions listed in paragraph (C), the FDIC. 12 U.S.C.
1813(q).
---------------------------------------------------------------------------

The Gramm-Leach-Bliley Act also provides for enforcement under the
following: (1) Federal Credit Union Act

[[Page 37742]]

[12 U.S.C. 1751 et seq.], by the Board of the NCUA with respect to any
federally insured credit union, and any subsidiaries of such an entity;
(2) the Securities Exchange Act of 1934 [15 U.S.C. 78a et seq.], by the
SEC with respect to any broker or dealer; (3) the Investment Company
Act of 1940 [15 U.S.C. 80a-1 et seq.], by the SEC with respect to
investment companies; (4) the Investment Advisers Act of 1940 [15
U.S.C. 80b-1 et seq.], by the SEC with respect to investment advisers
registered with the Commission under such Act; (5) State insurance law,
in the case of any person engaged in providing insurance, by the
applicable State insurance authority of the State in which the person
is domiciled, subject to section 6701 of the Gramm-Leach-Bliley Act;
(6) the Federal Trade Commission Act [15 U.S.C. 41 et seq.], by the
Federal Trade Commission for any other financial institution or other
person that is not subject to the jurisdiction of any agency or
authority listed above; and (7) subtitle E of the Consumer Financial
Protection Act of 2010 [12 U.S.C. 5561 et seq.], by the Bureau of
Consumer Financial Protection, in the case of any financial institution
and other covered person or service provider that is subject to the
jurisdiction of the Bureau.
The proposed rule includes these enforcement provisions as provided
in section 956.
FHFA's enforcement authority for the proposed rule derives from its
authorizing statute, the Safety and Soundness Act. FHFA is not one of
the ``Federal functional regulators'' listed in section 505 of the
Gramm-Leach-Bliley Act. Additionally, the applicability of Title V of
the Gramm-Leach-Bliley Act to Fannie Mae and Freddie Mac is limited by
their conditional exclusion from that Title's definition of ``financial
institution.'' But there is no evidence that Congress intended to
exclude FHFA, or Fannie Mae and Freddie Mac, from enforcement of the
proposed rule. To the contrary, Congress specifically included Fannie
Mae and Freddie Mac as covered financial institutions and FHFA as an
``appropriate federal regulator'' in section 956, and FHFA requires no
additional enforcement authority. The Safety and Soundness Act provides
FHFA with enforcement authority for all laws and regulations that apply
to its regulated entities.
13.1. The Agencies invite comment on all aspects of section __.13.

Sec. __.14 NCUA and FHFA Covered Institutions in Conservatorship,
Receivership, or Liquidation

The NCUA's and FHFA's proposed rules each include a section __.14
that would address those instances when a covered institution is placed
in conservatorship, receivership, or liquidation, including limited-
life regulated entities, under their respective authorizing statutes,
the Federal Credit Union Act or the Safety and Soundness Act.\228\ If a
covered institution is placed in conservatorship, receivership, or
liquidation, the conservator, receiver, or liquidating agent,
respectively, and not the covered institution's board or management,
has ultimate authority over all compensation arrangements, including
any incentive-based compensation for covered persons. When determining
or approving any incentive-based compensation plans for covered persons
at such a covered institution, the conservator, receiver, or
liquidating agent will implement the purposes of the Dodd-Frank Act by
prohibiting excessive incentive-based compensation and incentive-based
compensation that encourages inappropriate risk-taking.
---------------------------------------------------------------------------

\228\ The FDIC's proposed rule would not apply to institutions
for which the FDIC is appointed receiver under the FDIA or Title II
of the Dodd-Frank Act, as appropriate, as those statutes govern such
cases.
---------------------------------------------------------------------------

Institutions placed in conservatorship, receivership, or
liquidation may be subject to different needs and circumstances with
respect to attracting and retaining talent than other types of covered
institutions. In order to attract and retain qualified individuals at a
covered institution in conservatorship, for example, the conservator
may determine that while a significant portion of a covered person's
incentive-based compensation should be deferred, due to the uncertain
future of the covered institution in conservatorship, the deferral
period would be shorter than that set forth in the deferral provisions
of the proposed rule. In another example, where a conservator assumes
the roles and responsibilities of the covered institution's board and
its committees, the conservator may determine that it is not necessary
for the board of the covered institution, if any remains in
conservatorship, to approve a material adjustment to a senior executive
officer's incentive-based compensation arrangement as described by the
governance section of the proposed rule.
Certain provisions of the proposed rule, such as the deferral and
governance provisions, may not be appropriate for institutions in
conservatorship, receivership, or liquidation, and the incentive-based
compensation structure that best meets their needs while implementing
the purposes of the Dodd-Frank Act is appropriately left to the
conservator, receiver, or liquidating agent, respectively. Under the
applicable section __.14 of the proposed rule, if a covered institution
is placed in conservatorship, receivership, or liquidation under the
Safety and Soundness Act, for FHFA's proposed rule, or the Federal
Credit Union Act, for the NCUA's proposed rule, the respective
conservator, receiver, or liquidating agent would have the
responsibility to fulfill the requirements and purposes of 12 U.S.C.
5641. The conservator, receiver, or liquidating agent also has the
discretion to determine transition terms should the covered institution
cease to be in conservatorship, receivership, or liquidation.
14.1. Commenters are invited to address all aspects of section
__.14 of the proposed rule.

SEC Amendment to Exchange Act Rule 17a-4

The SEC is proposing an amendment to Exchange Act Rule 17a-4(e) (17
CFR 240.17a-4(e)) to require that broker-dealers maintain the records
required by Sec. __.4(f), and for Level 1 and Level 2 broker-dealers,
Sec. Sec. __.5 and __.11, in accordance with the recordkeeping
requirements of Exchange Act Rule 17a-4. Exchange Rule 17a-4
establishes the general formatting and storage requirements for records
that broker-dealers are required to keep. For the sake of consistency
with other broker-dealer records, the SEC believes that broker-dealers
should also keep the records required by Sec. __.4(f), and for Level 1
and Level 2 broker-dealers, Sec. Sec. __.5 and __.11, in accordance
with these requirements.
New paragraph (e)(10) of Exchange Act Rule 17a-4 would require
Level 1, Level 2, and Level 3 broker-dealers to maintain and preserve
in an easily accessible place the records required by Sec. __.4(f),
and for Level 1 and Level 2 broker-dealers, the records required by
Sec. Sec. __.5 and __.11. Paragraph (f) of Exchange Act Rule 17a-4
provides that the records a broker-dealer is required to maintain and
preserve under Exchange Act Rule 17a-3 (17 CFR 240.17a-3) and Exchange
Act Rule 17a-4 may be immediately produced or reproduced on
micrographic media or by means of electronic storage media. Paragraph
(j) of Exchange Act Rule 17a-4 requires a broker-dealer, which would
include a

[[Page 37743]]

broker-dealer that is a Level 1, Level 2, or Level 3 covered
institution pursuant to the proposed rules, to furnish promptly to a
representative of the SEC legible, true, complete, and current copies
of those records of the broker-dealer that are required to be preserved
under Exchange Act Rule 17a-4, or any other records of the broker-
dealer subject to examination under section 17(b) of the Securities
Exchange Act of 1934 that are requested by the representative.\229\
---------------------------------------------------------------------------

\229\ For a discussion generally of Exchange Act Rule 17a-4, see
Recordkeeping and Reporting Requirements for Security-Based Swap
Dealers, Major Security-Based Swap Participants, and Broker-Dealers;
Capital Rule for Certain Security-Based Swap Dealers, Release No.
34-71958 (Apr. 17, 2014), 79 FR 25194 (May 2, 2014).
---------------------------------------------------------------------------

SEC Amendment to Investment Advisers Act Rule 204-2

The SEC is proposing an amendment to rule 204-2 under the
Investment Advisers Act (17 CFR 275.204-2) to require that investment
advisers registered or required to be registered under section 203 of
the Investment Advisers Act (15 U.S.C. 80b-3) maintain the records
required by Sec. __.4(f) and, for those investment advisers that are
Level 1 or Level 2 covered institutions, Sec. Sec. __.5 and __.11, in
accordance with the recordkeeping requirements of rule 204-2. New
paragraph (a)(19) of rule 204-2 would require investment advisers
subject to rule 204-2 that are Level 1, Level 2, or Level 3 covered
institutions to make and keep true, accurate, and current the records
required by, and for the period specified in, Sec. __.4(f) and, for
those investment advisers that are Level 1 or Level 2 covered
institutions, the records required by, and for the periods specified
in, Sec. Sec. __.5 and __.11.
Rule 204-2 establishes the general recordkeeping requirements for
investment advisers registered or required to be registered under
section 203 of the Investment Advisers Act. For the sake of consistency
with other investment adviser records, the SEC is proposing that this
rule require such investment advisers that are covered institutions to
keep the records required by Sec. __.4(f) and those that are Level 1
or Level 2 covered institutions to keep the records required by
Sec. Sec. __.5 and __.11 in accordance with the requirements of rule
204-2.

III. Appendix to the Supplementary Information: Example Incentive-Based
Compensation Arrangement and Forfeiture and Downward Adjustment Review

For an incentive-based compensation arrangement to meet the
requirements of the proposed rule, particularly the requirement that
such an arrangement appropriately balance risk and reward, covered
institutions would need to look holistically at the entire incentive-
based arrangement. Below, for purposes of illustration only, the
Agencies outline an example of a hypothetical incentive-based
compensation arrangement that would meet the requirements of the
proposed rule and an example of how a forfeiture and downward
adjustment review might be conducted. These illustrations do not cover
every aspect of the proposed rule. They are provided as an aid to
understanding the proposed rule and would not carry the force and
effect of law or regulation, if issued as a companion to a final rule.
Reviewing these illustrations does not substitute for a review of the
proposed rule.
This example assumes that the final rule was published as proposed
and all incentive-based compensation programs and arrangements were
required to comply on or before January 1, 2020.

Ms. Ledger: Senior Executive Officer at Level 2 Covered Institution

Ms. Ledger is the chief financial officer at a bank holding
company, henceforth ``ABC,'' which has $200 billion in average total
consolidated assets. Under the definitions of the proposed rule Ms.
Ledger would be a senior executive officer and ABC would be a Level 2
covered institution.\230\
---------------------------------------------------------------------------

\230\ See the definitions of ``senior executive officer'' and
``Level 2 covered institution'' in section __.2 of the proposed
rule.
---------------------------------------------------------------------------

Ms. Ledger is provided incentive-based compensation under three
separate incentive-based compensation plans. The first plan, the
``Annual Executive Plan,'' is applicable to all senior executive
officers at ABC, and requires assessment over the course of one
calendar year. The second plan, the ``Annual Firm-Wide Plan,'' is
applicable to all employees at ABC, and is also based on a one-year
performance period that coincides with the calendar year. The third
plan, ``Ms. Ledger's LTIP,'' is applicable only to Ms. Ledger, and
requires assessment of performance over a three-year performance period
that begins on January 1 of year 1 and ends on December 31 of year 3.
These three plans together comprise Ms. Ledger's incentive-based
compensation arrangement.
The proposed rule would impose certain requirements on Ms. Ledger's
incentive-based compensation arrangement. Section __.4(a)(1) of the
proposed rule would require that Ms. Ledger's entire incentive-based
compensation arrangement, and each feature of that arrangement, not
provide excessive compensation. ABC would be required to consider the
six factors listed in section __.4(b) of the proposed rule, as well as
any other factors that ABC finds relevant, in evaluating whether Ms.
Ledger's incentive-based compensation arrangement provides excessive
compensation before approving Ms. Ledger's incentive-based compensation
arrangement.

Balance

Under section __.4(c)(1) of the proposed rule, the entire
arrangement would be required to appropriately balance risk and reward.
ABC would be expected to consider the risks that Ms. Ledger's
activities pose to the institution, and the performance that Ms.
Ledger's incentive-based compensation arrangement rewards. ABC might
consider both the type and target level of any associated performance
measures; how all performance measures would work together under the
three plans; the form of incentive-based compensation; the recourse ABC
has to reduce incentive-based compensation once awarded (through
forfeiture) \231\ including under the conditions outlined in section
__.7 of the proposed rule; the ability ABC has to use clawback of
incentive-based compensation once vested, including under the
conditions outlined in section __.7 of the proposed rule; and any
overlapping performance periods of the various incentive-based
compensation plans, which apply to Ms. Ledger.
---------------------------------------------------------------------------

\231\ This requirement for balance under section __.4(c)(1)
would not, however require forfeiture, or any specific forfeiture
measure, for any particular covered person. As discussed below,
sections __.7 and __.8 contain specific requirements applicable to
senior executive officers at Level 1 and Level 2 covered
institutions.
---------------------------------------------------------------------------

Under section __.4(d) of the proposed rule, Ms. Ledger's incentive-
based compensation arrangement would be required to include both
financial and non-financial measures of performance. These measures
would need to include considerations of risk-taking that are relevant
to Ms. Ledger's role within ABC and to the type of business in which
Ms. Ledger is engaged. They also would need to be appropriately
weighted to reflect risk-taking. The arrangement would be required to
allow non-financial

[[Page 37744]]

measures of performance to override financial measures of performance
when appropriate in determining Ms. Ledger's incentive-based
compensation. Any amounts to be awarded under Ms. Ledger's arrangement
would be subject to adjustment to reflect ABC's actual losses,
inappropriate risks Ms. Ledger took or was accountable for others
taking, compliance deficiencies Ms. Ledger was accountable for, or
other measures or aspects of Ms. Ledger's and ABC's financial and non-
financial performance. For example, the Annual Firm-Wide Plan might use
a forward-looking internal profit measure that takes into account
stressed conditions as a proxy for liquidity risk that Ms. Ledger's
activities pose to ABC and thus mitigates against incentives to take
imprudent liquidity risk. It might also include limits on liquidity
risk, the repeated breach of which would result in non-compliance with
a key non-financial performance objective.
In practice, each incentive-based compensation plan will include
various measures of performance, and under the proposed rule, each plan
would be required to include both financial and non-financial measures.
The Annual Firm-Wide Plan may be largely based on the change in value
of ABC's equity over the performance year, but that cannot be the only
basis for incentive-based compensation awarded under that plan. Non-
financial measures of Ms. Ledger's risk-taking activity would have to
be taken into account in determining the incentive-based compensation
awarded under that plan, and those non-financial measures would need to
be appropriately weighted so that they could override financial
measures. Even if ABC's equity performed very well over the performance
year, if Ms. Ledger was found to have violated risk performance
measures, Ms. Ledger should not be awarded the full target of
incentive-based compensation from the plan.
Because Ms. Ledger is a senior executive officer at a Level 2
covered institution, Ms. Ledger's incentive-based compensation
arrangement would not be considered to appropriately balance risk and
reward unless it was structured to be consistent with the requirements
set forth in sections __.7 and __.8 of the proposed rule. The
incentive-based compensation awarded to Ms. Ledger would not be
permitted to be based solely on relative performance measures \232\ or
be based solely on transaction revenue or volume.\233\ The Annual
Executive Plan may include a measure of ABC's TSR relative to its peer
group, but that plan would comply with the proposed rule only if other
absolute measures of ABC's or Ms. Ledger's performance were also
included (e.g., achievement of a three-year average return on risk
adjusted capital). Similarly, a plan that applied to significant risk-
takers who were engaged in trading might include transaction volume as
one of the financial performance measures, but that plan would comply
with the proposed rule only if it also included other factors, such as
measurement of transaction quality or the significant risk-taker's
compliance with the institution's risk-management policies.
---------------------------------------------------------------------------

\232\ See section __.8(c) of the proposed rule.
\233\ See section __.8(d) of the proposed rule.
---------------------------------------------------------------------------

Award of Incentive-Based Compensation for Performance Periods Ending
December 31, 2024

Ms. Ledger's incentive-based compensation is awarded on January 31,
2025. The Annual Executive Plan and the Annual Firm-Wide Plan are
awarded on this date for the performance period starting on January 1,
2024 and ending on December 31, 2024. Ms. Ledger's LTIP will be awarded
on this date for the performance period starting on January 1, 2022 and
ending on December 31, 2024. This example assumes ABC's share price on
December 31, 2024 (the end of the performance period) is $50.
Ms. Ledger's target incentive-based compensation award amount under
the Annual Executive plan is $60,000 and 1,000 shares of ABC.\234\
Under the Annual Firm-Wide Plan, Ms. Ledger's target incentive-based
compensation award amount is $30,000. Finally, under Ms. Ledger's LTIP,
her target incentive-based compensation award amount is $40,000 and
2,000 shares of ABC.
---------------------------------------------------------------------------

\234\ That is, if Ms. Ledger meets all of the performance
measure targets set out under that plan, she will be awarded both
$60,000 in cash and 1,000 shares of ABC stock.
---------------------------------------------------------------------------

To be consistent with the proposed rule, the maximum incentive-
based compensation amounts that ABC would be allowed to award to Ms.
Ledger are 125 percent of the target amount, which would amount to:
$75,000 and 1,250 shares under the Annual Executive Plan; $37,500 under
the Annual Firm-Wide Plan; and $50,000 and 2,500 shares under Ms.
Ledger's LTIP.
If Ms. Ledger were implicated in a forfeiture and downward
adjustment review during the performance period, ABC would be expected
to consider whether and by what amount to reduce the amounts awarded to
Ms. Ledger. As part of that review, ABC would be expected to consider
all of the amounts that could be awarded to Ms. Ledger under the Annual
Executive Plan, Annual Firm-Wide Plan, and Ms. Ledger's LTIP for
downward adjustment before any incentive-based compensation were
awarded to Ms. Ledger.\235\
---------------------------------------------------------------------------

\235\ See section __.7(b) of the proposed rule.
---------------------------------------------------------------------------

Regardless of whether a downward forfeiture and downward adjustment
review occurred, ABC would be expected to evaluate Ms. Ledger's
performance, including Ms. Ledger's risk-taking activities, at or near
the end of the performance period (December 31, 2024). ABC would be
required to use non-financial measures of performance, and particularly
measures of risk-taking, to determine Ms. Ledger's incentive-based
compensation award, possibly decreasing the amount Ms. Ledger would be
awarded if only financial measures were taken into account.\236\
---------------------------------------------------------------------------

\236\ See section __.4(d)(2) of the proposed rule.
---------------------------------------------------------------------------

Based on performance and taking into account Ms. Ledger's risk-
taking behavior, ABC decides to award Ms. Ledger: $30,000 and 1,000
shares under the Annual Executive Plan; $35,000 under the Annual Firm-
Wide Plan; and $40,000 and 2,000 shares under Ms. Ledger's LTIP.
Valuing the ABC equity at the time of award, the total value of Ms.
Ledger's award under the Annual Executive Plan is $80,000, under the
Annual Firm-Wide Plan is $35,000, and under Ms. Ledger's LTIP is
$140,000.

------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Target award Maximum award Actual award
-----------------------------------------------------------------------------------------------------------------------------------
Incentive-based compensation Value of Total Value of Total Value of Total
Cash ($) Equity equity value Cash ($) Equity equity value Cash \1\ Equity equity value
(#) ($) ($) (#) ($) ($) ($) \2\ (#) ($) ($)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Annual Executive Plan....................................... 60,000 1,000 50,000 110,000 75,000 1,250 62,500 137,500 30,000 1,000 50,000 80,000
Annual Firm-Wide Plan....................................... 30,000 ......... ......... 30,000 37,500 ......... ......... 37,500 35,000 ......... ......... 35,000
Ms. Ledger's LTIP........................................... 40,000 2,000 100,000 140,000 50,000 2,500 125,000 175,000 40,000 2,000 100,000 140,000
-----------------------------------------------------------------------------------------------------------------------------------

[[Page 37745]]

Total Incentive-Based Compensation...................... 130,000 3,000 150,000 280,000 162,500 3,750 87,500 350,000 105,000 3,000 150,000 255,000
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ The amount of actual cash award ABC chose to award.
\2\ The amount of actual equity award ABC chose to award.

To calculate the minimum required deferred amounts, ABC would have
to aggregate the amounts awarded under both the Annual Executive Plan
($80,000) and the Annual Firm-Wide Plan ($35,000), because each has the
same performance period, which is less than three years, to determine
the total amount of qualifying incentive-based compensation awarded
($115,000).\237\ At least 50 percent of that qualifying incentive-based
compensation would be required to be deferred for at least three
years.\238\ Thus, ABC would be required to defer cash and equity with
an aggregate value of at least $57,500 from qualifying incentive-based
compensation. ABC would have the flexibility to defer the amounts
awarded in cash or in equity, as long as the total deferred incentive-
based compensation was composed of both substantial amounts of deferred
cash and substantial amounts of deferred equity.\239\ ABC would also
have the flexibility to defer amounts awarded from either the Annual
Executive Plan or the Annual Firm-Wide Plan.
---------------------------------------------------------------------------

\237\ See section __.7(a)(1) of the proposed rule.
\238\ See sections __.7(a)(1)(i)(C) and __.7(a)(1)(ii)(B) of the
proposed rule.
\239\ See section __.7(a)(4)(i) of the proposed rule.
---------------------------------------------------------------------------

In this example, ABC chooses to defer $27,500 of cash and 650
shares from Ms. Ledger's award from the Annual Executive Plan, which
has a total value of $60,000 at the time of the award, for three years
and none of the award under the Annual Firm-Wide Plan.\240\
---------------------------------------------------------------------------

\240\ Ms. Ledger's entire award under the Annual Firm-Wide Plan,
$35,000, and remaining award under the Annual Executive Plan, $2,500
and 350 shares, could vest immediately.

--------------------------------------------------------------------------------------------------------------------------------------------------------
Total award Minimum required deferred Actual deferred
------------------------------------------------------------------------------------------------------------------------
Incentive-based compensation Value of Total Total Total Value of Total
Cash ($) Equity equity value value Deferral value Cash \2\ Equity equity value
(#) ($) ($) ($) rate (%) ($) ($) \3\ (#) ($) ($)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Annual Executive Plan.......... 30,000 1,000 50,000 80,000 ......... ......... ......... 27,500 650 32,500 60,000
Annual Firm-Wide Plan.......... 35,000 ......... ......... 35,000 ......... ......... ......... ......... ......... ......... .........
Qualified Incentive-Based 65,000 1,000 50,000 115,000 115,000 50 57,500 27,500 650 32,500 60,000
Compensation..................
Ms. Ledger's LTIP.............. 40,000 2,000 100,000 140,000 140,000 50 70,000 35,000 700 35,000 70,000
------------------------------------------------------------------------------------------------------------------------
Total Incentive-Based 105,000 3,000 150,000 255,000 255,000 50 127,500 62,500 1,350 67,500 130,000
Compensation..............
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ The aggregate amount from both the Annual Executive Plan and Annual Firm-Wide Plan.
\2\ The amount of actual cash award ABC chose to defer.
\3\ The amount of actual equity award ABC chose to defer.

Vesting Schedule

ABC would have the flexibility to determine the schedule by which
this deferred incentive-based compensation would be eligible for
vesting, as long as the cumulative total of the deferred incentive-
based compensation that has been made eligible for vesting by any given
year is not greater than the cumulative total that would have been
eligible for vesting had the covered institution made equal amounts
eligible for vesting each year.\241\ With deferred qualifying
incentive-based compensation valued at $60,000 and three-year vesting,
no more than $20,000 would be allowed to be eligible to vest on
December 31, 2025, and no more than $40,000 would be eligible to vest
on or before December 31, 2026. At least $20,000 would need to be
eligible to vest on December 31, 2027, to be consistent with the
proposed rule. In this example, ABC decides to make none of the
deferred award from the Annual Executive Plan eligible for vesting on
December 31, 2025; to make $13,750 and 325 shares (total value of cash
and equity $30,000) eligible for vesting on December 31, 2026; and to
make $13,750 and 325 shares (total value of cash and equity $30,000)
eligible for vesting on December 31, 2027.
---------------------------------------------------------------------------

\241\ See section __.7(a)(1)(iii) of the proposed rule.
---------------------------------------------------------------------------

Ms. Ledger's LTIP has a performance period of three years, so Ms.
Ledger's LTIP would meet the definition of a ``long-term incentive-
plan'' under the proposed rule.\242\ At least 50 percent of Ms.
Ledger's LTIP amount ($140,000) would be required to be deferred for at
least one year.\243\ Thus, ABC would be required to defer cash and
equity with an aggregate value of at least $70,000 from Ms. Ledger's
LTIP, which would be eligible for vesting on December 31, 2025. ABC
would have flexibility to defer the amounts awarded in cash or in
equity, as long as the total deferred incentive-based compensation were
composed of both substantial amounts of deferred cash and substantial
amounts of deferred equity.\244\ If ABC chooses to defer amounts
awarded from Ms. Ledger's LTIP for longer than one year, ABC would have
flexibility to determine the schedule on which it would be eligible for
vesting, as long as the cumulative total of the deferred incentive-
based compensation that has been made eligible for vesting by any given
year is not greater than the cumulative total that would have been
eligible for vesting had the covered institution made equal amounts
eligible for vesting in one year.\245\
---------------------------------------------------------------------------

\242\ See the definition of ``long-term incentive plan'' in
section __.2 of the proposed rule.
\243\ See sections __.7(a)(2)(i)(C) and __.7(a)(2)(ii)(B) of the
proposed rule.
\244\ See section __.7(a)(4)(i) of the proposed rule.
\245\ See section __.7(a)(2)(iii) of the proposed rule.
---------------------------------------------------------------------------

In this example, ABC chooses to defer $35,000 of cash and 700
shares of the award from Ms. Ledger's LTIP, which has a total value of
$70,000 at the time of the award, for one year.\246\ The non-deferred
amount ($35,000 and 700 shares) could vest at the time of the award on
January 31, 2025.
---------------------------------------------------------------------------

\246\ Ms. Ledger's remaining award under Ms. Ledger's LTIP would
vest immediately.
---------------------------------------------------------------------------

In summary, Ms. Ledger would receive $42,500 and 1,650 shares (a
total value of $125,000) immediately after December 31, 2024.\247\ A
total of $35,000 and 700 shares (total value $70,000) would be eligible
to vest on

[[Page 37746]]

December 31, 2025. A total of $13,750 and 325 shares (total value
$30,000) would be eligible to vest on December 31, 2026. Finally, a
total of $13,750 and 325 shares (total value $30,000) would again be
eligible to vest on December 31, 2027.
---------------------------------------------------------------------------

\247\ This amount would represent $2,500 and 350 shares awarded
under the Annual Executive Plan, $35,000 awarded under the Annual
Firm-Wide Plan and $5,000 and 1,300 shares awarded under Ms.
Ledger's LTIP.

--------------------------------------------------------------------------------------------------------------------------------------------------------
Immediate amounts payable Total amounts deferred
-------------------------------------------------------------------------------------------------------
Incentive-based compensation Value of Total value Value of Total value
Cash ($) Equity (#) equity ($) ($) Cash ($) Equity (#) equity ($) ($)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Annual Executive Plan........................... $2,500 350 $17,500 $20,000 $27,500 650 $32,500 $60,000
Annual Firm-Wide Plan........................... 35,000 ........... ........... 35,000 ........... ........... ........... ...........
Ms. Ledger's LTIP............................... 5,000 1,300 65,000 70,000 35,000 700 35,000 70,000
-------------------------------------------------------------------------------------------------------
Total Incentive-Based Compensation.......... 42,500 1,650 82,500 125,000 62,500 1,350 67,500 130,000
--------------------------------------------------------------------------------------------------------------------------------------------------------

Vesting Schedule
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
12/31/2025 12/31/2026 12/31/2027
-----------------------------------------------------------------------------------------------------------------------------------
Incentive-based compensation Value of Value of Value of
Cash ($) Equity equity Total Cash ($) Equity equity Total Cash ($) Equity equity Total
(#) ($) value ($) (#) ($) value ($) (#) ($) value ($)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Annual Executive Plan....................................... ......... ......... ......... ......... $13,750 325 $16,250 $30,000 $13,750 325 $16,250 $30,000
Ms. Ledger's LTIP........................................... $35,000 700 $35,000 $70,000 ......... ......... ......... ......... ......... ......... ......... .........
Amount Eligible for Vesting................................. ......... ......... ......... 70,000 ......... ......... ......... 30,000 ......... ......... ......... 30,000
Remaining Unvested Amount................................... ......... ......... ......... 60,000 ......... ......... ......... 30,000 ......... ......... ......... 0
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Use of Options in Deferred Incentive-Based Compensation

If, under the total award amount outlined above, ABC chooses to
award Ms. Ledger incentive-based compensation partially in the form of
options, and chooses to defer the vesting of those options, no more
than $38,250 worth of those options (the equivalent of 15 percent of
the aggregate incentive-based compensation awarded to Ms. Ledger) would
be eligible to be treated as deferred incentive-based
compensation.\248\ As an example, ABC may award Ms. Ledger options that
have a value at the end of the performance period of $10 and deferred
vesting. ABC may choose to award Ms. Ledger incentive-based
compensation with a total value of $255,000 in the following forms:
$30,000 in cash, 640 shares of equity (valued at $32,000), and 1,800
options (valued at $18,000) under the Annual Executive Plan; $35,000
cash under the Annual Firm-Wide Plan; and $40,000 cash, 1,600 shares of
equity (valued at $80,000), and 2,000 options (valued at $20,000) under
Ms. Ledger's LTIP. Of that award, ABC may defer: $27,500 in cash, 290
shares (valued at $14,500), and 1,800 options (valued at $18,000) under
the Annual Executive Plan (total value of deferred $60,000); none of
the award from the Annual Firm-Wide Plan; and $35,000 in cash, 300
shares (valued at $15,000) and 2,000 options (valued at $20,000) under
Ms. Ledger's LTIP (total value of deferred $70,000). The total value of
options being counted as deferred incentive-based compensation would be
$38,000, which would be 14.9 percent of the total incentive-based
compensation awarded ($255,000). Assuming the vesting schedule is
consistent with the proposed rule, Ms. Ledger's incentive-based
compensation arrangement would be consistent with the proposed rule,
because: (1) The value of Ms. Ledger's deferred incentive-based
compensation under the Annual Executive Plan (which comprises all of
Ms. Ledger's deferred qualifying incentive-based compensation) is more
than 50 percent of the value of Ms. Ledger's total qualifying
incentive-based compensation award ($115,000) and (2) the value of Ms.
Ledger's deferred incentive-based compensation under Ms. Ledger's LTIP
is 50 percent the value of Ms. Ledger's incentive-based compensation
awarded under a long-term incentive plan ($140,000).
---------------------------------------------------------------------------

\248\ See section __.7(a)(4)(ii).

Alternative Scenario 1: Deferred Options Consistent With the Proposed Rule
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total award amounts
-----------------------------------------------------------------------------------------------
Incentive-based compensation Value of Value of Total value
Cash ($) Equity (#) equity ($) Options (#) options ($) ($)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Annual Executive Plan................................... $30,000 640 $32,000 1,800 $18,000 $80,000
Annual Firm-Wide Plan................................... 35,000 .............. .............. .............. .............. 35,000
Ms. Ledger's LTIP....................................... 40,000 1,600 80,000 2,000 20,000 140,000
-----------------------------------------------------------------------------------------------
Total............................................... 105,000 2,240 112,000 3,800 38,000 255,000
--------------------------------------------------------------------------------------------------------------------------------------------------------
Amounts immediately payable
--------------------------------------------------------------------------------------------------------------------------------------------------------
Annual Executive Plan................................... $2,500 350 $17,500 .............. .............. 20,000
Annual Firm-Wide Plan................................... 35,000 .............. .............. .............. .............. 35,000
Ms. Ledger's LTIP....................................... 5,000 1,300 65,000 .............. .............. 70,000
-----------------------------------------------------------------------------------------------

[[Page 37747]]

Total............................................... 42,500 1,650 82,500 .............. .............. 125,000
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total deferred amounts
--------------------------------------------------------------------------------------------------------------------------------------------------------
Annual Executive Plan................................... $27,500 290 $14,500 1,800 $18,000 $60,000
Annual Firm-Wide Plan................................... .............. .............. .............. .............. .............. ..............
Ms. Ledger's LTIP....................................... 35,000 300 15,000 2,000 20,000 70,000
-----------------------------------------------------------------------------------------------
Total............................................... 62,500 590 29,500 3,800 38,000 130,000
--------------------------------------------------------------------------------------------------------------------------------------------------------

------------------------------------------------------------------------

------------------------------------------------------------------------
Aggregate Incentive-Based Compensation Awarded............. $255,000
Option Value at 15% Threshold Maximum...................... 38,250
Minimum Qualifying Incentive-Based Compensation--Deferral 57,500
at 50%....................................................
Minimum Incentive-Based Compensation Required under a Long- 70,000
Term Incentive Plan--Deferral at 50%......................
------------------------------------------------------------------------

In contrast, if ABC chooses to award Ms. Ledger more options than
in the example above, Ms. Ledger's incentive-based compensation
arrangement may no longer be consistent with the proposed rule. As a
second alternative scenario, ABC may choose to award Ms. Ledger
incentive-based compensation with a total value of $255,000 in the
following forms: $30,000 In cash, 500 shares of equity (valued at
$25,000), and 2,500 options (valued at $25,000) under the Annual
Executive Plan; $35,000 cash under the Annual Firm-Wide Plan; and
$40,000 cash, 1,600 shares of equity (valued at $80,000), and 2,000
options (valued at $20,000) under Ms. Ledger's LTIP. Of that award, if
ABC defers the following amounts, the arrangement would not be
consistent with the proposed rule: $27,500 in cash, 150 shares (valued
at $7,500), and 2,500 options (valued at $25,000) under the Annual
Executive Plan (total value of deferred $60,000); none of the award
from the Annual Firm-Wide Plan; and $35,000 in cash, 300 shares (valued
at $15,000) and 2,000 options (valued at $20,000) under Ms. Ledger's
LTIP (total value of deferred $70,000). The total value of options
would be $45,000, which would be 17.6 percent of the total incentive-
based compensation awarded ($255,000). Thus, 675 of those options, or
$6,750 worth, would not qualify to meet the minimum deferral
requirements of the proposed rule. Combining qualifying incentive-based
compensation and incentive-based compensation awarded under a long-term
incentive plan, Ms. Ledger's total minimum required deferral amount
would be $127,500, and yet incentive-based compensation worth only
$123,250 would be eligible to meet the minimum deferral requirements.
ABC could alter the proportions of incentive-based compensation awarded
and deferred in order to comply with the proposed rule.

Alternative Scenario 2: Deferred Options Inconsistent With the Proposed Rule
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total award amounts
-----------------------------------------------------------------------------------------------
Incentive-based compensation Value of Value of Total value
Cash ($) Equity (#) equity ($) Options (#) options ($) ($)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Annual Executive Plan................................... $30,000 500 $25,000 2,500 $25,000 $80,000
Annual Firm-Wide Plan................................... 35,000 .............. .............. .............. .............. 35,000
Ms. Ledger's LTIP....................................... 40,000 1,600 80,000 2,000 20,000 140,000
-----------------------------------------------------------------------------------------------
Total............................................... 105,000 2,100 105,000 4,500 45,000 255,000
--------------------------------------------------------------------------------------------------------------------------------------------------------
Amounts immediately payable
--------------------------------------------------------------------------------------------------------------------------------------------------------
Annual Executive Plan................................... $2,500 350 $17,500 .............. .............. $20,000
Annual Firm-Wide Plan................................... 35,000 .............. .............. .............. .............. 35,000
Ms. Ledger's LTIP....................................... 5,000 1,300 65,000 .............. .............. 70,000
-----------------------------------------------------------------------------------------------
Total............................................... 42,500 1,650 82,500 .............. .............. 125,000
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total deferred amounts
--------------------------------------------------------------------------------------------------------------------------------------------------------
Annual Executive Plan................................... $27,500 150 $7,500 2,500 $25,000 $60,000
Annual Firm-Wide Plan................................... .............. .............. .............. .............. .............. ..............
Ms. Ledger's LTIP....................................... 35,000 300 15,000 2,000 20,000 70,000
-----------------------------------------------------------------------------------------------
Total............................................... 62,500 450 22,500 4,500 45,000 130,000
--------------------------------------------------------------------------------------------------------------------------------------------------------

[[Page 37748]]

------------------------------------------------------------------------

------------------------------------------------------------------------
Aggregate Incentive-Based Compensation Awarded............. $255,000
Option Value at 15% Threshold Maximum...................... 38,250
Non-Qualifying Options..................................... 6,750 or
675 options
Incentive-Based Compensation Eligible to Meet the Minimum 123,250
Deferral Requirements.....................................
------------------------------------------------------------------------

Other Requirements Specific to Ms. Ledger's Incentive-Based
Compensation Arrangement

Under the proposed rule, ABC would not be allowed to accelerate the
vesting of Ms. Ledger's deferred incentive-based compensation, except
in the case of Ms. Ledger's death or disability, as determined by ABC
pursuant to sections __.7(a)(1)(iii)(B) and __.7(a)(2)(iii)(B).
Before vesting, ABC may determine to reduce the amount of deferred
incentive-based compensation that Ms. Ledger receives pursuant to a
forfeiture and downward adjustment review.\249\ If Ms. Ledger, or an
employee Ms. Ledger managed, had been responsible for an event
triggering the proposed rule's requirements for forfeiture and downward
adjustment review, ABC would be expected to consider all of the
unvested deferred amounts from the Annual Executive Plan and Ms.
Ledger's LTIP for forfeiture before any incentive-based compensation
vested even if the event occurred outside of the relevant performance
period for the awards discussed in the example (i.e., January 1, 2022
to December 31, 2024).\250\ ABC may also rely on other performance
adjustments during the deferral period to appropriately balance Ms.
Ledger's incentive-based compensation arrangement. In this case ABC
would take into account information about Ms. Ledger's and ABC's
performance that becomes better known during the deferral period to
potentially reduce the amount of deferred incentive-based compensation
that vests. ABC would not be allowed to increase the amount of deferred
incentive-based compensation that vests. In the case of the deferred
equity awarded to Ms. Ledger, the number of shares or options awarded
to Ms. Ledger and eligible for vesting on each anniversary of the end
of the performance period is the maximum number of shares or options
that may vest on that date. An increase in the total value of those
shares or options would not be considered an increase in the amount of
deferred incentive-based compensation for the purposes of the proposed
rule.\251\
---------------------------------------------------------------------------

\249\ See ``Mr. Ticker: Forfeiture and downward adjustment
review'' discussion below for more details about the requirements
for a forfeiture and downward adjustment review.
\250\ See section __.7(b) of the proposed rule.
\251\ See section __.7(a)(3) of the proposed rule.
---------------------------------------------------------------------------

ABC would be required to include clawback provisions in Ms.
Ledger's incentive-based compensation arrangement that, at a minimum,
allowed for clawback for seven years following the date on which Ms.
Ledger's incentive-based compensation vested.\252\ These provisions
would permit ABC to recover up to 100 percent of any vested incentive-
based compensation if ABC determined that Ms. Ledger engaged in certain
misconduct, fraud or intentional misrepresentation of information, as
described in section __.7(c) of the proposed rule. Thus, if in the year
2030, ABC determined that Ms. Ledger engaged in fraud in the year 2024,
the entirety of the $42,500 and 1,650 shares of equity that vested
immediately after 2024, and as well as any part of her deferred
incentive-based compensation ($62,500 and 1,350 shares of equity) that
actually had vested by 2030, could be subject to clawback by ABC. Facts
and circumstances would determine whether the ABC would actually seek
to claw back amounts, as well as the specific amount ABC would seek to
recover from Ms. Ledger's already-vested incentive-based compensation.
---------------------------------------------------------------------------

\252\ See section __.7(c) of the proposed rule.
---------------------------------------------------------------------------

Finally, in order for Ms. Ledger's incentive-based compensation
arrangement to appropriately balance risk and reward, ABC would not be
permitted to purchase a hedging instrument or similar instrument on Ms.
Ledger's behalf that would offset any decrease in the value of Ms.
Ledger's deferred incentive-based compensation.\253\
---------------------------------------------------------------------------

\253\ See section __.8(a) of the proposed rule.
---------------------------------------------------------------------------

Risk Management and Controls and Governance

Sections __.4(c)(2) and __.4(c)(3) of the proposed rule would
require that Ms. Ledger's incentive-based compensation arrangement be
compatible with effective risk management and controls and be supported
by effective governance.
For Ms. Ledger's arrangement to be compatible with effective risk
management and controls, ABC's risk management framework and controls
would be required to comply with the specific provisions of section
__.9 of the proposed rule. ABC would have to maintain a risk management
framework for its incentive-based compensation program that is
independent of any lines of business, includes an independent
compliance program, and is commensurate with the size and complexity of
ABC's operations.\254\ ABC would have to provide individuals engaged in
control functions with the authority to influence the risk-taking of
the business areas they monitor and ensure that covered persons engaged
in control functions are compensated in accordance with the achievement
of performance objectives linked to their job functions, independent of
the performance of those business areas.\255\ In addition, ABC would
have to provide for independent monitoring of events related to
forfeiture and downward adjustment reviews and decisions of forfeiture
and downward adjustment reviews.\256\
---------------------------------------------------------------------------

\254\ See section __.9(a) of the proposed rule.
\255\ See section __.9(b) of the proposed rule.
\256\ See section __.9(c) of the proposed rule.
---------------------------------------------------------------------------

For Ms. Ledger's arrangement to be consistent with the effective
governance requirement in the proposed rule, the board of directors of
ABC would be required to establish a compensation committee composed
solely of directors who are not senior executive officers. The board of
directors, or a committee thereof, would be required to approve Ms.
Ledger's incentive-based compensation arrangements, including the
amounts of all awards and payouts under those arrangements.\257\ In
this example, the board of directors or a committee thereof (such as
the compensation committee) would be required to approve the total
award of $105,000 and 3,000 shares in 2024. Each time deferred amounts
are scheduled to vest (in this example, in December 31, 2025, December
31, 2026, and December 31, 2027), the board of directors or a committee
thereof would also be required to approve the amounts that vest.\258\
Additionally, the compensation committee would be required to receive
input from the risk and audit committees of the ABC's board of
directors on the effectiveness of risk measures and adjustments used to
balance risk and reward in incentive-based compensation
arrangements.\259\ Finally, the compensation committee would be
required to obtain at least annually two written assessments, one
prepared by ABC's management with input from the risk and audit
committees of the board of directors and a separate assessment written
from ABC's risk management or internal audit function developed
independently of ABC's senior management. Both

[[Page 37749]]

assessments would focus on the effectiveness of ABC's incentive-based
compensation program and related compliance and control processes in
providing appropriate risk-taking incentives.\260\
---------------------------------------------------------------------------

\257\ See section __.4(e) of the proposed rule.
\258\ See sections __.4(e)(2) and __.4(e)(3) of the proposed
rule.
\259\ See section __.10(b)(1) of the proposed rule.
\260\ See sections __.10(b)(2) and __.10(b)(3) of the proposed
rule.
---------------------------------------------------------------------------

Recordkeeping

In order to comply with the recordkeeping requirements in the
proposed rule, ABC would be required to document Ms. Ledger's
incentive-based compensation arrangement.\261\ ABC would be required to
maintain copies of the Annual Executive Plan, the Annual Firm-Wide
Plan, and Ms. Ledger's LTIP, along with all plans that are part of
ABC's incentive-based compensation program. ABC also would be required
to include Ms. Ledger on the list of senior executive officers and
significant risk-takers, including the legal entity for which she
works, her job function, her line of business, and her position in the
organizational hierarchy.\262\ Finally, ABC would be required to
document Ms. Ledger's entire incentive-based compensation arrangement,
including information on percentage deferred and form of payment and
any forfeiture and downward adjustment or clawback reviews and
decisions that pertain to her.\263\
---------------------------------------------------------------------------

\261\ See sections __.4(f) and __.5(a) of the proposed rule.
\262\ See section __.5(a) of the proposed rule.
\263\ See section __.5(a) of the proposed rule.
---------------------------------------------------------------------------

Mr. Ticker: Forfeiture and Downward Adjustment Review

Under section __.7(b) of the proposed rule, ABC would be required
to put certain portions of a senior executive officer's or significant
risk-taker's incentive-based compensation at risk of forfeiture and
downward adjustment upon certain triggering events.\264\ In this
example, Mr. Ticker is a significant risk-taker who is the senior
manager of a trader and a trading desk that engaged in inappropriate
risk-taking in calendar year 2021, which was discovered on March 1,
2024.\265\ The activity of the trader, and several other members of the
same trading desk, resulted in an enforcement proceeding against ABC
and the imposition of a significant fine.
---------------------------------------------------------------------------

\264\ See section __.7(b) of the proposed rule.
\265\ If Mr. Ticker's inappropriate risk-taking during 2021 were
instead discovered in another year, ABC could subject all deferred
amounts not yet vested in that year to forfeiture.
---------------------------------------------------------------------------

Mr. Ticker is provided incentive-based compensation under two
separate incentive-based compensation plans. The first plan, the
``Annual Firm-Wide Plan,'' is applicable to all employees at ABC, and
is based on a one-year performance period that coincides with the
calendar year. The second plan, ``Mr. Ticker's LTIP,'' is applicable to
all traders at Mr. Ticker's level, and requires assessment of
performance over a three-year performance period that begins on January
1, 2022 (year 1) and ends on December 31, 2024 (year 3). These two
plans together comprise Mr. Ticker's incentive-based compensation
arrangement.
The proposed rule would require ABC to conduct a forfeiture and
downward adjustment review both because the trades resulted from
inappropriate risk-taking and because they failed to comply with a
statutory, regulatory, or supervisory standard in a manner that
resulted in an enforcement or legal action against ABC.\266\ In
addition, the possibility exists that a material risk management and
control failure as described in section __.7(b)(2)(iii) of the proposed
rule has occurred, which would widen the group of covered employees
whose incentive-based compensation would be considered for possible
forfeiture and downward adjustment. Under the proposed rule, covered
institutions would be required to consider forfeiture and downward
adjustment for a covered person with direct responsibility for the
adverse outcome (in this case, the trader, if designated as a
significant risk-taker), as well as responsibility due to the covered
person's role or position in the covered institution's organizational
structure (in this case, Mr. Ticker for his possible lack of oversight
of the trader when such activities were conducted).\267\
---------------------------------------------------------------------------

\266\ See sections __.7(b)(2)(ii) and __.7(b)(2)(iv)(A) of the
proposed rule.
\267\ See section __.7(b)(3) of the proposed rule.
---------------------------------------------------------------------------

In this example, ABC determines that as the senior manager of the
trader, Mr. Ticker is responsible for inappropriate oversight of the
trader and that Mr. Ticker facilitated the inappropriate risk-taking
the trader engaged in. Under the proposed rule, ABC would have to
consider all of Mr. Ticker's unvested deferred incentive-based
compensation, including unvested deferred amounts awarded under Mr.
Ticker's LTIP, when determining the appropriate impact on Mr. Ticker's
incentive-based compensation.\268\ In addition, all of Mr. Ticker's
incentive-based compensation amounts not yet awarded for the current
performance period, including amounts to be awarded under Mr. Ticker's
LTIP, would have to be considered for possible downward
adjustment.\269\ The amount by which Mr. Ticker's incentive-based
compensation would be reduced could be part or all of the relevant
tranches which have not yet vested or have not yet been awarded. For
example, if Mr. Ticker's lack of oversight were determined to be only a
contributing factor that led to the adverse outcome (e.g., Mr. Ticker
identified and elevated the breach of related risk limits but made no
effort to follow up in order to ensure that such activity immediately
ceased), ABC might be comfortable reducing only a portion of the
incentive-based compensation to be awarded under Mr. Ticker's LTIP in
2024.
---------------------------------------------------------------------------

\268\ See section __.7(b)(1)(i) of the proposed rule.
\269\ See section __.7(b)(1)(ii) of the proposed rule.
---------------------------------------------------------------------------

To determine the amount or portion of Mr. Ticker's incentive-based
compensation that should be forfeited or adjusted downward under the
proposed rule, ABC would be required to consider, at a minimum, the six
factors listed in section __.7(b)(4) of the proposed rule.\270\ The
cumulative impact of these factors, when appropriately weighed in the
final decision-making process, might lead to lesser or greater impact
on Mr. Ticker's incentive-based compensation. For instance, if it were
found that Mr. Ticker had repeatedly failed to manage traders or others
who report to him, ABC might decide that a reduction of 100 percent of
Mr. Ticker's incentive-based compensation at risk would be
appropriate.\271\ On the other hand, if it were determined that Mr.
Ticker took immediate and meaningful actions to prevent the adverse
outcome from occurring and immediately escalated and addressed the
inappropriate behavior, the impact on Mr. Ticker's incentive-based
compensation could be less than 100 percent, or nothing.
---------------------------------------------------------------------------

\270\ See section __.7(b)(4) of the proposed rule.
\271\ See sections __.7(b)(4)(ii) and (iii) of the proposed
rule.
---------------------------------------------------------------------------

It is possible that some or all of Mr. Ticker's incentive-based
compensation may be forfeited before it vests, which could result in
amounts vesting faster than pro rata. In this case, ABC decides to
defer $30,000 of Mr. Ticker's incentive-based compensation for three
years so that $10,000 is eligible for vesting in 2022, $10,000 is
eligible for vesting in 2023, and $10,000 is eligible for vesting in
2024. This schedule would meet the proposed rule's pro rata vesting
requirement. No adverse information about Mr. Ticker's performance
comes to light in 2022 or 2023 and so $10,000 vests in each of those
years. However, Mr. Ticker's

[[Page 37750]]

inappropriate risk-taking during 2021 is discovered in 2024, causing
ABC to forfeit the remaining $10,000. Therefore, the amounts that vest
in this case are $10,000 in 2022, $10,000 in 2023, and $0 in 2024.
While the vesting is faster than pro rata due to the forfeiture, the
incentive-based compensation arrangement would still be consistent with
the proposed rule since the original vesting schedule would have been
in compliance.
ABC would be required to document the rationale for its decision
and to keep timely and accurate records that detail the individuals
considered for compensation adjustments, the factors weighed in
reaching a final decision and how those factors were considered during
the decision-making process.\272\
---------------------------------------------------------------------------

\272\ See section __.5(a)(3) of the proposed rule.
---------------------------------------------------------------------------

IV. Request for Comments

The Agencies are interested in receiving comments on all aspects of
the proposed rule.

V. Regulatory Analysis

A. Regulatory Flexibility Act

OCC: Pursuant to section 605(b) of the Regulatory Flexibility Act,
5 U.S.C. 605(b) (``RFA''), the initial regulatory flexibility analysis
otherwise required under section 603 of the RFA is not required if the
agency certifies that the proposed rule will not, if promulgated, have
a significant economic impact on a substantial number of small entities
(defined for purposes of the RFA to include banks and Federal branches
and agencies with assets less than or equal to $550 million) and
publishes its certification and a short, explanatory statement in the
Federal Register along with its proposed rule.
As discussed in the SUPPLEMENTARY INFORMATION section above,
section 956 of the Dodd-Frank Act does not apply to institutions with
assets of less than $1 billion. As a result, the proposed rule will
not, if promulgated, apply to any OCC-supervised small entities. For
this reason, the proposed rule will not, if promulgated, have a
significant economic impact on a substantial number of OCC-supervised
small entities. Therefore, the OCC certifies that the proposed rule
will not, if promulgated, have a significant economic impact on a
substantial number of small entities.
Board: The Board has considered the potential impact of the
proposed rule on small banking organizations in accordance with the RFA
(5 U.S.C. 603(b)). As discussed in the SUPPLEMENTARY INFORMATION above,
section 956 of the Dodd-Frank Act (codified at 12 U.S.C. 5641) requires
that the Agencies prohibit any incentive-based payment arrangement, or
any feature of any such arrangement, at a covered financial institution
that the Agencies determine encourages inappropriate risks by a
financial institution by providing excessive compensation or that could
lead to material financial loss. In addition, under the Dodd-Frank Act
a covered financial institution also must disclose to its appropriate
Federal regulator the structure of its incentive-based compensation
arrangements. The Board and the other Agencies have issued the proposed
rule in response to these requirements of the Dodd-Frank Act.
The proposed rule would apply to ``covered institutions'' as
defined in the proposed rule. Covered institutions as so defined
include specifically listed types of institutions, as well as other
institutions added by the Agencies acting jointly by rule. In every
case, however, covered institutions must have at least $1 billion in
total consolidated assets pursuant to section 956(f). Thus the proposed
rule is not expected to apply to any small banking organizations
(defined as banking organizations with $550 million or less in total
assets). See 13 CFR 121.201.
The proposed rule would implement section 956(a) of the Dodd-Frank
act by requiring a covered institution to create annually and maintain
for a period of at least seven years records that document the
structure of all its incentive-based compensation arrangements and
demonstrate compliance with the proposed rule. A covered institution
must disclose the records to the Board upon request. At a minimum, the
records must include copies of all incentive-based compensation plans,
a record of who is subject to each plan, and a description of how the
incentive-based compensation program is compatible with effective risk
management and controls.
Covered institutions with at least $50 billion in consolidated
assets, and their subsidiaries with at least $1 billion in total
consolidated assets, would be subject to additional, more specific
requirements, including that such covered institutions create annually
and maintain for a period of at least seven years records that
document: (1) The covered institution's senior executive officers and
significant risk-takers, listed by legal entity, job function,
organizational hierarchy, and line of business; (2) the incentive-based
compensation arrangements for senior executive officers and significant
risk-takers, including information on percentage of incentive-based
compensation deferred and form of award; (3) any forfeiture and
downward adjustment or clawback reviews and decisions for senior
executive officers and significant risk-takers; and (4) any material
changes to the covered institution's incentive-based compensation
arrangements and policies. These larger covered institutions must
provide these records in such form and with such frequency as requested
by the Board, and they must be maintained in a manner that allows for
an independent audit of incentive-based compensation arrangements,
policies, and procedures.
As described above, the volume and detail of information required
to be created and maintained by a covered institution is tiered;
covered institutions with less than $50 billion in total consolidated
assets are subject to less rigorous and detailed informational
requirements than larger covered institutions. As such, the Board
expects that the volume and detail of information created and
maintained by a covered institution with greater than $50 billion in
consolidated assets, that may use incentive-based arrangements to a
significant degree, would be substantially greater than that created
and maintained by a smaller institution.
The proposed rule would implement section 956(b) of the Dodd-Frank
Act by prohibiting a covered institution from having incentive-based
compensation arrangements that may encourage inappropriate risks (i) by
providing excessive compensation or (ii) that could lead to material
financial loss. The proposed rule would establish standards for
determining whether an incentive-based compensation arrangement
violates these prohibitions. These standards would include deferral,
forfeiture, downward adjustment, clawback, and other requirements for
certain covered persons at covered institutions with total consolidated
assets of more than $50 billion, and their subsidiaries with at least
$1 billion in assets, as well as specific prohibitions on incentive-
based compensation arrangements at these institutions. Consistent with
section 956(c), the standards adopted under section 956 are comparable
to the compensation-related safety and soundness standards applicable
to insured depository institutions under section 39 of the FDIA. The
proposed rule also would supplement existing guidance adopted by the
Board and the other Federal Banking Agencies regarding incentive-based
compensation (i.e., the 2010 Federal Banking Agency Guidance, as

[[Page 37751]]

defined in the SUPPLEMENTARY INFORMATION above).
The proposed rule also would require all covered institutions to
have incentive-based compensation arrangements that are compatible with
effective risk management and controls and supported by effective
governance. In addition, the board of directors, or a committee
thereof, of a covered institution to conduct oversight of the covered
institution's incentive-based compensation program and to approve
incentive-based compensation arrangements and material exceptions or
adjustments to incentive-based compensation policies or arrangements
for senior executive officers. For covered institutions with greater
than $50 billion in total consolidated assets, and their subsidiaries
with at least $1 billion in total consolidated assets, the proposed
rule includes additional specific requirements for risk management and
controls, governance and policies and procedures. Thus, like the
deferral, forfeiture, downward adjustment, clawback and other
requirements referred to above, risk management, governance, and
policies and procedures requirements are tiered based on the size of
the covered institution, with smaller institutions only subject to
general risk management, controls, and governance requirements and
larger institutions subject to more detailed requirements, including
policies and procedures requirements. Therefore, the requirements of
the proposed rule in these areas would be expected to be less extensive
for covered institutions with less than $50 billion in total
consolidated assets than for larger covered institutions.
As noted above, because the proposed rule applies to institutions
that have at least $1 billion in total consolidated assets, if adopted
in final form it is not expected to apply to any small banking
organizations for purposes of the RFA. In light of the foregoing, the
Board does not believe that the proposed rule, if adopted in final
form, would have a significant economic impact on a substantial number
of small entities supervised by the Board. The Board specifically seeks
comment on whether the proposed rule would impose undue burdens on, or
have unintended consequences for, small institutions and whether there
are ways such potential burdens or consequences could be addressed in a
manner consistent with section 956 of the Dodd-Frank Act.
FDIC: In accordance with the RFA, 5 U.S.C. 601-612 (``RFA''), an
agency must provide an initial regulatory flexibility analysis with a
proposed rule or to certify that the rule will not have a significant
economic impact on a substantial number of small entities (defined for
purposes of the RFA to include banking entities with total assets of
$550 million or less).
As described in the Scope and Initial Applicability section of the
SUPPLEMENTARY INFORMATION above, the proposed rule would establish
general requirements applicable to the incentive-based compensation
arrangements of all institutions defined as covered institutions under
the proposed rule (i.e., covered institutions with average total
consolidated assets of $1 billion or more that offers incentive-based
compensation to covered persons). As of December 31, 2015, a total of
353 FDIC-supervised institutions had total assets of $1 billion or more
and would be subject to the proposed rule.
As of December 31, 2015, there were 3,947 FDIC-supervised
depository institutions. Of those depository institutions, 3,262 had
total assets of $550 million or less. All FDIC-supervised depository
institutions that fall under the $550 million asset threshold, by
definition, would not be subject to the proposed rule, regardless of
their incentive-based compensation practices.
Therefore, the FDIC certifies that the notice of proposed
rulemaking would not have a significant economic impact on a
substantial number of small FDIC-supervised institutions.
FHFA: FHFA believes that the proposed rule will not have a
significant economic impact on a substantial number of small entities,
since none of FHFA's regulated entities come within the meaning of
small entities as defined in the RFA (see 5 U.S.C. 601(6)), and the
proposed rule will not substantially affect any business that its
regulated entities might conduct with such small entities.
NCUA: The RFA requires NCUA to prepare an analysis to describe any
significant economic impact a regulation may have on a substantial
number of small entities.\273\ For purposes of this analysis, NCUA
considers small credit unions to be those having under $100 million in
assets.\274\ Section 956 of the Dodd Frank Act and the NCUA's proposed
rule apply only to credit unions with $1 billion or more in assets.
Accordingly, NCUA certifies that the proposed rule would not have a
significant economic impact on a substantial number of small entities
since the credit unions subject to NCUA's proposed rule are not small
entities for RFA purposes.
---------------------------------------------------------------------------

\273\ 5 U.S.C. 603(a).
\274\ 80 FR 57512 (September 24, 2015).
---------------------------------------------------------------------------

SEC: Pursuant to 5 U.S.C. 605(b), the SEC hereby certifies that the
proposed rules would not, if adopted, have a significant economic
impact on a substantial number of small entities. The SEC notes that
the proposed rules would not apply to broker-dealers or investment
advisers with less than $1 billion in total consolidated assets.
Therefore, the SEC believes that all broker-dealers and investment
advisers that are likely to be covered institutions under the proposed
rules would not be small entities.
The SEC encourages written comments regarding this certification.
The SEC solicits comment as to whether the proposed rules could have an
effect on small entities that has not been considered. The SEC requests
that commenters describe the nature of any impact on small entities and
provide empirical data to support the extent of such impact.

B. Paperwork Reduction Act

Certain provisions of the proposed rule contain ``collection of
information'' requirements within the meaning of the Paperwork
Reduction Act (PRA) of 1995.\275\ In accordance with the requirements
of the PRA, the Agencies may not conduct or sponsor, and a respondent
is not required to respond to, an information collection unless it
displays a currently valid Office of Management and Budget (OMB)
control number. The information collection requirements contained in
this joint notice of proposed rulemaking have been submitted by the
OCC, FDIC, NCUA, and SEC to OMB for review and approval under section
3506 of the PRA and section 1320.11 of OMB's implementing regulations
(5 CFR part 1320). The Board reviewed the proposed rule under the
authority delegated to the Board by OMB. FHFA has found that, with
respect to any regulated entity as defined in section 1303(20) of the
Safety and Soundness Act (12 U.S.C. 4502(20)), the proposed rule does
not contain any collection of information that requires the approval of
the OMB under the PRA. The recordkeeping requirements are found in
sections __.4(f), __.5, and __.11.
---------------------------------------------------------------------------

\275\ 44 U.S.C. 3501-3521.
---------------------------------------------------------------------------

Comments are invited on:
(a) Whether the collections of information are necessary for the
proper performance of the Agencies' functions, including whether the
information has practical utility;
(b) The accuracy of the estimates of the burden of the information

[[Page 37752]]

collections, including the validity of the methodology and assumptions
used;
(c) Ways to enhance the quality, utility, and clarity of the
information to be collected;
(d) Ways to minimize the burden of the information collections on
respondents, including through the use of automated collection
techniques or other forms of information technology; and
(e) Estimates of capital or start up costs and costs of operation,
maintenance, and purchase of services to provide information.
All comments will become a matter of public record. Comments on
aspects of this notice that may affect reporting, recordkeeping, or
disclosure requirements and burden estimates should be sent to the
addresses listed in the ADDRESSES section. A copy of the comments may
also be submitted to the OMB desk officer for the Agencies by mail to
U.S. Office of Management and Budget, 725 17th Street NW., #10235,
Washington, DC 20503, by facsimile to (202) 395-5806, or by email to
oira_submission@omb.eop.gov, Attention, Commission and Federal Banking
Agency Desk Officer.
Proposed Information Collection
Title of Information Collection: Recordkeeping Requirements
Associated with Incentive-Based Compensation Arrangements.
Frequency of Response: Annual.
Affected Public: Businesses or other for-profit.
Respondents:
OCC: National banks, Federal savings associations, and Federal
branches or agencies of a foreign bank with average total consolidated
assets greater than or equal to $1 billion and their subsidiaries.
Board: State member banks, bank holding companies, savings and loan
holding companies, Edge and Agreement corporations, state-licensed
uninsured branches or agencies of a foreign bank, and foreign banking
organization with average total consolidated assets greater than or
equal to $1 billion and their subsidiaries.
FDIC: State nonmember banks, state savings associations, and state
insured branches of a foreign bank, and certain subsidiaries thereof,
with average total consolidated assets greater than or equal to $1
billion.
NCUA: Credit unions with average total consolidated assets greater
than or equal to $1 billion.
SEC: Brokers or dealers registered under section 15 of the
Securities Exchange Act of 1934 and investment advisers as such term is
defined in section 202(a)(11) of the Investment Advisers Act of 1940,
in each case, with average total consolidated assets greater than or
equal to $1 billion.
Abstract: Section 956(e) of the Dodd-Frank Act requires that the
Agencies prohibit incentive-based payment arrangements at a covered
financial institution that encourage inappropriate risks by a financial
institution by providing excessive compensation or that could lead to
material financial loss. Under the Dodd-Frank Act, a covered financial
institution also must disclose to its appropriate Federal regulator the
structure of its incentive-based compensation arrangements sufficient
to determine whether the structure provides ``excessive compensation,
fees, or benefits'' or ``could lead to material financial loss'' to the
institution. The Dodd-Frank Act does not require a covered financial
institution to disclose compensation of individuals as part of this
requirement.
Section __.4(f) would require all covered institutions to create
annually and maintain for a period of at least seven years records that
document the structure of all its incentive-based compensation
arrangements and demonstrate compliance with this part. A covered
institution must disclose the records to the Agency upon request. At a
minimum, the records must include copies of all incentive-based
compensation plans, a record of who is subject to each plan, and a
description of how the incentive-based compensation program is
compatible with effective risk management and controls.
Section __.5 would require a Level 1 or Level 2 covered institution
to create annually and maintain for a period of at least seven years
records that document: (1) The covered institution's senior executive
officers and significant risk-takers, listed by legal entity, job
function, organizational hierarchy, and line of business; (2) the
incentive-based compensation arrangements for senior executive officers
and significant risk-takers, including information on percentage of
incentive-based compensation deferred and form of award; (3) any
forfeiture and downward adjustment or clawback reviews and decisions
for senior executive officers and significant risk-takers; and (4) any
material changes to the covered institution's incentive-based
compensation arrangements and policies. A Level 1 or Level 2 covered
institution must create and maintain records in a manner that allows
for an independent audit of incentive-based compensation arrangements,
policies, and procedures, including, those required under Sec. __.11.
A Level 1 or Level 2 covered institution must provide the records
described above to the Agency in such form and with such frequency as
requested by Agency.
Section __.11 would require a Level 1 or Level 2 covered
institution to develop and implement policies and procedures for its
incentive-based compensation program that, at a minimum (1) are
consistent with the prohibitions and requirements of this part; (2)
specify the substantive and procedural criteria for the application of
forfeiture and clawback, including the process for determining the
amount of incentive-based compensation to be clawed back; (3) require
that the covered institution maintain documentation of final
forfeiture, downward adjustment, and clawback decisions; (4) specify
the substantive and procedural criteria for the acceleration of
payments of deferred incentive-based compensation to a covered person,
consistent with section __.7(a)(1)(iii)(B) and section
__.7(a)(2)(iii)(B)); (5) identify and describe the role of any
employees, committees, or groups authorized to make incentive-based
compensation decisions, including when discretion is authorized; (6)
describe how discretion is expected to be exercised to appropriately
balance risk and reward; (7) require that the covered institution
maintain documentation of the establishment, implementation,
modification, and monitoring of incentive-based compensation
arrangements, sufficient to support the covered institution's
decisions; (8) describe how incentive-based compensation arrangements
will be monitored; (9) specify the substantive and procedural
requirements of the independent compliance program consistent with
section 9(a)(2); and (10) ensure appropriate roles for risk management,
risk oversight, and other control function personnel in the covered
institution's processes for designing incentive-based compensation
arrangements and determining awards, deferral amounts, deferral
periods, forfeiture, downward adjustment, clawback, and vesting; and
assessing the effectiveness of incentive-based compensation
arrangements in restraining inappropriate risk-taking.
Collection of Information Is Mandatory
The collection of information will be mandatory for any covered
institution subject to the proposed rules.
Confidentiality
The information collected pursuant to the collection of information
will be

[[Page 37753]]

kept confidential, subject to the provisions of applicable law.
Estimated Paperwork Burden
In determining the method for estimating the paperwork burden the
Board, OCC and FDIC made the assumption that covered institution
subsidiaries of a covered institution subject to the Board's, OCC's or
FDIC's proposed rule, respectively, would act in concert with one
another to take advantage of efficiencies that may exist. The Board,
OCC and FDIC invite comment on whether it is reasonable to assume that
covered institutions that are affiliated entities would act jointly or
whether they would act independently to implement programs tailored to
each entity.
Estimated Average Hours per Response
Recordkeeping Burden
Sec. __.4(f)-20 hours (Initial setup 40 hours).
Sec. Sec. __.5 and __.11 (Level 1 and Level 2)-20 hours (Initial
setup 40 hours).
OCC
Number of respondents: 229 (Level 1-18, Level 2-17, and Level 3-
194).
Total estimated annual burden: 15,840 hours (10,560 hours for
initial setup and 5,280 hours for ongoing compliance).
Board
Number of respondents: 829 (Level 1-15, Level 2-51, and Level 3-
763).
Total estimated annual burden: 53,700 hours (35,800 hours for
initial setup and 17,900 hours for ongoing compliance).
FDIC
Number of respondents: 353 (Level 1-0, Level 2-13, and Level 3-
340).
Total estimated annual burden: 21,960 hours (14,640 hours for
initial setup and 7,320 hours for ongoing compliance).
NCUA
Number of respondents: 258 (Level 1-0, Level 2-1, and Level 3-257).
Total estimated annual burden: 15,540 hours (10,360 hours for
initial setup and 5,180 hours for ongoing compliance).
SEC
Number of respondents: 806 (Level 1-58, Level 2-36, and Level 3-
712).
Total estimated annual burden: 54,000 hours (36,000 hours for
initial setup and 18,000 hours for ongoing compliance)
Amendments to Exchange Act Rule 17a-4 and Investment Advisers Act
Rule 204-2: The proposed amendments to Exchange Act Rule 17a-4 and
Investment Advisers Act Rule 204-2 contain ``collection of information
requirements'' within the meaning of the PRA. The SEC has submitted the
collections of information to OMB for review in accordance with 44
U.S.C. 3507 and 5 CFR 1320.11. An agency may not conduct or sponsor,
and a person is not required to respond to, a collection of information
unless it displays a currently valid OMB control number. OMB has
assigned control number 3235-0279 to Exchange Act Rule 17a-4 and
control number 3235-0278 to Investment Advisers Act Rule 204-2. The
titles of these collections of information are ``Rule 17a-4; Records to
be Preserved by Certain Exchange Members, Brokers and Dealers'' and
``Rule 204-2 under the Investment Advisers Act of 1940.'' The
collections of information required by the proposed amendments to
Exchange Act Rule 17a-4 and Investment Advisers Act Rule 204-2 will be
necessary for any broker-dealer or investment adviser (registered or
required to be registered under section 203 of the Investment Advisers
Act (15 U.S.C. 80b-3)) (``covered investment advisers''), as
applicable, that is a covered institution subject to the proposed
rules.
A. Summary of Collection of Information
The SEC is proposing amendments to Exchange Act Rule 17a-4(e) (17
CFR 240.17a-4(e)) and Investment Advisers Act Rule 204-2 (17 CFR
275.204-2) to require that broker-dealers and covered investment
advisers that are covered institutions maintain the records required by
Sec. __.4(f), and for broker-dealers or covered investment advisers
that are Level 1 or Level 2 covered institutions, Sec. Sec. __.5 and
__.11, in accordance with the recordkeeping requirements of Exchange
Act Rule 17a-4 or Investment Advisers Act Rule 204-2, as applicable.
B. Proposed Use of Information
The collections of information are necessary for, and will be used
by, the SEC to determine compliance with the proposed rules and section
956 of the Dodd-Frank Act. Exchange Act Rule 17a-4 requires a broker-
dealer to preserve records if the broker-dealer makes or receives the
type of record and establishes the general formatting and storage
requirements for records that broker-dealers are required to keep.
Investment Advisers Act Rule 204-2 establishes general recordkeeping
requirements for covered investment advisers. For the sake of
consistency with other broker-dealer or covered investment adviser
records, the SEC believes that broker-dealers and covered investment
advisers that are covered institutions should also keep the records
required by Sec. __.4(f), and for broker-dealers or covered investment
advisers that are Level 1 or Level 2 covered institutions, Sec. Sec.
__.5 and __.11, in accordance with these requirements.
C. Respondents
The collections of information will apply to any broker-dealer or
covered investment adviser that is a covered institution under the
proposed rules. The SEC estimates that 131 broker-dealers and
approximately 669 investment advisers will be covered institutions
under the proposed rules. The SEC further estimates that of those 131
broker-dealers, 49 will be Level 1 or Level 2 covered institutions, and
82 will be Level 3 covered institutions and that of those 669
investment advisers, approximately 18 will be Level 1 covered
institutions, approximately 21 will be Level 2 covered institutions,
and approximately 630 will be Level 3 covered institutions.\276\
---------------------------------------------------------------------------

\276\ For a discussion of how the SEC arrived at these
estimates, see the SEC Economic Analysis at Section V.I.
---------------------------------------------------------------------------

D. Total Annual Reporting and Recordkeeping Burden
The collection of information would add three types of records to
be maintained and preserved by broker-dealers and covered investment
advisers: The records required by Sec. __.4(f), and for broker-dealers
or covered investment advisers that are Level 1 or Level 2 covered
institutions, the records required by Sec. __.5 and the policies and
procedures required by Sec. __.11.
1. Exchange Act Rule 17a-4
In recent proposed amendments to Exchange Act Rule 17a-4, the SEC
estimated that proposed amendments adding three types of records to be
preserved by broker-dealers pursuant to Exchange Act Rule 17a-4(b)
would impose an initial burden of 39 hours per broker-dealer and an
ongoing annual burden of 18 hours and $360 per broker-dealer.\277\ The
SEC believes that those

[[Page 37754]]

estimates provide a reasonable estimate for the burden imposed by the
collection of information because the collection of information would
add three types of records to be preserved by broker-dealers pursuant
to Exchange Act Rule 17a-4(e). The records required to be preserved
under Exchange Act Rule 17a-4(e) are subject to the similar formatting
and storage requirements as the records required to be preserved under
Exchange Act Rule 17a-4(b). For example, paragraph (f) of Exchange Act
Rule 17a-4 provides that the records a broker-dealer is required to
maintain and preserve under Exchange Act Rule 17a-4, including those
under paragraph (b) and (e), may be immediately produced or reproduced
on micrographic media or by means of electronic storage media.
Similarly, paragraph (j) of Exchange Act Rule 17a-4 requires a broker-
dealer to furnish promptly to a representative of the SEC legible,
true, complete, and current copies of those records of the broker-
dealer that are required to be preserved under Exchange Act Rule 17a-4,
including those under paragraph (b) and (e).
---------------------------------------------------------------------------

\277\ Recordkeeping and Reporting Requirements for Security-
Based Swap Dealers, Major Security-Based Swap Participants, and
Broker-Dealers; Capital Rule for Certain Security-Based Swap
Dealers, Release No. 34-71958 (Apr. 17, 2014), 79 FR 25194, 25267
(May 2, 2014). The burden hours estimated by the SEC for amending
Exchange Act Rule 17a-4(b) include burdens attributable to ensuring
adequate physical space and computer hardware and software storage
for the records and promptly producing them when requested. These
burdens may include, as necessary, acquiring additional physical
space, computer hardware, and software storage and establishing and
maintaining additional systems for computer software and hardware
storage.
---------------------------------------------------------------------------

The SEC notes, however, that paragraph (b) of Exchange Act Rule
17a-4 includes a three-year minimum retention period while paragraph
(e) does not include any retention period. Thus, to the extent that a
portion of the SEC's previously estimated burdens with respect to the
amendments to Exchange Act Rule 17a-4(b) represent the burden of
complying with the minimum retention period, using those same burden
estimates with respect to the collection of information may represent a
slight overestimate because the collection of information does not
include a minimum retention period. The SEC believes, however, that the
previously estimated burdens with respect to the amendments to Exchange
Act Rule 17a-4(b) represent a reasonable estimate of the burdens of the
collection of information given the other similarities between Exchange
Act Rule 17a-4(b) and Exchange Act Rule 17a-4(e) discussed above.
Moreover, the burden to create, and the retention period for, the
records required by Sec. __.4(f), and for Level 1 and Level 2 broker-
dealers, the records required by Sec. __.5 and the policies and
procedures required by Sec. __.11, is accounted for in the PRA
estimates for the proposed rules. Consequently, the burdens imposed by
the collection of information are to ensure adequate physical space and
computer hardware and software storage for the records and promptly
produce them when requested.\278\
---------------------------------------------------------------------------

\278\ As discussed above, paragraph (j) of Exchange Act Rule
17a-4 requires a broker-dealer to furnish promptly to a
representative of the SEC legible, true, complete, and current
copies of those records of the broker-dealer that are required to be
preserved under Exchange Act Rule 17a-4. Thus, the SEC estimates
that this promptness requirement will be part of the incremental
burden of the collection of information.
---------------------------------------------------------------------------

Therefore, the SEC estimates that each of the three types of
records required to be preserved pursuant to the collection of
information will each impose an initial burden of 13 hours \279\ per
respondent and an ongoing annual burden of 6 hours \280\ and $120 \281\
per respondent. This is the result of dividing the SEC's previously
estimated burdens with respect to the amendments to Exchange Act Rule
17a-4(b) by three to produce a per-record burden estimate.
---------------------------------------------------------------------------

\279\ 13 hours is the result of dividing the SEC's previously
estimated burdens with respect to the amendments to Exchange Act
Rule 17a-4(b) (39 hours) by three to produce a per-record burden
estimate. 39 hours/3 types of records = 13 hours per record. These
internal hours likely will be performed by a senior database
administrator.
\280\ 6 hours is the result of dividing the SEC's previously
estimated burdens with respect to the amendments to Exchange Act
Rule 17a-4(b) (18 hours) by three to produce a per-record burden
estimate. 18 hours/3 types of records = 6 hours per record. These
internal hours likely will be performed by a compliance clerk.
\281\ $120 is the result of dividing the SEC's previously
estimated cost with respect to the amendments to Exchange Act Rule
17a-4(b) ($360) by three to produce a per-record cost estimate. $360
hours/3 types of records = $120 per record.
---------------------------------------------------------------------------

The SEC estimates that requiring broker-dealers to maintain the
records required by Sec. __.4(f) in accordance with Exchange Act Rule
17a-4 will impose an initial burden of 13 hours per respondent and a
total ongoing annual burden of 6 hours and $120 per respondent. The
total burden for all respondents will be 1,703 hours initially (13
hours x 131 Level 1, Level 2, and Level 3 broker-dealers) and 786 hours
annually (6 hours x 131 Level 1, Level 2, and Level 3 broker-dealers)
with an annual cost of $15,720 ($120 x 131 Level 1, Level 2, and Level
3 broker-dealers).
The SEC estimates that requiring Level 1 and Level 2 broker-dealers
to maintain the records required by Sec. __.5 in accordance with
Exchange Act Rule 17a-4 will impose an initial burden of 13 hours per
respondent and a total ongoing annual burden of 6 hours and $120 per
respondent. The total burden for all Level 1 and Level 2 broker-dealers
will be 637 hours initially (13 hours x 49 Level 1 and Level 2 broker-
dealers) and 294 hours annually (6 hours x 49 Level 1 and Level 2
broker-dealers) with an annual cost of $5,880 ($120 x 49 Level 1 and
Level 2 broker-dealers).
The SEC estimates that requiring Level 1 and Level 2 broker-dealers
to maintain the policies and procedures required by Sec. __.11 in
accordance with Exchange Act Rule 17a-4 will impose an initial burden
of 13 hours per respondent and a total ongoing annual burden of 6 hours
and $120 per respondent. The total burden for all Level 1 and Level 2
broker-dealers will be 637 hours initially (13 hours x 49 Level 1 and
Level 2 broker-dealers) and 294 hours annually (6 hours x 49 Level 1
and Level 2 broker-dealers) with an annual cost of $5,880 ($120 x 49
Level 1 and Level 2 broker-dealers).
In the Supporting Statement accompanying the most recent extension
of Exchange Act Rule 17a-4's collection of information, the SEC
estimated that each registered broker-dealer spends 254 hours annually
to ensure it is in compliance with Rule 17a-4 and produce records
promptly when required, and $5,000 each year on physical space and
computer hardware and software to store the requisite documents and
information.\282\ Thus, for Level 3 broker-dealers, as a result of the
collection of information, the total annual burden to ensure compliance
with Rule 17a-4 and produce records promptly when required will be 260
hours \283\ and $5,120 \284\ per Level 3 broker-dealer, or 21,320 hours
and $419,840 per all 82 Level 3 broker-dealers. For Level 1 and Level 2
broker-dealers, as a result of the collection of information, the total
annual burden to ensure compliance with Rule 17a-4 and produce records
promptly when required will be 272 hours \285\ and $5,360 \286\ per
Level 1 and Level 2

[[Page 37755]]

broker-dealer, or 13,328 hours and $262,640 per all 49 Level 1 and
Level 2 broker-dealers.
---------------------------------------------------------------------------

\282\ See Supporting Statement for the Paperwork Reduction Act
Information Collection Submission for Rule 17a-4, Collection of
Information for Exchange Act Rule 17a-4 (OMB Control No. 3235-0279),
Office of information and Regulatory Affairs, Office of Management
and Budget, available at https://www.reginfo.gov/public/doPRAMain.
\283\ 254 hours + 6 hour annual burden of maintaining the
records required by Sec. __.4(f) in accordance with Exchange Act
Rule 17a-4.
\284\ $5,000 + $ 120 annual cost of maintaining the records
required by Sec. __.4(f) in accordance with Exchange Act Rule 17a-
4.
\285\ 254 hours + 6 hour annual burden of maintaining the
records required by Sec. __.4(f) in accordance with Exchange Act
Rule 17a-4 + 6 hour annual burden of maintaining the records
required by Sec. __.5 in accordance with Exchange Act Rule 17a-4 +
6 hour annual burden of maintaining the policies and procedures
required by Sec. __.11 in accordance with Exchange Act Rule 17a-4.
\286\ $5,000 + $120 annual cost of maintaining the records
required by Sec. __.4(f) in accordance with Exchange Act Rule 17a-4
+ $120 annual cost of maintaining the records required by Sec. __.5
in accordance with Exchange Act Rule 17a-4 + $120 annual cost of
maintaining the policies and procedures required by Sec. __.11 in
accordance with Exchange Act Rule 17a-4.

Summary of Collection of Information Burdens per Record Type
----------------------------------------------------------------------------------------------------------------
Initial hourly Annual hourly Annual cost
burden estimate burden estimate estimate per
Nature of information collection burden per respondent per respondent respondent (all
(all respondents) (all respondents) respondents)
----------------------------------------------------------------------------------------------------------------
Sec. __.4(f) Recordkeeping for Level 1, Level 2, and 13 (1,703) 6 (786) $120 ($15,720)
Level 3 Broker-Dealers................................
Sec. __.5 Recordkeeping for Level 1 and Level 2 13 (637) 6 (294) 120 (5,880)
Broker-Dealers........................................
Sec. __.11 Policies and Procedures for Level 1 and 13 (637) 6 (294) 120 (5,880)
Level 2 Broker-Dealers................................
========================================================
----------------------------------------------------------------------------------------------------------------

Summary of Collection of Information Burdens per Respondent Type
----------------------------------------------------------------------------------------------------------------
Initial hourly Annual hourly Annual cost
burden estimate burden estimate estimate per
Nature of information collection burden per respondent per respondent respondent (all
(all respondents) (all respondents) respondents)
----------------------------------------------------------------------------------------------------------------
Level 1 and Level 2 Broker-Dealers (49 total).......... 39 (1,911) 18 (882) $360 ($17,640)
Level 3 Broker-Dealers (82 total)...................... 13 (1,066) 6 (492) 120 (9,840)
----------------------------------------------------------------------------------------------------------------

Summary of Collection of Information Burdens per Respondent Type Including Estimate of Annual Compliance With
Rule 17a-4
----------------------------------------------------------------------------------------------------------------
Annual hourly Annual cost
burden estimate estimate per
Nature of information collection burden per respondent respondent (all
(all respondents) respondents)
-----------------------------------------------------------------------------------------------
Level 1 and Level 2 Broker-Dealers (49 total)............ 272 (13,328) $5,360 ($262,640)
Level 3 Broker-Dealers (82 total)........................ 260 (21,320) 5,120 (419,840)
----------------------------------------------------------------------------------------------------------------

As discussed above, the SEC estimates an increase of $120 for Level
3 broker-dealers and $360 for Level 1 and Level 2 broker-dealers to the
$5,000 spent each year by a broker-dealer on physical space and
computer hardware and software to store the requisite documents and
information as a result of the collection of information. The SEC
estimates that respondents will not otherwise seek outside assistance
in completing the collection of information or experience any other
external costs in connection with the collection of information.
2. Investment Advisers Act Rule 204-2
The currently-approved total annual burden estimate for rule 204-2
is 1,986,152 hours. This burden estimate was based on estimates that
10,946 advisers were subject to the rule, and each of these advisers
spends an average of 181.45 hours preparing and preserving records in
accordance with the rule. Based on updated data as of January 4, 2016,
there are 11,956 registered investment advisers.\287\ This increase in
the number of registered investment advisers increases the total burden
hours of current rule 204-2 from 1,986,152 to 2,169,417, an increase of
183,265 hours.\288\
---------------------------------------------------------------------------

\287\ Based on data from the Commission's Investment Adviser
Registration Depository (``IARD'') as of January 4, 2016.
\288\ This estimate is based on the following calculations:
(11,956 - 10,946) x 181.45 = 183,265; 183,265 + 1,986,152 =
2,169,417.
---------------------------------------------------------------------------

The proposed amendment to rule 204-2 would require covered
investment advisers that are Level 1, Level 2, or Level 3 covered
institutions to make and keep true, accurate, and current the records
required by, and for the period specified in, Sec. __.4(f) and, for
those covered investment advisers that are Level 1 or Level 2 covered
institutions, the records required by, and for the periods specified
in, Sec. Sec. __.5 and __.11.

[[Page 37756]]

Based on SEC staff experience, the SEC estimates that the proposed
amendment to rule 204-2 would increase each registered investment
adviser's average annual collection burden under rule 204-2 by 2 hours
\289\ for each of the three types of records required to be preserved
pursuant to the collection of information.\290\ Therefore, for a
covered investment adviser that is a Level 1 covered institution, the
increase in its average annual collection burden would be from 181.45
hours to 187.45 hours,\291\ and would thus increase the annual
aggregate burden for rule 204-2 by 108 hours,\292\ from 2,169,417 hours
to 2,169,525 hours.\293\ As monetized, the estimated burden for each
such investment adviser's average annual burden under rule 204-2 would
increase by approximately $450,\294\ which would increase the estimated
monetized aggregate annual burden for rule 204-2 by $8,100, from
$162,706,275 to $162,714,375.\295\ For a covered investment adviser
that is a Level 2 covered institution, the increase in its average
annual collection burden would be from 181.45 hours to 185.45
hours,\296\ and would thus increase the annual aggregate burden for
rule 204-2 by 84 hours,\297\ from 2,169,525 hours \298\ to 2,169,609
hours.\299\ As monetized, the estimated burden for each such investment
adviser's average annual burden under rule 204-2 would increase by
approximately $300,\300\ which would increase the estimated monetized
aggregate annual burden for rule 204-2 by $6,300, from $162,714,375
\301\ to $162,720,675.\302\ For a covered investment adviser that is a
Level 3 covered institution, the increase in its average annual
collection burden would be from 181.45 hours to 183.45 hours,\303\ and
would thus increase the annual aggregate burden for rule 204-2 by 1,260
hours,\304\ from 2,169,609 hours \305\ to 2,170,869 hours.\306\ As
monetized, the estimated burden for each such investment adviser's
average annual burden under rule 204-2 would increase by approximately
$150,\307\ which would increase the estimated monetized aggregate
annual burden for rule 204-2 by $94,500, from $162,720,675 \308\ to
$162,815,175.\309\ The SEC estimates that the proposed amendment does
not result in any additional external costs associated with this
collection of information for rule 204-2.
---------------------------------------------------------------------------

\289\ The burden hours estimated by the SEC for amending
Investment Advisers Act Rule 204-2 assumes that the covered
investment adviser already has systems in place to comply with the
general requirements of Investment Advisers Rule 204-2. Accordingly,
the 2 burden hours estimated by the SEC for each type of record
required to be preserved pursuant to these proposed rules is
attributable solely to the burden associated with maintaining such
record.
\290\ The records required by Sec. __.4(f), and for covered
investment advisers that are Level 1 or Level 2 covered
institutions, the records required by Sec. __.5 and the policies
and procedures required by Sec. __.11.
\291\ This estimate is based on the following calculation:
181.45 existing hours + 6 new hours = 187.45 hours.
\292\ This estimate is based on the following calculation: 18
(Level 1 covered institution) advisers x 6 hours = 108 hours.
\293\ This estimate is based on the following calculation:
2,169,417 hours + 108 hours = 2,169,525 hours.
\294\ This estimate is based on the following calculation: 6
hours x $75 (hourly rate for an administrative assistant) = $450.
The hourly wage used is from SIFMA's Management & Professional
Earnings in the Securities Industry 2013, modified to account for an
1800-hour work-year and inflation and multiplied by 5.35 to account
for bonuses, firm size, employee benefits, and overhead.
\295\ This estimate is based on the following calculations:
2,169,417 hours x $75 = $162,706,275. 2,169,525 hours x $75 =
$162,714,375. $162,714,375 - $162,706,275 = $8,100.
\296\ This estimate is based on the following calculation:
181.45 existing hours + 4 new hours = 185.45 hours.
\297\ This estimate is based on the following calculation: 21
(Level 2 covered institution) advisers x 4 hours = 84 hours.
\298\ This estimate includes the increase in the annual
aggregate burden for covered investment advisers that are Level 1
covered institutions.
\299\ This estimate is based on the following calculation:
2,169,525 hours + 84 hours = 2,169,609 hours.
\300\ This estimate is based on the following calculation: 4
hours x $75 (hourly rate for an administrative assistant) = $300.
The hourly wage used is from SIFMA's Management & Professional
Earnings in the Securities Industry 2013, modified to account for an
1800-hour work-year and inflation and multiplied by 5.35 to account
for bonuses, firm size, employee benefits, and overhead.
\301\ This estimate includes the monetized increase in the
annual aggregate burden for covered investment advisers that are
Level 1 covered institutions.
\302\ This estimate is based on the following calculations:
2,169,525 hours x $75 = $162,714,375. 2,169,609 hours x $75 =
$162,720,675. $162,720,675 - $162,714,375 = $6,300.
\303\ This estimate is based on the following calculation:
181.45 existing hours + 2 new hours = 183.45 hours.
\304\ This estimate is based on the following calculation: 630
(Level 3 covered institution) advisers x 2 hours = 1,260 hours.
\305\ This estimate includes the increase in the annual
aggregate burden for covered investment advisers that are Level 1 or
Level 2 covered institutions.
\306\ This estimate is based on the following calculation:
2,169,609 hours + 1,260 hours = 2,170,869 hours.
\307\ This estimate is based on the following calculation: 2
hours x $75 (hourly rate for an administrative assistant) = $150.
The hourly wage used is from SIFMA's Management & Professional
Earnings in the Securities Industry 2013, modified to account for an
1800-hour work-year and inflation and multiplied by 5.35 to account
for bonuses, firm size, employee benefits, and overhead.
\308\ This estimate includes the monetized increase in the
annual aggregate burden for covered investment advisers that are
Level 1 or Level 2 covered institutions.
\309\ This estimate is based on the following calculations:
2,169,609 hours x $75 = $162,720,675. 2,170,869 hours x $75 =
$162,815,175. $162,815,175 - $162,706,275 = $94,500.
---------------------------------------------------------------------------

E. Collection of Information Is Mandatory
The collections of information will be mandatory for any broker-
dealer or covered investment adviser that is a covered institution
subject to the proposed rules.
F. Confidentiality
The information collected pursuant to the collections of
information will be kept confidential, subject to the provisions of
applicable law.
G. Retention Period of Recordkeeping Requirements
The collections of information will not impose any retention period
with respect to recordkeeping requirements. The retention period for
the records required by Sec. __.4(f) and the records required by Sec.
__.5 is accounted for in the PRA estimates for the proposed rules.
H. Request for Comment
Pursuant to 44 U.S.C. 3505(c)(2)(B), the SEC solicits comment to:
1. Evaluate whether the proposed collections are necessary for the
proper performance of its functions, including whether the information
shall have practical utility;
2. Evaluate the accuracy of its estimate of the burden of the
proposed collections of information;
3. Determine whether there are ways to enhance the quality,
utility, and clarity of the information to be collected; and
4. Evaluate whether there are ways to minimize the burden of
collections of information on those who are to respond, including
through the use of automated collection techniques or other forms of
information technology.
Persons submitting comments on the collection of information
requirements should direct them to the Office of Management and Budget,
Attention: Desk Officer for the Securities and Exchange Commission,
Office of Information and Regulatory Affairs, Washington, DC 20503, and
should also

[[Page 37757]]

send a copy of their comments to Brent J. Fields, Secretary, Securities
and Exchange Commission, 100 F Street NE., Washington, DC 20549-1090,
with reference to File No. S7-07-16. Requests for materials submitted
to OMB by the SEC with regard to this collection of information should
be in writing, with reference to File No. S7-07-16, and be submitted to
the Securities and Exchange Commission, Office of FOIA Services, 100 F
Street NE., Washington, DC 20549. As OMB is required to make a decision
concerning the collections of information between 30 and 60 days after
publication of this proposal, a comment to OMB is best assured of
having its full effect if OMB receives it within 30 days of
publication.

C. The Treasury and General Government Appropriations Act, 1999--
Assessment of Federal Regulations and Policies on Families

NCUA and the FDIC have determined that this proposed rulemaking
would not affect family well-being within the meaning of Section 654 of
the Treasury and General Government Appropriations Act of 1999.\310\
---------------------------------------------------------------------------

\310\ Public Law 105-277, 112 Stat. 2681 (1998).
---------------------------------------------------------------------------

D. Riegle Community Development and Regulatory Improvement Act of 1994

The Riegle Community Development and Regulatory Improvement Act of
1994 (``RCDRIA'') requires that each Federal Banking Agency, in
determining the effective date and administrative compliance
requirements for new regulations that impose additional reporting,
disclosure, or other requirements on insured depository institutions,
consider, consistent with principles of safety and soundness and the
public interest, any administrative burdens that such regulations would
place on depository institutions, including small depository
institutions, and customers of depository institutions, as well as the
benefits of such regulations. In addition, new regulations that impose
additional reporting, disclosures, or other new requirements on insured
depository institutions generally must take effect on the first day of
a calendar quarter that begins on or after the date on which the
regulations are published in final form.
The Federal Banking Agencies note that comment on these matters has
been solicited in the discussions of section __.1 and __.3 in Part II
of the Supplementary Information, as well as other sections of the
preamble, and that the requirements of RCDRIA will be considered as
part of the overall rulemaking process. In addition, the Federal
Banking Agencies also invite any other comments that further will
inform the Federal Banking Agencies' consideration of RCDRIA.

E. Solicitation of Comments on Use of Plain Language

Section 722 of the Gramm-Leach-Bliley Act \311\ requires the
Federal Banking Agencies to use plain language in all proposed and
final rules published after January 1, 2000. The Federal Banking
Agencies invite comments on how to make these proposed rules easier to
understand. For example:
---------------------------------------------------------------------------

\311\ Public Law 106-102, section 722, 113 Stat. 1338 1471
(1999).
---------------------------------------------------------------------------

Have the agencies organized the material to suit your
needs? If not, how could this material be better organized?
Are the requirements in the proposed rules clearly stated?
If not, how could the proposed rules be more clearly stated?
Do the proposed rules contain language or jargon that is
not clear? If so, which language requires clarification?
Would a different format (grouping and order of sections,
use of headings, paragraphing) make the proposed rules easier to
understand? If so, what changes to the format would make the proposed
rules easier to understand?
What else could the Agencies do to make the regulation
easier to understand?

F. OCC Unfunded Mandates Reform Act of 1995 Determination

The OCC has analyzed the proposed rule under the factors set forth
in section 202 of the Unfunded Mandates Reform Act of 1995 (``UMRA'')
(2 U.S.C. 1532). Under this analysis, the OCC considered whether the
proposed rule includes Federal mandates that may result in the
expenditure by State, local, and tribal governments, in the aggregate,
or by the private sector, of $100 million or more in any one year
(adjusted annually for inflation). For the following reasons, the OCC
finds that the proposed rule does not trigger the $100 million UMRA
threshold. First, the mandates in the proposed rule do not apply to
State, local, and tribal governments. Second, the overall estimate of
the maximum one-year cost of the proposed rule to the private sector is
approximately $50 million. For this reason, and for the other reasons
cited above, the OCC has determined that this proposed rule will not
result in expenditures by State, local, and tribal governments, or the
private sector, of $100 million or more in any one year. Accordingly,
this proposed rule is not subject to section 202 of the UMRA.

G. Differences Between the Federal Home Loan Banks and the Enterprises

Section 1313(f) of the Safety and Soundness Act requires the
Director of FHFA, when promulgating regulations relating to the Federal
Home Loan Banks, to consider the differences between the Federal Home
Loan Banks and the Enterprises (Fannie Mae and Freddie Mac) as they
relate to: The Federal Home Loan Banks' cooperative ownership
structure; the mission of providing liquidity to members; the
affordable housing and community development mission; their capital
structure; and their joint and several liability on consolidated
obligations (12 U.S.C. 4513(f)). The Director also may consider any
other differences that are deemed appropriate. In preparing this
proposed rule, the Director considered the differences between the
Federal Home Loan Banks and the Enterprises as they relate to the above
factors, and determined that the rule is appropriate. FHFA requests
comments regarding whether differences related to those factors should
result in any revisions to the proposed rule.

H. NCUA Executive Order 13132 Determination

Executive Order 13132 encourages independent regulatory agencies to
consider the impact of their actions on state and local interests. In
adherence to fundamental federalism principles, NCUA, an independent
regulatory agency,\312\ voluntarily complies with the Executive Order.
As required by statute, the proposed rule, if adopted, will apply to
federally insured, state-chartered credit unions. These institutions
are already subject to numerous provisions of NCUA's rules, based on
the agency's role as the insurer of member share accounts and the
significant interest NCUA has in the safety and soundness of their
operations. Because the statute specifies that this rule must apply to
state-chartered credit unions, NCUA has determined that the proposed
rule does not constitute a policy that has federalism implications for
purposes of the Executive Order.
---------------------------------------------------------------------------

\312\ 44 U.S.C. 3502(5).
---------------------------------------------------------------------------

I. SEC Economic Analysis

A. Introduction
As discussed above, section 956 of the Dodd-Frank Act requires the
SEC, jointly with other appropriate Federal regulators, to prescribe
regulations or

[[Page 37758]]

guidelines to require covered institutions to disclose information
about their incentive-based compensation arrangements sufficient for
the Agencies to determine whether their compensation structure provides
an executive officer, employee, director or principal shareholder with
excessive compensation, fees or benefits or could lead to material
financial loss to the firm. Section 956 also requires the Agencies to
jointly prescribe regulations or guidelines that prohibit any type of
incentive-based compensation arrangements, or any feature of these
arrangements, that the Agencies determine encourages inappropriate
risks by covered institutions by providing excessive compensation to
officers, employees, directors, or principal shareholders (``covered
persons'') or that could lead to material financial loss to the covered
institution. While section 956 requires rulemaking to address a number
of types of financial institutions, the rule being proposed by the SEC
would apply to broker-dealers registered with the SEC under section 15
of the Securities Exchange Act (``broker-dealers'' or ``BDs'') and
investment advisers, as defined in section 202(a)(11) of the Investment
Advisers Act of 1940 (``investment advisers'' or ``IAs'').
In connection with its rulemakings, the SEC considers the likely
economic effects of the rules. This section provides the SEC's economic
analysis of the main likely effects of the proposed rule on broker-
dealers and investment advisers that would be covered under the
proposed rule. For purposes of this analysis, the SEC addresses the
potential economic effects for covered BDs and IAs resulting from the
statutory mandate and from the SEC's exercise of discretion together,
recognizing that it is often difficult to separate the economic effects
arising from these two sources. The SEC also has considered the
potential costs and benefits of reasonable alternative means of
implementing the mandate. Where practicable, the SEC has attempted to
quantify the effects of the proposed rule; however, in certain cases
noted below, the SEC is unable to provide a reasonable estimate because
the SEC lacks the necessary data.
In particular, because the SEC's regulation of individuals'
compensation has historically been centered on disclosures by reporting
companies, the SEC lacks information and data regarding the present
incentive-based compensation practices of broker-dealers and investment
advisers if those entities are not themselves reporting companies under
the Exchange Act. In addition, in proposing these rules jointly for
public comment, the Agencies have relied in part on the supervisory
experience of the Federal Banking Agencies.\313\ Accordingly, for the
purposes of evaluating the economic impact of the proposed rule, the
SEC has considered outside analyses and other studies regarding the
effects of incentive-based compensation that are not directly related
to broker-dealers or investment advisers. In addition, the SEC is
requesting that commenters provide data that will permit the SEC to
perform a more direct analysis of the economic impact on broker-dealers
and investment advisers that the proposed rules would have if adopted.
---------------------------------------------------------------------------

\313\ See, e.g., OCC, Board, FDIC, and Office of Thrift
Supervision, ``Guidance on Sound Incentive Compensation Policies''
(``2010 Federal Banking Agency Guidance''), 75 FR 36395 (June 25,
2010), available at: https://www.federalreserve.gov/newsevents/press/bcreg/20100621a.htm. As discussed above, the Federal Banking
Agencies have found that any incentive-based compensation
arrangement at a covered institution will encourage inappropriate
risks if it does not sufficiently expose the risk-takers to the
consequences of their risk decisions over time, and that in order to
do this, it is necessary that meaningful portions of incentive-based
compensation be deferred and placed at risk of reduction or
recovery. This economic analysis relies in part on these Agencies'
supervisory experience described above.
---------------------------------------------------------------------------

The SEC requests comment on all aspects of the economic effects,
including the costs and benefits of the proposed rule and possible
alternatives to the proposed rule. The SEC appreciates comments that
include data or qualitative information that would enable it to
quantify the costs and benefits associated with the proposed rule and
alternatives to the proposed rule.
B. Broad Economic Considerations
Economic theory suggests that even compensation practices that are
optimal from the perspective of one set of stakeholders may not be
optimal from the perspective of others. As discussed below, pay
packages that are optimal from the point of view of certain
shareholders may not be optimal from the point of view of taxpayers and
other stakeholders.
In particular, as discussed above, under certain facts and
circumstances, even pay packages that are optimal from the point of
view of shareholders may induce an excessive amount of risk-taking that
could create potentially negative externalities for taxpayers. For
example, also as discussed above, some have argued that during
financial crises the losses of certain financial institutions have
resulted in taxpayer assistance.\314\ To the extent that the proposed
rule would curtail pay convexity \315\ by imposing restrictions of
certain amounts, components, and features of incentive-based
compensation, the proposed rule may have potential benefits by lowering
the likelihood of an outcome that may induce negative externalities.
The extent of these potential benefits would depend on specific facts
and circumstances at the firm level and individual level, including
whether the size, centrality, and business complexity of the firm and
the position of the individual materially affect the level of risk,
including risks that could lead to negative externalities. While
academic literature does not provide clear evidence that broker-dealers
and investment advisers have produced negative externalities for
taxpayers,\316\ the proposed rule may address scenarios where such
externalities could nonetheless arise because the incentive-based
compensation arrangements at a broker-dealer or investment adviser
generate differences in risk preferences between managers \317\ and
taxpayers.
---------------------------------------------------------------------------

\314\ See Gorton, G., 2012. Misunderstanding Financial Crises:
Why We Don't See Them Coming, Oxford University Press; French et
al., 2010. Excerpts from The Squam Lake Report: Fixing the Financial
System. Journal of Applied Corporate Finance 22, 8-21.
\315\ Pay convexity describes the shape of the payoff curve as a
result of compensation arrangements. More convex payoff curves
provide higher rewards for taking on risk.
\316\ In the academic literature, some studies relate to a broad
spectrum of firms in different industries, while other studies
related to firms, primarily banks, in the financial services sector.
The SEC is not aware of studies that focus on broker-dealers and
investment advisers. While certain findings in the financial
services sector may apply also to broker-dealers and investment
advisers, any generalization is subject to a number of limitations.
For example, BDs and IAs differ from other financial services firms
with respect to business models, nature of the risks posed by the
institutions, and the nature and identity of the persons affected by
those risks.
\317\ The SEC's economic analysis uses the term ``managers'' in
an economic (rather than organizational) connotation as the persons
or entities that are able to make decisions on behalf of, or that
impact, another person or entity. Thus, managers in this context
would include covered persons such as senior executive officers and
significant risk-takers.
---------------------------------------------------------------------------

From an economic standpoint, when the risk preferences of managers
(agents) differ from the risk preferences of stakeholders (principals)
of a firm, risk-taking may be considered inappropriate from the point
of view of a particular stakeholder.\318\ While the economic

[[Page 37759]]

theory mainly focuses on the principal-agent relationship between
managers and shareholders, an agency problem may also exist between
managers and taxpayers and between managers and debtholders. For
example, certain levels of risk-taking (e.g., those associated with
investments in R&D-intensive activities) may be optimal \319\ for
shareholders but considered to be excessive for debtholders. In
general, debtholders are likely to require a rate of return on their
investment that is proportionate to the riskiness of the firm and to
put in place covenants in the contracts governing the debt that
restrict those managerial actions that, in their view, may constitute
inappropriate risk-taking but that shareholders may find
appropriate.\320\
---------------------------------------------------------------------------

\318\ The literature in economics and finance typically refers
to a principal-agent model to describe the employment relationship
between shareholders and managers of a firm. The principal
(shareholder) hires an agent (manager) to operate the firm. More
generally, the principal-agent model is also used to describe the
relationship between managers and stakeholders. For example, see
Jensen, M., Meckling, W. 1976. Theory of the Firm: Managerial
Behavior, Agency Costs and Ownership Structure. Journal of Financial
Economics 3, 305-360.
\319\ The economic literature uses the term of ``optimal''
(``suboptimal'') level of risk-taking in a technical manner to
describe the alignment (misalignment) in risk preferences between
managers and a particular stakeholder. Here ``optimal'' means from
the point of view of a particular stakeholder (e.g., shareholders).
Hereafter, consistently with the economic literature, the SEC's
economic analysis uses these terms without any normative connotation
or implication.
\320\ Both managers and shareholders have an incentive to engage
in activities that promise high payoffs if successful even if they
have a low probability of success. If such activities turn out well,
managers and shareholders capture most of the gains, whereas if they
turn out badly debtholders bear most of the costs. In the principal-
agent relationship between managers and debtholders, inappropriate
risk taking would amount to managers' actions that transfer risks
from shareholders to debtholders and that benefit shareholders at
the expense of debtholders. See Jensen, M., Meckling, W. 1976.
Theory of the Firm: Managerial Behavior, Agency Costs and Ownership
Structure. Journal of Financial Economics 3, 305-360.
---------------------------------------------------------------------------

Tying managerial compensation to firm performance aims at aligning
the incentives of management with the interests of shareholders.\321\
Managers are likely to be motivated by drivers other than their
explicit compensation, including for example career advancements,
personal pride, and job retention concerns. Beyond that, making their
compensation in part depend on firm performance could incentivize
managers to exert effort and make decisions that maximize shareholder
value. In a principal-agent relationship between shareholders and
managers, there may be an incentive misalignment that may give rise to
agency problems between the parties: For example, managers may take on
projects that benefit their personal wealth but do not necessarily
increase the value of the firm. Absent a variable component in the
compensation arrangements that encourages risk-taking, risk averse and
undiversified managers \322\ may take less risk than is optimal from
the point of view of shareholders.\323\
---------------------------------------------------------------------------

\321\ See Ibid.
\322\ The differential degree of diversification between
managers' and shareholders' portfolios may lead to a misalignment of
managerial incentives from optimal risk-taking from the point of
view of shareholders. In general, executives are relatively
undiversified compared to the average investor, because a
significant fraction of executives' wealth is invested into the
companies they operate, through the value of their firm-specific
human capital and their portfolio holdings, including their
compensation-related claims. The concentration of managerial wealth
in their employer company may lead to managerial aversion towards
value-enhancing but risky projects since such projects can place
undiversified managerial wealth at heightened levels of risk. See
Hall, B., and Murphy, K. 2002. Stock Options for Undiversified
Executives. Journal of Accounting and Economics 33, 3-42.
\323\ Most managers would operate in a multi-period framework.
In this environment, managers would still have incentives to exert
effort and make decisions that maximize shareholder value due to
career concerns and expectations about future wages.
---------------------------------------------------------------------------

With an aim to incentivize managers to take on risk that is optimal
for shareholders and to attract and retain managerial talent,
managerial compensation arrangements most often include incentive-based
compensation, which is the variable component of compensation that
serves as an incentive or a reward for performance.\324\ Incentive-
based compensation arrangements typically include \325\ performance-
based compensation whose award is conditional on achieving specified
performance measures that are evaluated over a certain time period
(i.e., short-term and long-term incentive plans), in absolute terms or
in relation to a peer group. It encompasses a wide range of forms of
compensation instruments. Among these forms, equity-based compensation
(e.g., performance share units, restricted stock units, and stock
option awards) ties managerial wealth to stock performance to motivate
managers to take actions--exert effort and take risks--that are more
directly aligned with the interests of shareholders. Equity awards are
typically subject to multi-year vesting schedules and vesting
conditions restricting managers from unwinding their equity positions
during vesting periods. Relatedly, some managers are often prohibited
from hedging their equity positions in their firm's stock against any
downside in the stock value.
---------------------------------------------------------------------------

\324\ Incentive-based compensation addresses the fact that
shareholders cannot observe how much effort managers exert or should
exert. Because shareholders do not know and cannot specify every
action managers should take in every scenario, shareholders delegate
many of the decisions to managers by compensating them based on the
results from those decisions.
\325\ See, for example, Frydman, C., and R. Saks, 2010.
Executive Compensation: A New View from a Long-Term Perspective,
1936-2005. Review of Financial Studies 23, 2099-2138.
---------------------------------------------------------------------------

Incentivizing managers through compensation to take on
shareholders' preferred amount of risk requires a delicate balancing
act, because different combinations of amounts, components and features
of incentive-based compensation may make managerial pay more or less
sensitive to firm risk than the level that is desired by shareholders
to maximize their return. In particular, different combinations may
make pay a nonlinear (in particular, convex) function of performance;
in other words, a greater increment in payoffs is realized in the case
of high performance, compared to when performance is moderate or poor.
While there has been ample debate about how certain characteristics of
incentive-based compensation may affect pay convexity and induce risk-
taking, the economic literature has not conclusively identified a
specific amount, component, or feature of incentive-based compensation
that uniformly leads to inappropriate risk-taking, due to differential
facts and circumstances at both the firm level and individual level.
For example, stock options and risk grants are often seen as a form
of incentive-based compensation that, under certain conditions, may
lead to incentives for taking inappropriate risk from shareholders'
point of view.\326\ Compared to cash incentives or restricted stock
units, stock options have an asymmetric payoff structure since they
provide the option holder with unlimited upside potential and limited
downside. In particular, given that a positive outcome from risk-taking
is a positive payoff, whereas a negative outcome does not symmetrically
penalize the option holder, the design of stock options is likely to
encourage managers to undertake risks. The empirical research on the
effect of stock options on risk-taking does in general support a
positive relation between option-based compensation and risk-
taking;\327\ however, as a whole, the academic evidence is mixed on
whether stock options induce inappropriate risk-

[[Page 37760]]

taking from the point of view of shareholders.
---------------------------------------------------------------------------

\326\ See Frydman and Jenter. CEO Compensation. Annual Review of
Financial Economics (2010).
\327\ See Guay, W. 1999. The sensitivity of CEO wealth to equity
risk: An analysis of the magnitude and determinants. Journal of
Financial Economics 53, 43-71. Stock options, as opposed to common
stockholdings, increase the sensitivity of CEOs' wealth to equity
risk. The study documents a positive relation between the convexity
in compensation arrangements and stock return volatility suggesting
that such compensation arrangements are related to riskier investing
and financing decisions. Stock options are mostly used in companies
where underinvestment is value-increasing but risky projects may
lead to significant losses in the value of these companies.
---------------------------------------------------------------------------

Some studies show that the relation between option-based
compensation and risk-taking incentives is not uniform across different
firms, and the incentives to undertake risk may vary depending on
certain conditions.\328\ For example, options that are deep in-the-
money may lead the option holder to moderate risk exposure to protect
the value of the option. On the other hand, options that are deep out-
of-the-money may provide incentives for excessive risk-taking.
Additionally, there is significant variation across companies with
regard to the use of options in compensation arrangements. Stock
options are a relatively more significant component of compensation
arrangements for executives in companies where risk-taking is important
for maximizing shareholder value.\329\
---------------------------------------------------------------------------

\328\ See Ross, S. 2004. Compensation, Incentives, and the
Duality of Risk Aversion and Riskiness. Journal of Finance 59, 207-
225; Carpenter, J. 2000. Does Option Compensation Increase
Managerial Risk Appetite? Journal of Finance 55, 2311-2332. Both
studies question the common belief that stock options unequivocally
induce holders to undertake more risk. Although the asymmetric
payoff structure of options is likely to encourage risk-taking in
some cases, there are also circumstances where options may lead to
decreased appetite for risk taking by option holders.
\329\ See Guay (1999).
---------------------------------------------------------------------------

Another example of a characteristic in incentive-based compensation
arrangements that is commonly considered to potentially provide
incentives for actions that carry undesired risks is the
disproportionate use of short-term (e.g., measured over a period of one
year) performance measures (i.e., accounting, stock price-based, or
nonfinancial measures) that may steer managers toward short-termism
without adequate regard of the long-term risks potentially posed to
long-term firm value.\330\ In doing so, managers may reap the rewards
of their actions in the short run but may not participate in the
potentially negative outcomes that may materialize in the long run.
Short-termism may lead to investment distortions in the long run, such
as under- \331\ or over-investment,\332\ that are potentially
detrimental to shareholder value. Some academic studies suggest that
managers' focus on short-term performance may arise simply out of their
reputation and career concerns, and compensation awards tied to short-
term performance measures may accentuate the tendency toward short-
termism.\333\
---------------------------------------------------------------------------

\330\ See Bizjak, J., Brickley, J., Coles, J. 1993. Stock-based
incentive compensation and investment behavior. Journal of
Accounting and Economics 16, 349-372. The authors argue that
managerial concern about current stock prices could lead management
to distort optimal investment decisions in an effort to influence
the current stock price. Such short-termism is likely to be
exacerbated when there is a significant information asymmetry
between management and investors. The study argues that compensation
arrangements with longer horizons are a potential solution to such
behavior, and finds that firms with higher information asymmetries
between management and shareholders actually use compensation
arrangements with relatively longer horizons.
\331\ See Stein, J. 1989. Efficient Capital Markets, Inefficient
Firms: A Model of Myopic Corporate Behavior. Quarterly Journal of
Economics 104, 655-669.
\332\ See Bebchuk, L., Stole, L. 1993. Do Short-Term Objectives
Lead to Under- or Overinvestment in Long-Term Projects? Journal of
Finance 48, 719-729. The paper develops a model showing that,
depending on the nature of the information asymmetry between
management and shareholders, either under- or over-investment in
long-run projects is likely to occur. When shareholders cannot
observe the level of investment in long-term projects, the model
predicts that managers would underinvest. When shareholders can
observe the level of investment but not the productivity of such
investment, then managers have incentives to over-invest.
\333\ See Narayanan, M.P. 1985. Managerial Incentives for Short-
Term Results. Journal of Finance 40, 1469-1484; and Stein, J. 1989.
Efficient Capital Markets, Inefficient Firms: A Model of Myopic
Corporate Behavior. Quarterly Journal of Economics 104, 655-669.
These studies examine managerial incentives to focus on shorter-term
performance at the expense of longer-term value. When managers have
information about firm decisions that investors do not have,
focusing on short-term performance may be an optimal strategy from
managers to enhance their perceived skill and reputation, as well as
achieve higher compensation. The studies also argue that even if the
market anticipates such short-termism from managers, the optimal
strategy for managers would still be to focus on short-term results.
Narayanan (1985) also shows that short-termism can be partially
curbed by offering longer-term contracts to managers.
A survey of Chief Financial Officers indicates that, among other
motivations, career concerns and reputation act as leading
motivations for the significant focus of executives on delivering
short-term performance (e.g., quarterly earnings expectations). The
survey also documents that executives are willing to forgo long-term
value enhancing activities and projects in order to deliver on
short-term performance targets. See Graham, J., Harvey, C., and
Rajgopal, S. 2005. The Economic Implications of Corporate Financial
Reporting. Journal of Accounting and Economics 40, 3-73.
---------------------------------------------------------------------------

Studies document that short-term incentive plans or annual bonuses
typically represent a small fraction of executive compensation.\334\
Additionally, a recent study provides evidence of a significant
increase in the number of firms granting multi-year accounting-based
performance incentives to their chief executive officers
(``CEOs'').\335\ Firms with relatively less volatile accounting
performance measures and a stronger presence of long-term shareholders
are more likely to utilize these compensation arrangements. As a whole,
the academic evidence is mixed on whether short-term incentive plans
induce inappropriate risk-taking from the point of view of certain
shareholders. However, there is evidence that certain equity-based
compensation arrangements may provide incentives for earnings
management \336\ and misreporting \337\ that could lead to lower long-
term shareholder value. Finally, there is also evidence that
compensation contracts with relatively shorter horizons are positively
related (in a statistical sense) to proxies for earnings
management.\338\
---------------------------------------------------------------------------

\334\ See Frydman, C., and R. Saks, 2010. Executive
Compensation: A New View from a Long-Term Perspective, 1936-2005.
Review of Financial Studies 23, 2099-2138. The paper documents the
evolution of various characteristics of executive compensation
arrangements for the 50 largest U.S. companies since 1936. Long-term
pay including deferred bonuses in the form of restricted stock and
stock options comprised the largest part of executive compensation
in recent years. For example, 35% of total executive pay for these
companies was in the form of long-term bonuses in the form of
restricted stock in 2005.
\335\ See Li, Z., and L. Wang, 2013. Executive Compensation
Incentives Contingent on Long-Term Accounting Performance, Working
Paper. The study documents a significant increase in the use of
long-term accounting performance plans for CEOs of S&P500 companies.
More specifically, the study documents that 43% of S&P500 companies
used long-term accounting performance plans in CEO compensation
arrangements in 2008, compared to 16% of S&P500 companies in 1996.
In general terms, these plans usually rely on a three-year
performance measurement period of various accounting measures of
performance such as earnings, revenues, cash flows and other metrics
to determine payouts to CEOs in the form of mostly equity or cash.
The paper does not find evidence that such compensation arrangements
are used by CEOs to extract excessive compensation.
\336\ See Bergstresser, D., Philippon, T. 2006. CEO incentives
and earnings management. Journal of Financial Economics 80, 511-529.
The paper presents evidence that highly incentivized CEOs, as
measured by the significance of stock and options in CEOs'
compensation arrangements, are more likely to engage in earnings
management that misrepresents the true economic performance of a
company, with the intent to personally profit from such
misrepresentation of performance. Although tying CEOs' wealth to
company performance aims at aligning the incentives of CEOs with
those of shareholders, the strength of such incentives may lead to
unintended consequences such as incentives to misrepresent company
performance in efforts to increase the value of their compensation.
\337\ See Burns, N., Kedia, S. 2006. The impact of performance-
based compensation on misreporting. Journal of Financial Economics
79, 35-67. The study provides empirical evidence that CEOs whose
option portfolios are more sensitive to the stock price of the
company are more likely to misreport their performance. The paper
does not find any evidence that the sensitivity of other components
of performance-based compensation to stock price, such as restricted
stock and bonuses, are related to the propensity to misreport
performance. The asymmetric payoff structure of stock options
provides incentives to CEOs to misreport because of the limited
downside risk associated with the detection of misreporting.
\338\ See Gopalan, R., Milbourn, T., Song, F., and Thakor, A.
2014. Duration of Executive Compensation. Journal of Finance 69,
2777-2817. The paper constructs a measure of executive pay duration
that reflects the vesting periods of different pay components to
investigate its association with short-termism. Pay duration is
positively related to growth opportunities, long-term assets, R&D
intensity, lower risk and better recent stock performance. Longer
CEO pay duration is negatively related with income increasing
accruals.

---------------------------------------------------------------------------

[[Page 37761]]

The presence of a number of mitigating factors may explain why
evidence is inconclusive on the effects of incentive-based compensation
on inappropriate risk-taking. One such factor is corporate governance
and, more specifically, board of directors oversight over executive
compensation. The board of directors, as an agent of shareholders, may
monitor managers and review their performance (e.g., through the
compensation committee of the board of directors) in the case of
decreases in shareholder value that, among other factors, may be a
result of inappropriate risk-taking.\339\ Also, corporate boards may
attempt to determine compensation arrangements for executives in a way
that aligns executives' interests with those of shareholders. The
empirical evidence on the effectiveness of board of directors oversight
over executive compensation is mixed. One study finds evidence
suggesting that certain boards are not effective in setting executive
compensation because executives are often rewarded for performance due
to luck.\340\ Another study provides evidence that CEOs play an
important role in the nomination and selection of board of directors
members, suggesting that board of directors oversight may be impaired
as a result.\341\ Other studies find that firms with strong governance
are better than firms with weak governance at monitoring the CEO and
have better control of size and structure of CEO pay.\342\
---------------------------------------------------------------------------

\339\ While the SEC is not aware of any literature that directly
examines inappropriate risk-taking and managerial retention
decisions, there is evidence in the academic literature documenting
a higher likelihood of managerial turnover following poor
performance measured with stock returns or accounting measures of
performance (See for example, Engel, E., Hayes, R., and Wang, X.
2003. CEO Turnover and Properties of Accounting Information. Journal
of Accounting and Economics 36, 197-226; and Farell, K., and
Whidbee, D. 2003. The Impact of Firm Performance Expectations on CEO
Turnover and Replacement Decisions. Journal of Accounting and
Economics 36, 165-196.).
\340\ See Bertrand, M., and S. Mullainathan, 2001. Are CEOs
rewarded for luck? The ones without principals are. Quarterly
Journal of Economics 116, 901-932. The paper examines whether the
component of firm performance that is outside of managerial control
is related to managerial compensation. According to the efficient
contracting view of compensation, i.e. compensation arrangements are
used to mitigate principal-agent problems, executives should not be
rewarded (nor penalized) for performance due to luck. The authors
propose a `skimming view' for managerial compensation where CEOs
capture the compensation setting process and find evidence that CEOs
of oil companies get rewarded when changes in oil prices induce
favorable changes in company performance. See also Bebchuk, L.A.,
Fried, J.M., Walker, D.I., 2002. Managerial power and rent
extraction in the design of executive compensation. University of
Chicago Law Review 69, 751-846.
\341\ See Coles, J., Daniel, N., and Naveen, L. Co-opted Boards.
2014. Review of Financial Studies 27, 1751-1796. The study examines
whether independent directors that are appointed after the current
CEO assumed office are effective monitors of the CEO. The findings
show that there is a difference in the monitoring efficiency between
independent directors holding their position prior to the current
CEO's appointment vs. independent directors that join the board of
directors after the current CEO has assumed office (Co-opted board
members). The percentage of `co-opted' board members in a company is
negatively related with various measures of board monitoring. For
example, these companies tend to pay their CEOs more and have lower
turnover-performance sensitivity (i.e., CEOs are less likely to be
fired following deteriorating firm performance). The study questions
whether independent directors appointed after CEO assumed office are
really independent to the CEO.
Relatedly, another study finds that on average directors receive
a very high level of votes in elections, in the post-SOX era. The
evidence points to the fact that if a director is slated, she is
elected. However, the study also finds evidence that lower levels of
director votes lead to reductions in `abnormal' compensation and an
increase in the level of CEO turnover. This latter result is
particularly strong when these directors serve as chair or members
of the compensation committee. See Cai, J., Garner, J., and Walking
R. 2009. Journal of Finance 64, 2389-2421.
\342\ See Core, J., R.W. Holthausen, and D.F. Larcker. 1999.
Corporate Governance, Chief Executive Officer Compensation, and Firm
Performance. Journal of Financial Economics 51, 371-406. The paper
finds that board and ownership structure explain differences in CEO
compensation across firms to a significant extent. Weaker governance
structures are related to greater agency problems resulting in
higher CEO compensation.
See Chhaochharia, V., and Grinstein, Y. 2009. CEO Compensation
and Board Structure. Journal of Finance 64, 231-261, showing that
companies that were least compliant with new regulations issued in
2002 by NYSE and NASDAQ (regarding governance listing standards)
decreased compensation to their CEOs to a significant extent. The
decrease in CEO compensation is mainly attributable to decreases in
bonus and stock-based compensation. The results suggest that
requirements for board of directors structure and procedures have a
significant effect on the structure and size of CEO compensation.
See also Fahlenbrach, R. 2009. Shareholder Rights, Boards, and CEO
Compensation. Review of Finance 13, 81-113, finding evidence of a
substitution effect between compensation and other governance
mechanisms.
---------------------------------------------------------------------------

Another example of a mitigating factor is the implementation of
risk controls over business activities that academic studies have
generally found effective at curbing inappropriate risk-taking. One
study \343\ examines the relation between risk controls at bank holding
companies (``BHCs'') and outcomes related to risk-taking, such as the
fraction of loans that are non-performing, during the financial crisis.
In this study, the strength and quality of risk controls are proxied by
the existence, independence, experience and centrality of the Chief
Risk Officer and the corresponding Risk Committee. The study finds that
BHCs with strong risk controls during years preceding the crisis had
lower frequencies of underperforming loans and better operating and
stock performance during the crisis. In this study, this relation was
not significant in the years outside of the financial crisis indicating
that strong risk controls, as measured by this study, curtailed extreme
risk exposures only during the financial crisis. Another study \344\
shows that lenders with relatively powerful risk managers, as measured
by the level of the risk manager's compensation relative to the level
of named executive officers' compensation, experience lower loan
default rates, interpreting this finding as evidence that strong risk
management is effective in reducing the origination of low quality
loans.
---------------------------------------------------------------------------

\343\ See Ellul, A., Yerramilli, V. 2013. Stronger Risk
Controls, Lower Risk: Evidence from U.S. Bank Holding Companies.
Journal of Finance 68, 1757-1803.
\344\ See Keys, B., Mukherjee, T., Seru, A., Vig, V. 2009.
Financial regulation and securitization: Evidence from subprime
loans. Journal of Monetary Economics 56, 700-720.
---------------------------------------------------------------------------

Another mechanism that could play a mitigating role at curtailing
the potential effects of incentive-based compensation on inappropriate
risk-taking is reputation and career concerns of executives. On one
hand, some studies show that managers' concerns about the effects of
current performance on their future compensation are important in
affecting managerial incentives, even in the absence of formal
compensation contracts.\345\ For example, executives with greater
career concerns typically have an incentive to take less risk than
optimal for the company \346\ and an executive's pay-for-performance
sensitivity is higher as the executive becomes older.\347\ This
suggests that

[[Page 37762]]

inappropriate risk-taking could be less severe for younger executives,
for whom there are more periods over which to spread the reward for
their efforts.\348\ On the other hand, as mentioned above, some studies
also argue that career concerns can lead executives to focus on
delivering short-term performance to enhance their present reputation,
at the expense of long-term value.\349\
---------------------------------------------------------------------------

\345\ See Gibbons, Robert, and Kevin J. Murphy. 1992. Optimal
incentive contracts in the presence of career concerns: Theory and
evidence, Journal of Political Economy 100, 468-505. The paper shows
that career concerns can have important effects on incentives even
in the absence of formal contracts. The importance of career
concerns as a motivating mechanism is particularly relevant for
younger managers whose ability is not yet established in the labor
market. Moreover, the evidence shows that CEOs' pay-for-performance
sensitivity is stronger for CEOs closer to retirement, consistent
with the idea that career concerns are not strong for older CEOs and
are thus re-enforced through formal contracts.
\346\ See Holmstrom, B. 1999. Managerial Incentive Problems: A
Dynamic Perspective. Review of Economic Studies 66, 169-182. The
study models incentives for effort and risk taking by agents in the
presence of career concerns. With regards to risk taking, the model
shows that younger managers whose talent or ability is not yet known
to the market may be reluctant to choose risky projects that are
optimal from a shareholders' perspective.
\347\ See Gibbons, Robert, and Kevin J. Murphy, 1992. Optimal
incentive contracts in the presence of career concerns: Theory and
evidence, Journal of Political Economy 100, 468-505.
\348\ Young CEOs are likely to differ in other dimensions such
as character, knowledge, and experience and hence establishing a
causal effect of career concerns on risk taking could be difficult.
See Cziraki, P., and M. Xu, 2013. CEO career concerns and risk-
taking, working paper.
\349\ See Narayanan, M.P. 1985. Managerial Incentives for Short-
Term Results. Journal of Finance 40, 1469-1484; and Stein, J. 1989.
Efficient Capital Markets, Inefficient Firms: A Model of Myopic
Corporate Behavior. Quarterly Journal of Economics 104, 655-669.
---------------------------------------------------------------------------

Some studies argue that compensation structures did not encourage
inappropriate risk-taking and that managers were severely penalized
since their portfolio values suffered considerably during the financial
crisis.\350\ According to these studies, executives held significant
amounts of their financial institutions' equity in the form of stock
options and restricted stock when the crisis occurred and the value of
these holdings declined dramatically and quickly, wiping out most of
their value. The fact that executives were still significantly exposed
to firm performance by holding on to stock options and restricted stock
units when the crisis occurred can be viewed as an indicator that these
executives had no knowledge of the significant risks associated with
their actions.\351\ According to this view, executives were held
accountable and penalized upon the realization of the risks undertaken.
---------------------------------------------------------------------------

\350\ See Murphy, K. 2009. Compensation Structure and Systemic
Risk. U.S.C. Marshall School of Business Working Paper. Compensation
for CEOs and other named executive officers (NEOs) significantly
suffered during the crisis. For TARP recipient institutions: Bonuses
declined by approximately 80% from 2007 to 2008, and the value of
stock options and restricted stock held by NEOs declined by more
than 80% during the same time period. Executive compensation also
significantly declined for non-TARP recipients but the decline was
lower than for TARP recipients.
\351\ See Fahlenbrach, R., Stulz, R. 2011. Bank CEO Incentives
and the Credit Crisis. Journal of Financial Economics 99, 11-26. The
study examines the link between bank performance during the crisis
and CEO incentives from compensation arrangements preceding the
crisis. The evidence shows that banks whose CEOs' incentives were
better aligned with the interests of shareholders performed worse
during the crisis. The authors argue that a potential explanation
for their findings is that CEOs with better aligned incentives
undertook higher risks before the crisis; such risks were not
suboptimal for shareholders at the point in time when they were
undertaken. This explanation is also corroborated by the fact that
CEOs did not unload their equity holdings prior to the crisis and,
as a result, their wealth significantly declined.
---------------------------------------------------------------------------

However, some other studies argue that, whereas bank executives
lost significant amounts of wealth tied to their stock and stock option
holdings during the crisis, they also received significant amounts of
compensation during the years leading up to the financial crisis.\352\
Significant amounts of short-term bonuses were paid in the years
preceding the crisis, even to executives of financial institutions that
failed soon thereafter. While bank executives walked away with
significant gains during the years leading up to the crisis, investors
suffered significant losses in their investments in these institutions
and, in some cases, taxpayers provided capital support to save these
institutions from default. Thus, the underlying actions that generated
significant positive performance and resulted in significant payouts to
executives in the short run were also responsible for the realization
of the associated risks in the long run. Another study \353\ finds that
risk-taking incentives for CEOs at large commercial banks substantially
increased around 2000 and suggests that this increase in risk-taking
incentives was, at least partly, a response to growth opportunities
resulting from deregulation. The study also finds that CEOs responded
to the increased risk-taking incentives by increasing both systematic
and idiosyncratic risks. CEOs with strong risk-taking incentives were
also more likely to invest in mortgage backed securities; this finding
is interpreted as knowledge on behalf of these CEOs regarding the risks
associated with such investments. Finally, the study finds that,
whereas boards of directors responded by moderating risk-taking
incentives in situations where these incentives were particularly
strong, such an effect was absent at the very largest banks with strong
growth opportunities.
---------------------------------------------------------------------------

\352\ See Bebchuk, L., Cohen, A., Spamann, H. 2010. The Wages of
Failure: Executive Compensation at Bear Stearns and Lehman 2000-
2008. Yale Journal on Regulation 27, 257-282. The study presents
details regarding payouts made to CEOs and executives of Bear Sterns
and Lehman Brothers during the 2000-2008 period. During the 2000-
2008 period, executive teams at Bear Sterns cashed out a total of
$1.4 billion in cash bonuses and equity sales whereas the executives
at Lehman cashed out a total of $1 billion. The authors argue that
the divergence between how top executives and their shareholders
fared may suggest that pay arrangements provided incentives for
excessive risk taking.
See Bhagat, S., Bolton, B. 2013. Bank Executive Compensation and
Capital Requirements Reform. Working Paper. The study examines,
among other things, 2000-2008 net payoffs to CEOs of 14 financial
institutions that received TARP assistance during the crisis.
Consistent with the findings of Bebchuk et al. (2010), this study
shows that CEOs of TARP assisted institutions cashed out significant
amounts of compensation prior to the crisis, but also suffered
significant losses when the crisis hit. The authors find that TARP
CEOs cashed out significantly higher amounts of compensation during
the 2000-2008 period compared to other institutions that did not
receive TARP assistance; the finding is interpreted as evidence that
TARP CEOs were aware of the increased risks associated with their
actions and significantly limited their exposure to firm performance
before the crisis hit.
\353\ See DeYoung, R., Peng, E., Yan, Meng. 2013. Executive
Compensation and Business Policy Choices at U.S. Commercial Banks.
Journal of Financial and Quantitative Analysis 48, 165-196. The
study examines CEOs' risk-taking incentives at large commercial
banks over the 1995-2006 period. The authors link the increase in
risk-taking incentives at these banks to growth opportunities due to
deregulation. They find that board of directors moderated CEO risk-
taking incentives but this effect is absent at the largest banks
with strong growth opportunities and a history of highly aggressive
risk-taking incentives.
---------------------------------------------------------------------------

Finally, there are also studies that argue that compensation
structures were not responsible for the differential risk-taking and
performance of financial institutions during crises. In particular, a
study argues that the differential risk culture across banks determines
the differential performance of these institutions.\354\ For example,
banks that performed poorly during the 1998 crisis were also found to
perform poorly, and had higher failure rates, during the recent
financial crisis. Another recent study argues that, prior to 2008,
risk-taking was inherently different across financial institutions and
the fact that high-risk financial institutions paid high amounts of
compensation to their executives was not an indicator of excessive
compensation practices but represented compensation for the additional
risk to which executives' wealth was exposed.\355\ The study

[[Page 37763]]

suggests that at financial institutions, compensation was the result of
efficient contracting between managers and shareholders. The study did
not find support for the view that compensation determined risk-taking
and ultimately led to the failure of many institutions.
---------------------------------------------------------------------------

\354\ See Fahlenbrach, R., Prilmeier, R., Stulz, R. 2012. This
Time Is the Same: Using Bank Performance in 1998 to Explain Bank
Performance during the Recent Financial Crisis. Journal of Finance
67, 2139-2185. The paper examines whether inherent business models
or/and culture drive certain banks to perform worse during crises.
The study documents that banks that performed poorly, performance
measured in terms of stock returns, after Russia's default in 1998
were also likely to perform poorly during the recent financial
crisis. These banks had greater degrees of leverage, relied more on
short-term market funding and grew faster during the years leading
up to both crisis periods. The authors interpret their findings as
being attributable to differential risk-taking cultures across banks
that persist over time.
\355\ See Cheng, I., Hong, H., Scheinkman, J. 2015. Yesterday's
Heroes: Compensation and Risk at Financial Firms. Journal of Finance
70, 839-879. The paper examines the link between managerial pay and
risk taking in the financial industry. Specifically, the paper
builds upon efficient contracting theory to predict that managers in
companies facing greater amounts of uncontrollable risk would
require higher levels of compensation. Given that higher levels of
uncontrollable risk expose managerial compensation to increased
risk, risk averse managers require additional compensation for the
increased risk exposure. Using various measures of arguably
uncontrollable company risk, such as lagged risk measures and risk
measures when the company had an IPO, the authors find a positive
relation between current compensation and historical measures of
risk. They interpret their results as inherent differences in risk
among financial companies driving differences in compensation levels
among these companies.
---------------------------------------------------------------------------

Taken all together, while there is debate about certain amounts,
components, and features of incentive-based compensation that
potentially encourage risk-taking, the existing academic literature
does not provide conclusive evidence about a specific type of
incentive-based compensation arrangement that leads to inappropriate
risk-taking without taking into account other considerations, such as
firm characteristics or other governance mechanisms. In particular,
there may be mitigating factors--some more effective than others--that
allow efficient contracting to develop compensation arrangements for
managers to align managerial interests with shareholders' interests and
provide incentives for maximization of shareholder value.
If it is the case that some institutions are able to contract
efficiently for compensation arrangements, for any such institution
that is a covered BD or IA with large balance sheet assets, and if such
institution does not pose potentially negative externalities on
taxpayers, the proposed rule may curtail the pay convexity resulting
from such efficient contracting between managers and shareholders with
potential unintended consequences. In particular, unintended
consequences may include curbing risk-taking incentives to a level that
is lower than what shareholders deem optimal, with consequent negative
effects on efficiency and shareholder value. These potential negative
effects on efficiency and shareholder value could manifest themselves
in a number of ways. For example, the lower-than-optimal level of risk-
taking could affect covered BDs' and IAs' transactions for their own
accounts as well as operations that involve customers and clients. The
SEC expects that whether such consequences occur would depend on the
specific facts and circumstances of each covered BD or IA.
In addition, the proposed rule may result in losses of managerial
talent that may migrate from covered institutions to firms in different
industries or abroad, especially if CEOs have developed, in recent
decades, general managerial skills that are transferable across firms
and industries, as some studies assert.\356\ It should be noted,
however, as the discussion in the Preamble suggests, that some foreign
regulators (e.g., in UK) have adopted stricter limits on incentive-
based compensation. Thus, some foreign regulators' restrictions on
incentive-based compensation may limit the likelihood of human capital
migrating to foreign institutions subject to those restrictions.
Moreover, given that incentive-based compensation is also designed to
attract and retain managerial talent, the proposed rule may result in
an increased level of total compensation to make up for the limits
imposed to award opportunities, for the decrease in present value of
the awards that are deferred, or for the increase in the uncertainty
associated with the fact that managers may not be able to retain the
compensation awards due to the potential for forfeiture during the
deferral period and/or clawback during the period following vesting of
such awards. If these unintended consequences occur, they may
contribute to reduce the competitiveness of certain U.S. financial
institutions in their role of intermediation, potentially affecting
other industries.
---------------------------------------------------------------------------

\356\ See Custodio, Claudia, Miguel Ferreira, and Pedro Matos.
2013. Generalists versus Specialists: Lifetime Work Experience and
Chief Executive Officer Pay. Journal of Financial Economics 108,
471-492.
---------------------------------------------------------------------------

On the other hand, for those covered institutions, including BDs
and IAs with large balance sheets, that do have the potential to
generate negative externalities, the proposed rule may result in better
alignment of incentives between managers at these institutions and
taxpayers and hence may have potential benefits by lowering the
likelihood of an outcome that may induce negative externalities.
Lowering the likelihood of negative externalities would be beneficial
for the long-term health of these institutions, other institutions that
are interconnected with those covered institutions and, in turn, the
long-term health of the U.S. economy. The extent of these potential
benefits, as mentioned above, would depend on specific facts and
circumstances at the firm level and individual level.
C. Baseline
The baseline for the SEC's economic analysis of the proposed rule
includes the current incentive-based compensation practices of those
covered institutions that are regulated by the SEC--registered broker-
dealers and investment advisers--and the relevant regulatory
requirements that may currently affect such compensation
practices.\357\
---------------------------------------------------------------------------

\357\ When referencing investment advisers, the SEC's economic
analysis references those institutions that meet the definition of
investment adviser under section 202(a)(11) of the Investment
Advisers Act, including any such institutions that may be prohibited
or exempted from registering with the SEC under the Investment
Advisers Act and any that are exempt from registration but are
reporting.
---------------------------------------------------------------------------

1. Covered Institutions
Section 956(f) limits the scope of the requirements to covered
institutions with total assets of at least $1 billion. The proposed
rule defines covered institution as a regulated institution that has
average total consolidated assets of $1 billion or more. Regulated
institutions include covered BDs and IAs. Based on their average total
consolidated assets, the proposed rule further classifies covered
institutions into three levels: Level 1 covered institutions with
average total consolidated assets greater than or equal to $250
billion; Level 2 covered institutions with average total consolidated
assets greater than or equal to $50 billion, but less than $250
billion; and Level 3 covered institutions with average total
consolidated assets greater than or equal to $1 billion, but less than
$50 billion.
In the case of BDs and IAs, a Level 1 BD or IA is a covered
institution with average total consolidated assets greater than or
equal to $250 billion, or a covered institution that is a subsidiary of
a depository institution holding company that is a Level 1 covered
institution. A Level 2 BD or IA is a covered institution with average
total consolidated assets greater than or equal to $50 billion that is
not a Level 1 covered institution; or a covered institution that is a
subsidiary of a depository institution holding company that is a Level
2 covered institution. A Level 3 BD or IA is a covered institution with
average total consolidated assets greater than or equal to $1 billion
that is not a Level 1 covered institution or Level 2 covered
institution
Table 1 shows the number of covered BDs and IAs as of December 31,
2014, sorted by the size of a BD or IA as a covered institution by
itself, without considering the size of that covered institution's
parent depository holding company, if any (hereafter, ``unconsolidated
Level 1,'' ``unconsolidated Level 2,'' and ``unconsolidated Level 3''
BDs and

[[Page 37764]]

IAs).\358\ We use 2014 data in our analysis because this is the most
recent year for which compensation data is available. From FOCUS
reports, there were 131 BDs with total assets above $1 billion at the
end of calendar year 2014.\359\ From Item 1(O) of Form ADV the SEC
estimated that, out of 11,702 IAs registered with the SEC, or reporting
to the SEC as an exempt reporting adviser, 669 IAs had total assets of
at least $1 billion as of December 31, 2014, although the SEC lacks
information that allows it to further classify these IAs as Level 1,
Level 2, or Level 3 covered institutions.\360\
---------------------------------------------------------------------------

\358\ The terms ``unconsolidated Level 1 covered institution,''
``unconsolidated Level 2 covered institution,'' and ``unconsolidated
Level 3 covered institution'' used in the SEC's economic analysis
differ from the terms ``Level 1 covered institution,'' ``Level 2
covered institution,'' and ``Level 3 covered institution'' as
defined in the proposed rule.
\359\ Total assets are taken from FOCUS report, Part II
Statement of Financial Condition. The assets reported in the FOCUS
report are required to be consolidated total assets if a BD has
subsidiaries.
\360\ Form ADV requires IAs to report consolidated balance sheet
assets. The 669 number includes 59 IAs that are not registered with
the SEC but are reporting.

Table 1--Number of Broker-Dealers and Investment Advisers
----------------------------------------------------------------------------------------------------------------
Unconsolidated Unconsolidated Unconsolidated
Institution Level 1 Level 2 Level 3 Total
----------------------------------------------------------------------------------------------------------------
Broker-dealers (BDs).................... 7 13 111 131
Investment advisers (IAs)............... n/a n/a n/a 669
----------------------------------------------------------------------------------------------------------------

i. Broker-Dealers
In 2014, 4,416 unique BDs filed FOCUS reports. Of these 4,416 BDs,
seven had total assets greater than $250 billion (Level 1 BDs), 13 had
total assets between $50 billion and $250 billion (unconsolidated Level
2 BDs), and 111 had total assets between $1 billion and $50 billion
(unconsolidated Level 3 BDs) in 2014.\361\ As shown in Table 2, these
unconsolidated Level 3 BDs had total assets equal to $9.6 billion on
average and $3.7 billion in median; and about 70 percent (78 out of
111) of them had total assets below $10 billion.
---------------------------------------------------------------------------

\361\ For purposes of this analysis, the SEC determined the
unconsolidated level of each BD. For example, if a BD alone had
total assets between $1 billion and $50 billion at the end of at
least one calendar quarter in 2014, it was classified in this
economic analysis as an unconsolidated Level 3 BD. Similarly, if a
BD alone had total assets between $50 and $250 billion (greater than
$250 billion) in at least one quarter in 2014, it was classified in
this economic analysis as an unconsolidated Level 2 (Level 1) BD.
This classification method differs from the proposed rule. Thus,
some of the unconsolidated Level 2 and unconsolidated Level 3 BDs
discussed in this economic analysis may be Level 1 and Level 2
covered institutions after consolidation and for purposes of the
proposed rule. Given that an unconsolidated Level 1 BD alone has
greater than or equal to $250 billion in total assets, an
unconsolidated Level 1 BD would be a Level 1 covered institution for
purposes of the proposed rule, regardless of consolidation.

Table 2--Size Distribution of BDs
----------------------------------------------------------------------------------------------------------------
Mean size ($ Median size ($ Size range ($ Number of BDs
BD size Number of BDs billion) billion) billion) per size range
----------------------------------------------------------------------------------------------------------------
Below $1 billion................ 4,285 $0.02 $0.001
$1-$49 billion (Unconsolidated 111 9.6 3.7 <=10 78
Level 3).......................
10-20 16
.............. .............. .............. 20-30 3
.............. .............. .............. 30-40 12
.............. .............. .............. >40 2
$50-$250 billion (Unconsolidated 13 90.6 80.3 50-100 9
Level 2).......................
.............. .............. .............. 100-$150 2
.............. .............. .............. 150-200 2
.............. .............. .............. >200 0
Over $250 billion (Level 1)..... 7 312.3 275.2 250-300 4
.............. .............. .............. 300-350 2
.............. .............. .............. 350-400 0
.............. .............. .............. >400 1
----------------------------------------------------------------------------------------------------------------

The SEC's analysis indicates that, in 2014, all of the
unconsolidated Level 1 and unconsolidated Level 2 BDs were subsidiaries
of a holding company or parent institution. Of these parent
institutions, only one was not a depository institution holding
company. The majority of the unconsolidated Level 3 BDs were also part
of a larger corporate structure. It should be noted that some parent
institutions owned more than one BD. Out of the 111 unconsolidated
Level 3 BDs, 21 BDs were non-reporting, stand-alone institutions (i.e.,
entities that are not part of a larger corporate structure).
In Table 3, the parent institutions of the affected BDs are
classified into Level 1, Level 2, or Level 3, based on the ultimate
parent's total consolidated assets.\362\ As of the end of 2014, there
were 23 unique Level 1 parents and 9 unique Level 2 parents that owned
covered Level 1, unconsolidated Level 2, and unconsolidated Level 3
BDs. An additional 18 unique parents were Level 3 covered institutions,
and those owned only unconsolidated Level 3 BDs. The SEC was not able
to classify 29 parent institutions due to the lack of data on their
total consolidated assets.
---------------------------------------------------------------------------

\362\ The name of the ultimate parent was obtained using the
company information in the Capital IQ database. The SEC found total
assets information for public parents in the Compustat database.
Total assets information for some of the private parents the SEC
found in the Capital IQ database.

[[Page 37765]]

Table 3--Distribution of BDs by Level Size of the Parent
----------------------------------------------------------------------------------------------------------------
BD as a subsidiary of a
---------------------------------------------------------------- BD as a stand-
Parent size n/ alone
Level 1 parent Level 2 parent Level 3 parent a institution
----------------------------------------------------------------------------------------------------------------
Number of unconsolidated Level 1 7 0 0 0 0
BDs............................
Number of unique parents........ 7 .............. .............. .............. ..............
Number of public parents........ 7 .............. .............. .............. ..............
Median BD assets ($ billion).... $275.2 .............. .............. .............. ..............
Median parent assets ($ billion) $1,882.9 .............. .............. .............. ..............
Number of unconsolidated Level 2 13 0 0 0 0
BDs............................
Number of unique parents........ 11 .............. .............. .............. ..............
Number of public parents........ 11 .............. .............. .............. ..............
Median BD assets ($ billion).... $80.3 .............. .............. .............. ..............
Median parent assets ($ billion) $1,702.1 .............. .............. .............. ..............
Number of unconsolidated Level 3 18 11 23 36 23
BDs............................
Number of unique parents........ 14 9 19 29 ..............
Number of public parents........ 14 8 17 .............. ..............
Median BD assets ($ billion).... $9.5 $4.0 $3.0 $4.4 ..............
Median parent assets ($ billion) $850.8 $127.7 $9.2 n/a ..............
-------------------------------------------------------------------------------
Total number of unique 23 9 19 29 ..............
parents....................
-------------------------------------------------------------------------------
Total number of public 23 8 17 .............. ..............
parents....................
----------------------------------------------------------------------------------------------------------------

The majority of BDs that were subsidiaries were held by a parent
registered with the SEC as a reporting institution (i.e., public
company). All parents of Level 1 BDs and almost all of the parents of
unconsolidated Level 2 BDs were public companies, while 39 out of the
71 unique parents of unconsolidated Level 3 BDs were public companies.
Twenty three BDs were not subsidiaries but stand-alone companies that
were private Level 3 BDs.
ii. Investment Advisers
The SEC does not have a precise way of distinguishing among the
largest IAs because Form ADV requires an adviser to indicate only
whether it has $1 billion or more in assets on the last day of its most
recent fiscal year.\363\ In addition, the information contained on Form
ADV relates only to registered investment advisers and exempt reporting
advisers, while the proposed rule would apply to all investment
advisers.\364\ As of December 2014, there were 669 IAs with assets of
at least $1 billion, of which 129 IAs were affiliated with banking or
thrift institutions.\365\ For the remaining 540 IAs the SEC does not
have information on how many of them are stand-alone companies and how
many are affiliated with non-bank parent companies. Of the 669 IAs, 51
are dually registered as BDs with the SEC.\366\ Of the 129 IAs
affiliated with banking or thrift institutions, 39 IAs are affiliated
with banks and thrifts with $50 billion or more in assets. Of the 39
IAs, 10 IAs were affiliated with banks and thrift institutions with
assets between $50 billion and $250 billion; and 23 IAs were affiliated
with banks and thrift institutions with assets of more than $250
billion. As Table 4 shows, the 39 IAs have 25 unique parent
institutions and most of these parent institutions (17) are public
companies.
---------------------------------------------------------------------------

\363\ See Item 1.O of Part 1A of Form ADV. As noted above, the
SEC has not historically examined its regulated entities' use of
incentive-based employee compensation. In this regard, Form ADV does
not contain information with respect to such practices.
\364\ By its terms, the definition of ``covered financial
institution'' in section 956 includes any institution that meets the
definition of ``investment adviser'' under the Investment Advisers
Act, regardless of whether the institution is registered as an
investment adviser under that Act. Most investment advisers
(including registered investment advisers, exempt reporting
advisers, or otherwise) currently do not report to the SEC their
average total consolidated assets, so the SEC is unable to determine
with particularity how many have average total consolidated assets
greater than or equal to $1 billion and less than $50 billion,
greater than or equal to $50 billion and less than $250 billion, or
greater than or equal to $250 billion. The estimates used in this
section with respect to investment advisers, however, are based on
data reported by registered investment advisers and exempt reporting
advisers with the SEC on Form ADV, because the SEC estimates that it
is unlikely that investment advisers that are prohibited from
registering with the SEC would be subject to the proposed rule.
\365\ Form ADV requires an adviser to indicate whether it has a
``related person'' that is a ``banking or thrift institution,'' but
does not require an adviser to identify a related person by type
(e.g., a depository institution holding company). See Item 7 of Part
1A and Item 7.A of Schedule D to Form ADV. These estimates are
therefore limited by the information reported by registered
investment advisers and exempt reporting advisers in their Forms ADV
and has necessitated manual referencing of the institutions
specified.
\366\ Because the data presented below for the effects on BDs
and IAs are presented separately, in aggregate, they may overstate
the costs and other economic effects for dual registrants.

Table 4--Distribution of 39 IAs Affiliated With Level 1 and Level 2 Banks and Thrifts, by Level Size of the
Parent
----------------------------------------------------------------------------------------------------------------
IA as a subsidiary of a
-----------------------------------------------
Parent size n/
Level 1 parent Level 2 parent a
----------------------------------------------------------------------------------------------------------------
Number of IAs................................................... 23 10 6
Number of unique parents........................................ 10 9 6
Number of public parents........................................ 10 7 0
----------------------------------------------------------------------------------------------------------------

[[Page 37766]]

2. Current Incentive-Based Compensation Practices
The SEC does not have information on the incentive-based
compensation practices of the BDs and IAs themselves. The main reason
why the SEC lacks such information is that BDs and IAs are generally
not public reporting companies and as a result they do not provide the
type of compensation information that a public reporting company would
file with the SEC as part of its communications with shareholders.
Notwithstanding these limitations on the data regarding the incentive-
based compensation arrangements at BDs or IAs, when the BDs or IAs are
subsidiaries of public reporting companies, the SEC has information for
the public reporting company that is the parent of these BDs and IAs.
In particular, the information on incentive-based compensation
practices for named executive officers (``NEOs'') is annually disclosed
in proxy statements and annual reports filed with the SEC. NEOs
typically include the principal executive officer, the principal
financial officer, and three most highly compensated executives.\367\
---------------------------------------------------------------------------

\367\ For a company that is not a smaller reporting company,
Item 402(a)(3) of Regulation S-K defines named executive officers
as: (1) All individuals serving as the company's principal executive
officer or acting in a similar capacity during the last completed
fiscal year (PEO), regardless of compensation level; (2) All
individuals serving as the company's principal financial officer or
acting in a similar capacity during the last completed fiscal year
(PFO), regardless of compensation level; (3) The company's three
most highly compensated executive officers other than the PEO and
PFO who were serving as executive officers at the end of the last
completed fiscal year; and (4) Up to two additional individuals for
whom disclosure would have been provided under the immediately
preceding bullet point, except that the individual was not serving
as an executive officer of the company at the end of the last
completed fiscal year.
---------------------------------------------------------------------------

Given that it lacks data on the BDs and IAs themselves, for the
purposes of this economic analysis, the SEC uses data on incentive-
based compensation of the NEOs at the parent institutions, which for
unconsolidated Level 1 and unconsolidated Level 2 BDs are mostly bank
holding companies,\368\ as an indirect measure of incentive-based
compensation practices at the subsidiary level.\369\ The SEC also
analyzes the incentive-based compensation of public reporting
institutions with assets between $1 billion and $50 billion, many of
which are not bank holding companies, because it is possible that size
may be a determinant of incentive-based compensation arrangements and
thus the incentive-based compensation of an unconsolidated Level 3 BD
or IA may be more similar to that of a public reporting institution
with assets between $1 billion and $50 billion.
---------------------------------------------------------------------------

\368\ For Level 1 and unconsolidated Level 2 BDs, the SEC's
analysis indicates that, as of December 2014, two of their 20 unique
parent institutions are non-bank holding companies (one investment
management firm and one investment bank/brokerage). For the 39 IAs
described in Table 4, six of their 25 unique parent institutions are
not bank holding companies, For unconsolidated Level 3 BDs, 20 of
the 42 unique parent institutions for which data on their size is
available are not bank holding companies.
\369\ It is also possible that the compensation practices
between Level 1 parent and unconsolidated Level 2 subsidiary (or
between Level 2 parent and unconsolidated Level 3 subsidiary) may be
closer to each other than those of Level 1 parent and unconsolidated
Level 3 subsidiary.
---------------------------------------------------------------------------

While the SEC utilizes the above-referenced public reporting
company data, it should be noted that there are a number of caveats
that may impact the SEC's analysis. First, the incentive-based
compensation arrangement at the subsidiary level may differ from that
of the parent level due to either the difference between the size of
the subsidiary relative to the size of the parent, or because the
business model of the subsidiary is different from that of the parent.
More specifically, the incentive-based compensation arrangement of bank
holding companies may be different than that of BDs or IAs given the
fundamentally differing natures of the underlying business models and
the composition of their respective balance sheets. Further, the
incentive-based compensation practices at a public reporting company
could be different than those at a non-public reporting company. The
SEC also does not have information about incentive-based compensation
of non-NEOs and of those employees included in the definition of
significant risk-takers under the proposed rule. These caveats mean
that the SEC's analysis, which is mainly based on data from public bank
holding companies, may not accurately reflect incentive-based
compensation practices at BDs and IAs. To address this lack of data,
the SEC has supplemented its analysis with anonymized supervisory data
from the Board and the OCC, with limitations to the generalizability of
the analysis on non-NEOs and significant risk-takers similar to the
ones discussed above.
i. Named Executive Officers
Table 5A presents data on the compensation structure of NEOs at
Level 1, Level 2, and Level 3 parent public reporting institutions of
unconsolidated Level 1, unconsolidated Level 2, and unconsolidated
Level 3 BDs as of the end of fiscal year 2014.\370\ In addition to the
CEO and the CFO, NEOs typically include the chief operating officer
(``COO''), the general counsel (``GC''), and the heads of business
units such as wealth management and investment banking. As shown in
Table 5A, incentive-based compensation is a significant component of
NEO compensation at parent institutions. It is approximately 90 percent
of total compensation for Level 1 parent institutions and 85 percent
for Level 2 parent institutions (median values are also reported in
parentheses).\371\ Additionally, a sizable fraction of incentive-based
compensation is in the form of long-term incentive compensation, which
is mainly awarded in the form of stock, stock options, or debt
instruments.\372\ The SEC observes that the use of stock options varies
by size of the parent institution: Stock options represent on average 6
percent of long-term incentive compensation for Level 1 parents, while
they represent approximately 20 percent of long-term incentive
compensation for Level 2 parents.\373\
---------------------------------------------------------------------------

\370\ Data comes from Compustat's ExecuComp database. Out of 30
unique Level 1 and Level 2 parent institutions of Level 1, Level 2,
and Level 3 BDs, compensation data is not available for 16 parent
institutions.
\371\ Incentive-based compensation is determined as Total
compensation as reported in SEC filings--Salary.
\372\ Long-term incentive compensation is determined using the
following items from Compustat's ExecuComp database: Total
compensation as reported in SEC filings--Salary--Bonus--Other annual
compensation. Short-term incentive compensation is determined as
Bonus + Other annual compensation.
\373\ This is consistent with evidence of decreased use of stock
options in compensation arrangements over the last decade, with
companies replacing the use of stock options with restricted stock
units. See Frydman and Jenter, CEO Compensation, Annual Review of
Financial Economics (2010).

[[Page 37767]]

Table 5A--Compensation Structure of BD Parent Institutions by Level Size
----------------------------------------------------------------------------------------------------------------
Level 1 parent Level 2 parent Level 3 parent
----------------------------------------------------------------------------------------------------------------
Incentive-based compensation as percent of total compensation... 90% (90%) 85% (86%) 83% (87%)
Short-term incentive compensation as percent of total 15% (0%) 1% (0%) 21% (0%)
compensation...................................................
Long-term incentive compensation as percent of total 74% (81%) 85% (86%) 62% (77%)
compensation...................................................
Option awards as percent of long-term incentive compensation.... 6% (0%) 20% (18%) 4% (0%)
Stock awards as percent of long-term incentive compensation..... 68% (69%) 40% (37%) 44% (49%)
Number of NEOs per institution.................................. 5.5 (5) 5.3 (5) 5.4 (5)
Number of parent institutions with available compensation data.. 10 4 7
----------------------------------------------------------------------------------------------------------------

Table 5B presents similar statistics for the compensation
structures of Level 1 and Level 2 parent institutions of IAs that were
affiliated with banks and thrift institutions with assets of more than
$50 billion.\374\ The summary statistics for the parent companies of
IAs mirrors the statistics for the BDs' parent companies: A significant
portion of NEO compensation is in the form of incentive-based
compensation, most of which is long-term incentive compensation that
comes in the form of stock awards.\375\ Both Level 1 and Level 2 IA
parents exhibit relatively little use of options.
---------------------------------------------------------------------------

\374\ There is an overlap between the parent institutions of BDs
and IAs: About half of the IAs' parents are also parents of BDs and
included in Table 5A.
\375\ This is not surprising given that approximately half of
the IAs' parent institutions are also parent institutions of BDs and
included in Table 5A.

Table 5B--Compensation Structure of Level 1 and Level 2 IA Parent
Institutions
------------------------------------------------------------------------
Level 1 parent Level 2 parent
------------------------------------------------------------------------
Incentive compensation as percent of 90% (90%) 84% (94%)
total compensation.....................
Short-term incentive compensation as 20% (28%) 2% (0%)
percent of total compensation..........
Long-term incentive compensation as 70% (65%) 82% (84%)
percent of total compensation..........
Option awards as percent of long-term 8% (0%) 9% (0%)
incentive compensation.................
Stock awards as percent of long-term 71% (73%) 51% (55%)
incentive compensation.................
Number of NEOs per institution.......... 5.2 (5) 5.2 (5)
Number of parent institutions with 8 5
available compensation data............
------------------------------------------------------------------------

Table 6A provides summary statistics for types of incentive-based
compensation currently awarded by parent institutions of BDs, their
vesting periods, and the specific measures on which these awards are
based.\376\ All types of parent institutions use cash in their short-
term incentive compensation. Only 12 percent of Level 1 parent
institutions, and none of the Level 2 parent institutions, defer short-
term incentive compensation that is awarded in cash only. A significant
fraction of Level 1 parent institutions awards short-term incentive
compensation in the form of cash and stock.
---------------------------------------------------------------------------

\376\ Data for tables 6A through 10B is collected from the 2015
and 2007 proxy statements, 10-Ks, and 20-Fs of the Level 1, Level 2,
and Level 3 parent institutions.

Table 6A--Type and Frequency of Use of Incentive-Based Compensation Awards--Level 1, Level 2, and Level 3 BD Parent Institutions
--------------------------------------------------------------------------------------------------------------------------------------------------------
Short-term incentive compensation Long-term incentive compensation
--------------------------------------------------------------------------------------------------------------------------
Level 1 parent Level 2 parent Level 3 parent Level 1 parent Level 2 parent Level 3 parent
--------------------------------------------------------------------------------------------------------------------------------------------------------
Number of parent institutions 16................. 5.................. 13................. 16................ 5................. 13.
with available compensation
data.
Fraction of total
compensation:
CEO...................... 25%................ 44%................ 39%................ 52%............... 45%............... 60%.
Other NEOs............... 27%................ 45%................ 59%................ 50%............... 40%............... 40%.
Award:
Cash only--percent of 44%................ 100%............... 100%............... 6%................ 0%................ 0%.
institutions.
percent that defer 12%................ 0%................. 9%................. 6%................ 0%................ 0%.
cash.
Cash & stock--percent of 56%................ 0%................. 0%................. 6%................ 0%................ 9%.
institutions.
Avg percent of stock 55%................
in ST IC.
Avg deferral for 3 years............
stock.
Restricted stock-percent ................... ................... ................... 56%............... 60%............... 100%.
of institutions.
Avg percent of LT IC. ................... ................... ................... 36%............... 26%............... 75%.
Avg vesting period... ................... ................... ................... 3.5 years......... 3.3 years......... 3.4 years.
Type of vesting:
percent with pro- ................... ................... ................... 87%............... 100%.............. 82%.
rata.

[[Page 37768]]

percent with ................... ................... ................... 13%............... 0%................ 18%.
cliff.
Performance stock-- ................... ................... ................... 88%............... 80%............... 36%.
percent of institutions.
Avg percent of LT IC. ................... ................... ................... 53%............... 42%............... 44%.
Avg performance ................... ................... ................... 3.7 years......... 3 years........... 2 years.
period.
percent with perf ................... ................... ................... 6%................ 0%................ 100%.
period <3yrs.
percent with ................... ................... ................... 14%............... 0%................ 0%.
vesting.
Avg vesting period... ................... ................... ................... 3.7 years.........
Type of vesting:
percent with pro- ................... ................... ................... 100%..............
rata.
percent with ................... ................... ................... 0%................
cliff.
Options--percent of 0%................. 0%................. ................... 12%............... 60%............... 18%.
institutions.
Avg percent of LT IC. ................... ................... ................... 4%................ 20%............... 39%.
Avg vesting period... ................... ................... ................... 3.5 years......... 3.3 years......... 3 years.
Notional bonds--percent 0%................. 0%................. ................... 6%................ 0%................ 0%.
of institutions.
Avg percent of LT IC. ................... ................... ................... 30%...............
Avg vesting period... ................... ................... ................... 5 years...........
Performance measures:
EPS or Net income........ 44%................ 100%............... 31%................ 19%............... 50%............... 38%.
ROA...................... 6%................. 40%................ 0%................. 19%............... 25%............... 0%.
ROE...................... 44%................ 0%................. 31%................ 44%............... 50%............... 31%.
Pre-tax income........... 25%................ 0%................. 62%................ 6%................ 0%................ 54%.
Capital strength......... 31%................ 0%................. 0%................. 6%................ 0%................ 0%.
Efficiency ratios........ 13%................ 40%................ 0%................. 6%................ 0%................ 0%.
Strategic goals.......... 19%................ 25%................ 23%................ 13%............... 0%................ 23%.
TSR...................... 19%................ 25%................ 46%................ 56%............... 75%............... 54%.
--------------------------------------------------------------------------------------------------------------------------------------------------------

A significant percentage of long-term incentive compensation of BD
parent institutions comes in the form of restricted or performance
stock.\377\ Restricted stock accounts for about 36 percent of long-term
incentive compensation at Level 1 parent institutions and approximately
26 percent at Level 2 parent institutions. It has a vesting period of
approximately 3.5 years. Performance stock awards are more popular:
Over 80 percent of Level 1 and Level 2 parent institutions employ
performance stock, which on average accounts for approximately 53
percent of the long-term incentive compensation of Level 1 parents and
42 percent of that of Level 2 parents. Performance stock awards are
frequently evaluated using total shareholder return (``TSR''), return
on equity (``ROE''), return on assets (``ROA''), earnings per share
(``EPS''), or a combination of TSR and one or more accounting measures
of performance over an average of 3.7 years for Level 1 parent
institutions and 3 years for Level 2 parent institutions. About 14
percent of Level 1 parent institutions impose deferral after the
performance period for performance stock. The average deferral period
for these awards is approximately 4 years.
---------------------------------------------------------------------------

\377\ Restricted stock includes actual shares or share units
that are earned by continued employment, often referred to as time-
based awards. Performance stock consists of stock-denominated actual
shares or share units (performance shares) and grants of cash or
dollar-denominated units (performance units) earned based on
performance against predetermined objectives over a defined period.
---------------------------------------------------------------------------

Consistent with the results in Table 5A above, stock options do not
appear to be a popular component of incentive-based compensation
arrangements among Level 1 parent institutions. They are more
frequently used by Level 2 parent institutions, for which options
account for approximately 20 percent of long-term incentive
compensation. One of the Level 1 parents also uses debt instruments as
a part of NEOs' long-term incentive compensation, which fully vest
after five years (i.e. cliff vest). Similar results are obtained when
examining the compensation practices of Level 1 and Level 2 parent
institutions of IAs, as the summary statistics in Table 6B suggest.

Table 6B--Type and Frequency of Use of Incentive-Based Compensation Awards--Level 1 and Level 2 IA Parent
Institutions
----------------------------------------------------------------------------------------------------------------
Short-term incentive compensation Long-term incentive compensation
----------------------------------------------------------------------------------
Level 1 parent Level 2 parent Level 1 parent Level 2 parent
----------------------------------------------------------------------------------------------------------------
Number of parent institutions 10................. 6.................. 10................. 6.
with available compensation
data.
Fraction of total
compensation:
CEO...................... 23%................ 26%................ 64%................ 63%.
Other NEOs............... 27%................ 27%................ 58%................ 59%.

[[Page 37769]]

Award:
Cash only--percent of 60%................ 83%................ 0%................. 0%.
institutions.
percent that defer 10%................ 0%................. 0%................. 0%.
cash.
Cash & stock--percent of 40%................ 17%................ 10%................ 17%.
institutions.
Avg percent of stock 50%................
in ST IC.
Avg deferral for 3 years............
stock.
Restricted stock--percent ................... ................... 80%................ 67%.
of institutions.
Avg percent of LT IC. ................... ................... 51%................ 30%.
Avg vesting period... ................... ................... 3.5 years.......... 3.8 years.
Type of vesting:
percent with pro- ................... ................... 100%............... 100%.
rata.
percent with ................... ................... 0%................. 0%.
cliff.
Performance stock-- ................... ................... 80%................ 100%.
percent of institutions.
Avg percent of LT IC. ................... ................... 42%................ 56%.
Avg performance ................... ................... 3.9 years.......... 2.6 years.
period.
percent with perf ................... ................... 13%................ 0%.
period <3yrs.
percent with ................... ................... 13%................ 0%.
vesting.
Avg vesting period... ................... ................... 4 years............
Type of vesting:
percent with pro- ................... ................... 100%...............
rata.
percent with ................... ................... 0%.................
cliff.
Options--percent of 0%................. 0%................. 10%................ 50%.
institutions.
Avg percent of LT IC. ................... ................... 25%................ 28%.
Avg vesting period... ................... ................... 4 years............ 3.2 years.
Performance measures:
EPS or Net income........ 60%................ 67%................ 20%................ 50%.
ROA...................... 10%................ 17%................ 20%................ 17%.
ROE...................... 40%................ 33%................ 60%................ 67%.
Pre-tax income........... 10%................ 0%................. 0%................. 0%.
Capital strength......... 30%................ 0%................. 10%................ 17%.
Efficiency ratios........ 30%................ 17%................ 10%................ 17%.
Strategic goals.......... 20%................ 17%................ 20%................ 17%.
TSR...................... 30%................ 17%................ 50%................ 17%.
----------------------------------------------------------------------------------------------------------------

Table 7A reports whether incentive-based compensation of NEOs at
Level 1, Level 2, and Level 3 parent institutions of BDs is deferred or
subject to clawback, forfeiture, and certain prohibitions.\378\
---------------------------------------------------------------------------

\378\ From the disclosures provided by reporting companies on
clawback, forfeiture and certain prohibitions, the SEC is able to
establish whether a reporting company currently uses policies that
are in line with the proposed rule, but was not able to establish
compliance with certainty.

Table 7A--Current Deferral, Clawback, Forfeiture and Certain Prohibitions for NEOs at Level 1, Level 2, and
Level 3 BDs Parent Institutions
----------------------------------------------------------------------------------------------------------------
Level 1 parent Level 2 parent Level 3 parent
----------------------------------------------------------------------------------------------------------------
Number of parent institutions with available compensation data.. 16 5 13
Number of NEOs:
Total number of NEOs........................................ 104 24 66
Average number of NEOs per institution...................... 6 5 5
Deferred compensation:
Institutions with deferred compensation..................... 100% 80% 100%
Average percent of deferred compensation:
CEO..................................................... 75% 52% 65%
Other NEOs.............................................. 73% 49% 43%
Average number of years deferred............................ 3.5 2.6 3.3
Type of compensation deferred:
Institutions with cash...................................... 19% 25% 8%
Institutions with stock..................................... 100% 100% 100%
Institutions with bonds..................................... 6% N/A 8%
Clawback and forfeiture:
Institutions with clawback.................................. 100% 80% 92%
Institutions with forfeiture................................ 100% 60% 85%
Prohibitions:
Institutions prohibiting hedging............................ 75% 60% 62%

[[Page 37770]]

Institutions prohibiting volume-driven incentive-based N/A N/A N/A
compensation...............................................
Institutions prohibiting acceleration of payments except in 70% 14% 9%
case of death and disability...............................
Maximum incentive-based compensation:
Average percent............................................. 155% 190% 134%
Risk Management:
Institutions with Risk Committees........................... 100% 67% 62%
Institutions with fully independent Compensation Committee.. 93% 88% 83%
Institutions where CROs review compensation packages........ 31.3% 20% 15%
----------------------------------------------------------------------------------------------------------------

In general, the SEC's analysis of the compensation information
disclosed in proxy statements and annual reports by parent institutions
of covered BDs suggests that NEO compensation practices at most of the
parent institutions are in line with the main requirements and
prohibitions in the proposed rule. This may not be surprising given
that the baseline already reflects a regulatory response to the
financial crisis.\379\ For example, all Level 1 parents and 80 percent
of Level 2 parents of BDs require some form of deferral of incentive-
based executive compensation. The average Level 1 parent institution
defers 75 percent of incentive-based compensation awarded to CEOs and
73 percent awarded to other NEOs, which is above the minimum deferral
amount that would be required by the proposed rule. In a similar vein,
an average of 52 percent of incentive-based compensation awarded to
CEOs and 49 percent awarded to other NEOs is deferred at Level 2 parent
institutions, similar to what would be required by the proposed rule.
The length of the deferral period at Level 1 and Level 2 parent
institutions is also currently in line with what would be required by
the proposed rule: On average, 3.5 years for NEOs at Level 1 parent
institutions and approximately 3 years for those at Level 2 parent
institutions.
---------------------------------------------------------------------------

\379\ See, 2010 Federal Banking Agency Guidance, available at:
https://www.federalreserve.gov/newsevents/press/bcreg/20100621a.htm.
---------------------------------------------------------------------------

Regarding the type of incentive-based compensation that is being
deferred, both Level 1 and Level 2 parent institutions defer equity-
based compensation. One of the Level 1 parent institutions uses debt
instruments as incentive-based compensation and defers it as well. Only
a fraction of them (20 percent of Level 1 and 25 percent of Level 2
parent institutions), however, currently defer incentive-based
compensation in cash; the proposed rule would require deferral of
substantial portions of both cash and equity-like instruments for
senior executive officers and significant risk-takers at Level 1 and
Level 2 covered institutions. Thus, for both Level 1 and Level 2 parent
institutions the current composition of their deferred compensation
appears to conform to the proposed rule requirements with respect to
equity-like instruments, but only a few Level 1 and Level 2 parent
institutions appear to conform to the proposed rule requirements with
respect to deferral of cash.
Some of the other requirements and prohibitions for Level 1 and
Level 2 covered institutions in the proposed rule are also currently in
place at the parent institutions of covered BDs. For example, all of
the Level 1 parent institutions and a large majority of Level 2 parent
institutions require that the incentive-based compensation awards of
NEOs be subject to clawback and forfeiture provisions. The frequency of
the use of clawback and forfeiture by Level 1 and Level 2 parent
institutions is higher than that reported by a commenter \380\ based on
the results of a study.\381\ The commenter did not specify, however,
when the study was done, nor the number and type of companies covered
by the study.
---------------------------------------------------------------------------

\380\ All references to commenters in this economic analysis
refer to comments received on the 2011 Proposed Rule.
\381\ See comment letter from Financial Services Roundtable (May
31, 2011). The Roundtable conducted a study of a portion of its
membership. Data was collected on the risk management strategies and
the procedures for determining compensation since 2008.
---------------------------------------------------------------------------

A majority of parent institutions also have prohibitions on
hedging.\382\ Consistent with the proposed prohibition of relying
solely on relative performance measures when awarding incentive-based
compensation, all of the Level 1 and Level 2 parent institutions
currently use a mix of absolute and relative performance measures in
their incentive-based compensation arrangements. Additionally, most
Level 1 parent institutions prohibit acceleration of compensation
payments except in the cases of death or disability, whereas very few
Level 2 parent institutions do that. The average maximum incentive-
based compensation opportunity is 155 percent of the target amount for
Level 1 parent institutions and 190 percent for Level 2 parent
institutions, which is above what would be permitted by the proposed
rules. In the SEC's analysis of the compensation disclosure, the SEC
did not find any mention about prohibition of volume-driven incentive-
based compensation as would be proposed by the rule.
---------------------------------------------------------------------------

\382\ The proposed rule would prohibit covered institutions from
purchasing hedging instruments on behalf of covered persons. The
statistics regarding hedging prohibitions presented in Table 7A and
Table 7B, and Table 9A and Table 9B refer to complete prohibition
regarding the use of hedging instruments by senior executives and
directors respectively.
---------------------------------------------------------------------------

Similar results are obtained when analyzing the current practices
of the Level 1 and Level 2 parent institutions of IAs (Table 7B). All
IA parent institutions defer NEO compensation, on average, for three
years. Almost all parent companies subject incentive-based compensation
of NEOs to clawback and forfeiture and prohibit hedging transactions.

[[Page 37771]]

Table 7B--Current Deferral, Clawback, Forfeiture and Certain
Prohibitions for NEOs at Level 1 and Level 2 IA Parent Institutions
------------------------------------------------------------------------
Level 1 parent Level 2 parent
------------------------------------------------------------------------
Number of parent institutions with 10 6
available compensation data............
Number of NEOs:
Total number of NEOs................ 53 32
Average number of NEOs per 5 5
institution........................
Deferred compensation:
Institutions with deferred 100% 100%
compensation.......................
Average percent of deferred
compensation:......................
CEO............................. 77% 69%
Other NEOs...................... 71% 68%
Average number of years deferred.... 3.6 3.3
Type of compensation deferred:..........
Institutions with cash.............. 20% 67%
Institutions with stock............. 100% 100%
Institutions with bonds............. 0% 0
Clawback and forfeiture:
Institutions with clawback.......... 100% 100%
Institutions with forfeiture........ 100% 83%
Prohibitions:
Institutions prohibiting hedging.... 90% 67%
Institutions prohibiting volume- N/A N/A
driven incentive-based compensation
Institutions prohibiting 70% 0%
acceleration of payments but for
death and disability...............
Maximum incentive-based compensation:
Average percent..................... 148% 188%
Risk Management:
Institutions with Risk Committees... 100% 100%
Institutions with fully independent 80% 89%
Compensation Committee.............
Institutions where CROs review 50% 33%
compensation packages..............
------------------------------------------------------------------------

To examine how the use of the proposed rule's requirements and
prohibitions has changed since the financial crisis, in Tables 8A and
8B the SEC reports the use of incentive-based compensation deferral,
clawback, forfeiture, and some of the rule prohibitions by the Level 1
and Level 2 parent institutions of BDs and IAs in year 2007, just prior
to the financial crisis. A comparison with the results in Tables 7A and
7B shows that just prior to the financial crisis Level 1 and Level 2
covered institutions deferred less of NEOs' incentive-based
compensation compared to what they defer nowadays. More importantly,
the use of clawback and forfeiture in 2007 was far less common than it
is now: For example, none of these institutions reported using clawback
arrangements as of year 2007. Additionally, fewer covered institutions
had risk committees in year 2007.

Table 8A--Deferral, Clawback, Forfeiture and Certain Prohibitions for
NEOs at Level 1 and Level 2 BD Parent Institutions in Year 2007
------------------------------------------------------------------------
Level 1 parent Level 2 parent
------------------------------------------------------------------------
Number of parent institutions with 16 5
available compensation data............
Number of NEOs:
Total number of NEOs................ 101 26
Average number of NEOs per 6 5
institution........................
Deferred compensation:
Institutions with deferred 100% 100%
compensation.......................
Average percent of deferred
compensation:
CEO............................. 49% 34%
Other NEOs...................... 51% 28%
Average number of years deferred.... 3.3 3
Type of compensation deferred:
Institutions with cash.............. 0% 40%
Institutions with stock............. 100% 100%
Clawback and forfeiture:
Institutions with clawback.......... 0% 0%
Institutions with forfeiture........ 27% 40%
Prohibitions:
Institutions prohibiting hedging.... 14% 0%
Institutions prohibiting volume- N/A N/A
driven incentive-based compensation
Institutions prohibiting 67% 20%
acceleration of payments except in
case of death and disability.......
Maximum incentive-based compensation:
Average percent..................... 186% N/A
Risk Management:
Institutions with Risk Committees... 60% 20%

[[Page 37772]]

Institutions with fully independent 93% 100%
Compensation Committee.............
Institutions where CROs review 0% 0%
compensation packages..............
------------------------------------------------------------------------

Thus, the analysis suggests that following the financial crisis,
most Level 1 and Level 2 parent institutions of BDs and IAs have
adopted to a certain extent some of the provisions and prohibitions
that would be required by the proposed rule.

Table 8B--Deferral, Clawback, Forfeiture and Certain Prohibitions for
NEOs at Level 1 and Level 2 IA Parent Institutions in Year 2007
------------------------------------------------------------------------
Level 1 parent Level 2 parent
------------------------------------------------------------------------
Number of parent institutions with 10 5
available compensation data............
Number of NEOs:
Total number of NEOs................ 53 26
Average number of NEOs per 5 5
institution........................
Deferred compensation:
Institutions with deferred 100% 100%
compensation.......................
Average percent of deferred
compensation:
CEO............................. 45% 44%
Other NEOs...................... 53% 33%
Average number of years deferred:... 3.3 3.5
Type of compensation deferred:
Institutions with cash.............. 20% 40%
Institutions with stock............. 100% 100%
Clawback and forfeiture:
Institutions with clawback.......... 0% 0%
Institutions with forfeiture........ 40% 40%
Prohibitions:
Institutions prohibiting hedging.... 20% 0%
Institutions prohibiting volume- N/A N/A
driven incentive-based compensation
Institutions prohibiting 40% 100%
acceleration of payments but for
death and disability...............
Maximum incentive-based compensation
Risk Management:
Average percent..................... 223% N/A
Institutions with Risk Committees... 60% 0%
Institutions with fully independent 100% 100%
Compensation Committee.............
Institutions where CROs review 0% 0%
compensation packages..............
------------------------------------------------------------------------

Table 9A lists the most frequent triggers for clawback and
forfeiture, which include some type of misconduct and adverse
performance/outcome. About 19 percent of Level 1 parent institutions
use improper or excessive risk-taking as a trigger for forfeiture and
clawback. About 88 percent of Level 1 parent institutions use
misconduct, and 75 percent of Level 1 parent institutions also use
adverse performance as triggers for clawback, similar to the proposed
rules.

Table 9A--Percentage of Level 1, Level 2, and Level 3 BD Parent Institutions by Trigger for Forfeiture and Clawback
--------------------------------------------------------------------------------------------------------------------------------------------------------
Level 1 parents Level 2 parents Level 3 parents
-----------------------------------------------------------------------------------------------
Trigger Forfeiture: % Clawback: % of Forfeiture: % Clawback: % of Forfeiture: % Clawback: % of
of firms firms of firms firms of firms firms
--------------------------------------------------------------------------------------------------------------------------------------------------------
Adverse performance/outcome............................. 75 75 20 20 0 9
Misconduct/gross/detrimental conduct.................... 88 88 40 60 57 63
Improper/excessive risk-taking.......................... 19 19 0 0 14 18
Managerial failure...................................... 6 6 0 0 0 0
Restatement/inaccurate reporting........................ 19 19 40 60 71 73
Voluntary resignation/retirement........................ 13 13 0 0 0 0
Misuse of confidential information/competitive activity. .............. .............. .............. .............. 29 0
Policy/regulatory breach................................ 6 6 0 0 0 0
For-cause termination................................... 6 6 0 20 14 0

[[Page 37773]]

Number of parent institutions with available 16 .............. 5 .............. 13 ..............
compensation data......................................
--------------------------------------------------------------------------------------------------------------------------------------------------------

The use of forfeiture and clawback triggers is similar for IA
parent institutions, as Table 9B shows. A significant number of Level 1
parent institutions use adverse performance and misconduct as triggers
for both clawback and forfeiture.

Table 9B--Triggers for Forfeiture and Clawback of Level 1 and Level 2 IA Parent Institutions
----------------------------------------------------------------------------------------------------------------
Level 1 parents Level 2 parents
---------------------------------------------------------------
Trigger Forfeiture: % Clawback: % of Forfeiture: % Clawback: % of
of firms firms of firms firms
----------------------------------------------------------------------------------------------------------------
Adverse performance/outcome..................... 80 80 33 33
Misconduct/gross/detrimental conduct............ 60 70 50 67
Improper/excessive risk-taking.................. 40 40 17 17
Managerial failure.............................. 0 0 0 17
Restatement/inaccurate reporting................ 10 30 33 50
Misuse of confidential information/competitive 10 10 33 17
activity.......................................
For-cause termination........................... 10 10 33 17
Number of parent institutions with available 10 .............. 6 ..............
compensation data..............................
----------------------------------------------------------------------------------------------------------------

Some of the provisions of the proposed rule (e.g., prohibition of
hedging) would apply to covered persons that are non-employee directors
who receive incentive-based compensation at Level 1 and Level 2 covered
institutions. Table 10A presents summary statistics on the current
compensation practices of Level 1, Level 2, and Level 3 parent public
institutions of BDs with respect to their non-employee directors. The
data shows that most of the Level 1 parent institutions and all of the
Level 2 parent institutions provide incentive-based compensation to
their non-employee directors, and this compensation comes mainly in the
form of deferred equity. Additionally, a large percentage of both Level
1 and Level 2 parents prohibit hedging by non-employee directors.

Table 10A--Incentive-Based Compensation of Non-Employee Directors of BD Parents
----------------------------------------------------------------------------------------------------------------
Level 1 parents Level 2 parents Level 3 parents
----------------------------------------------------------------------------------------------------------------
Percentage of institutions with 77%...................... 100%.................... 100%.
non-employee directors receiving
IBC.
Non-employee director IBC as 56%...................... 46%..................... 55%.
percentage of total compensation.
Type of IBC:
Deferred equity.............. 90%...................... 100%.................... 100%.
Options...................... 10%...................... 50%..................... 8%.
Vesting (average number of years) 2.6 years................ 2.3 years............... 1.9 years.
Percentage of institutions 70%...................... 100%.................... 25%.
prohibiting hedging by non-
employee directors.
----------------------------------------------------------------------------------------------------------------

The analysis of non-employee director compensation at the Level 1
and Level 2 parent institutions of IAs in Table 10B shows similar
results: In all of the parent institutions non-employee directors
receive incentive-based compensation and a significant fraction of
parent institutions prohibit hedging transactions related to incentive-
based compensation.

Table 10B--Incentive-Based Compensation of Non-Employee Directors of IA
Parents
------------------------------------------------------------------------
Level 1 Level 2
------------------------------------------------------------------------
Percentage of institutions 100%................ 100%.
with non-employee directors
receiving IBC.
Non-employee director IBC as 56%................. 46%.
percentage of total
compensation.
Type of IBC:
Deferred equity......... 90%................. 100%.
Options................. 0%.................. 17%.
Vesting (average number of 1.5 years........... 1.6 years.
years).
Percentage of institutions 78%................. 83%.
prohibiting hedging by non-
employee directors.
------------------------------------------------------------------------

[[Page 37774]]

ii. Executives Other Than Named Executive Officers
While the above statistics are based on publicly disclosed
information on compensation for the five most highly compensated
executive officers at parent institutions, the proposed rule would
apply to any executive officer, employee, director or principal
shareholder (covered persons) who receives incentive-based
compensation. Thus, the data presented above may not be representative
for non-NEOs. To provide some evidence on the current incentive-based
compensation arrangements of non-NEOs, the SEC uses anonymized
supervisory data from the Board. It should be noted that the
composition of the supervisory data sample could be different than that
of the Level 1 and Level 2 parent institutions analyzed above. To
alleviate this potential selection problem, Table 10 compares NEO and
non-NEO compensation arrangements only for the supervisory data sample.
Also, the supervisory data comes from banks, while the data above is
from bank holding companies. Because there may be differences in
incentive-based compensation arrangements and policies at the bank
level and the bank holding company level, the supervisory data analysis
could yield different results compared to the results presented in the
tables above.
Since the supervisory data does not identify NEOs and non-NEOs but
identifies the managerial position of each executive, the SEC uses an
indirect approach to separate the two groups of executives. From the
proxy statements of Level 1 and Level 2 parent institutions, the SEC
identifies the executives that are most often included in the
definition of NEOs, in addition to the CEO and the CFO. These
executives are the COO, the GC, and often the heads of wealth
management or investment banking. The SEC then classifies these
executives as NEOs and any other executive as non-NEO. Table 11
presents summary statistics for NEOs and non-NEOs based on the
supervisory data.
Similar to NEOs, non-NEOs tend to have a significant fraction of
long-term incentive compensation in the form of restricted stock units
(``RSUs'') and performance stock units (``PSUs'') that is deferred on
average for about three years. Only 36 percent of institutions in the
sample used cash as incentive-based compensation for non-NEOs and a
significant fraction (on average about 50 percent across institutions
that use cash as incentive-based compensation) of the cash incentive-
based compensation is deferred. Similarly, 45 percent of the deferred
incentive-based compensation for non-NEOs was in the form of restricted
stock and 54 percent was in the form of performance share units. Fifty
percent of the institutions in the sample used options as incentive-
based compensation for non-NEOs, with average vesting period of
approximately 3.7 years.

Table 11--Existing Compensation Arrangements for NEO and Non-NEO Executives
----------------------------------------------------------------------------------------------------------------
Non-NEOs NEOs
----------------------------------------------------------------------------------------------------------------
Number of institutions with 14...................................... 14.
available compensation data.
Number of executives........ 112..................................... 50.
ST IC/total IC.............. 41%..................................... 40%.
Deferred IC/total IC........ 60%..................................... 64%.
Options/total IC............ 12%..................................... 13%.
percent of institutions with 70%..................................... 70%.
options.
Deferred IC subject to 57%..................................... 61%.
clawback and forfeit/
deferred IC.
Types of IC compensation
used:
Cash:
percent of institutions 36%..................................... 36%.
using cash.
cash as percent of 48%..................................... 50%.
deferred IC.
length of vesting....... 3 years................................. 3 years.
type of vesting......... 40% immediate, 60% pro-rata............. 40% immediate, 60% pro-rata.
RSUs:
percent of institutions 64%..................................... 64%.
using RSUs.
RSU as percent of 45%..................................... 47%.
deferred IC.
length of vesting....... 3.2 years............................... 3.2 years.
type of vesting......... 11% immediate, 89% pro-rata............. 11% immediate, 89% pro-rata.
PSUs:
percent of institutions 64%..................................... 64%.
using PSUs.
PSU as percent of 54%..................................... 56%.
deferred IC.
performance period...... 3 years................................. 3 years.
length of vesting....... 3 years................................. 3 years.
type of vesting......... 78% immediate, 22% pro-rata............. 78% immediate, 22% pro-rata.
Options:
percent of institutions 50%..................................... 50%.
using options.
Options as percent of 18%..................................... 19%.
deferred IC.
length of vesting....... 3.7 years............................... 3.7 years.
type of vesting......... 100% pro-rata........................... 100% pro-rata.
----------------------------------------------------------------------------------------------------------------

iii. Significant Risk-Takers
The proposed rule requirements also would apply to significant
risk-takers who receive incentive-based compensation. Because data on
the compensation of significant risk-takers is not publicly available,
the SEC relies on bank supervisory data from the OCC to provide some
evidence on the current practices regarding significant risk-taker
compensation at covered institutions. In the OCC anonymized data, banks
identify material risk-takers and specific compensation arrangements
for them. The definition of a material risk-taker is similar, but not
identical, to that of a significant risk-taker in the proposed rule.
Based on supervisory data from three Level 2 covered institutions, it
seems that the incentive-based compensation of material risk-takers is
subject to deferral, clawback and forfeiture. The fraction of
incentive-based compensation that is subject to deferral depends on the
size of the compensation a material risk-taker

[[Page 37775]]

receives. As Table 12 suggests, the percentage deferred varies, with
some exceptions, from 40 percent to 60 percent. The average length of
the deferral period is three years.

Table 12--Deferral Policy for Material Risk-Takers at Three Level 2 Covered Institutions
----------------------------------------------------------------------------------------------------------------
Length of
Institutions Deferral percent Forfeiture/clawback deferral
(years)
----------------------------------------------------------------------------------------------------------------
Institution 1........................ 40%-60%...................... Yes....................... 3
Institution 2........................ 40%.......................... Yes....................... 3
Institution 3........................ 10%-40%, 40% if bonus Yes....................... 3
>$750,000.
----------------------------------------------------------------------------------------------------------------

Due to the lack of data, the SEC is unable to shed light on current
significant risk-taker compensation practices with respect to some of
the other proposed rule requirements such as the use of hedging or the
type of compensation that is being deferred (cash vs. stock vs.
options). In addition, the data is based on information from only three
Level 2 covered institutions. It is also worth noting that the OCC data
is at the bank subsidiary level, not the depository institution holding
company level. Thus, it is possible that the features of the
compensation of significant risk-takers at the bank subsidiary level
may not be representative of the compensation of significant risk-
takers at BDs and IAs.
iv. Covered Persons at Subsidiaries
Economic theory suggests that, in large, complex, and
interconnected financial institutions that are perceived to receive
implicit government guarantee, managers of these institutions could
have the incentive to take on more risk than they would have taken had
there been no implicit government backstops, thus creating negative
externalities for taxpayers. As discussed above, the proposed rule
could decrease the likelihood of such negative externalities. To the
extent that certain BDs and IAs pose high risk that may lead to
externalities, covered persons likely would therefore include those
individuals who, by virtue of receiving incentive-based compensation,
are in a position of placing significant risks.
Under the proposed rule, senior executive officers and significant
risk-takers of BDs and IAs that are covered institutions would be
considered covered persons. The proposed rule would require
consolidation of subsidiaries of BHCs that are themselves covered
institutions for the purpose of applying certain rule requirements and
prohibitions to covered persons. As a result of this proposed
consolidation, covered persons employed at BDs and IAs would be subject
to the same requirements as the covered persons of their parent
institutions, even though the BDs and IAs may be of a smaller size, and
hence otherwise treated at a lower level, than their parent
institutions. This proposed consolidation would significantly affect
unconsolidated Level 3 BDs because most of them are held by Level 1 and
Level 2 covered institutions, as well as Level 3 IAs that are held by
Level 1 and Level 2 covered institutions. The proposed consolidation
would also affect unconsolidated Level 2 BDs and IAs that are held by
Level 1 covered institutions because those BDs and IAs will also become
Level 1 covered institutions for the purposes of the rule.
As of December 2014, there were 29 unconsolidated Level 3 BDs whose
parent institutions are Level 1 and Level 2 institutions (Table 3);
only one of those parent institutions was not a covered institution as
defined by the rule. Additionally, there were 38 unconsolidated Level 3
BDs whose parents were private institutions; while it is possible that
some of these may be Level 1 or Level 2 institutions, the SEC lacks
data to determine their size. With respect to the proposed rule
requirements, the current compensation arrangements of NEOs of Level 3
parent institutions exhibit some important differences compared to
Level 1 and Level 2 parent institutions. For example, Level 3 parent
institutions typically defer a smaller fraction of NEOs' incentive-
based compensation (Table 7A), defer cash less frequently (Table 7A),
and tend to use more options as part of their incentive-based
compensation arrangements (Table 6A), compared to Level 1 and Level 2
parent institutions. On the other hand, Level 3 covered institutions,
like Level 1 and Level 2 covered institutions, tend to apply forfeiture
and clawback and prohibit hedging (Table 7A).
The proposed rule also would require consolidation with respect to
certain significant risk-takers. Under the proposed definition of
significant risk-taker, employees of a subsidiary that could put
substantial capital of the parent institution at risk would be deemed
significant risk-takers of the parent institution, and the proposed
rule requirements would apply to them in the same manner as the
significant risk-taker at their parent institutions. Because data on
the compensation of significant risk-takers is not publicly available,
the SEC relies on bank supervisory data from the OCC regarding the
current compensation practices for significant risk-takers at Level 3
financial institutions; the SEC does not have data on the compensation
arrangements at Level 1 and Level 2 institutions. Table 13 shows
summary statistics for the compensation arrangements of significant
risk-takers at Level 3 covered institutions. The compensation
arrangements of significant risk-takers of Level 3 covered institutions
seem similar to those of NEOs of Level 3 covered institutions. It is
also worth noting that the OCC data is at the bank subsidiary level,
not the depository institution holding company level. Thus, it is
possible that the features of the compensation of significant risk-
takers at the bank subsidiary level may not be representative of the
compensation of significant risk-takers at BDs and IAs.

Table 13--Existing Compensation Arrangements for Significant Risk-Takers
of Level 3 Covered Institutions
------------------------------------------------------------------------
Significant risk-takers
------------------------------------------------------------------------
Number of institutions with 5.
available compensation data.

[[Page 37776]]

ST IC/total IC............... 77%.
Deferred IC/total IC......... 23%.
Deferred IC subject to 89%.
clawback and forfeit/
deferred IC.
Types of IC compensation
used:
Cash:
percent of institutions 80%.
using cash.
cash as percent of 22%.
deferred IC.
length of vesting........ 0.33 years.
type of vesting.......... 100% pro-rata.
RSUs:
percent of institutions 100%.
using RSUs.
RSU as percent of 31%.
deferred IC.
length of vesting........ 3 years.
type of vesting.......... 40% immediate, 60% pro-rata.
PSUs:
percent of institutions 80%.
using PSUs.
PSU as percent of 12%.
deferred IC.
performance period....... 1.9 years.
length of vesting........ 3 years.
type of vesting.......... 80% immediate, 20% pro-rata.
Options:
percent of institutions 20%.
using options.
Options as percent of 25%.
deferred IC.
length of vesting........ NA.
type of vesting.......... NA.
------------------------------------------------------------------------

3. Regulatory Baseline
The existing regulatory environment, especially after the financial
crisis of 2007-2008, is also relevant to the current compensation
practices of covered institutions and the effects of the proposed
rulemaking. Several guidance and codes that specifically target
incentive-based compensation have been adopted by various financial
regulators that may also apply to some BDs and IAs. Some of those
prescribe compensation practices and suggest prohibitions that are
similar to the requirements and prohibitions in the proposed rules.
i. Guidance on Sound Incentive Compensation Policies
In June 2010, the U.S. Federal Banking Agencies \383\ adopted the
Guidance on Sound Incentive Compensation Policies.\384\ The guidance
applies to banking institutions and, because most of the parents of
Level 1 and Level 2 BDs are bank holding companies subject to the
guidance, its principles may apply to these BDs as well if the
compensation structures at subsidiaries are similar to those at the
parent institutions and the parent institution determines to implement
relatively uniform incentive-based compensation policies for the
consolidated institution. The guidance may also apply to the 39 IAs
that are affiliated with banks and thrift institutions with assets of
more than $50 billion.
---------------------------------------------------------------------------

\383\ The Federal Banking Agencies, as of 2010, were the Board,
OCC, FDIC, and Office of Thrift Supervision.
\384\ See, 2010 Federal Banking Agency Guidance, available at:
https://www.federalreserve.gov/newsevents/press/bcreg/20100621a.htm.
---------------------------------------------------------------------------

The guidance is designed to prevent incentive-based compensation
policies at banking institutions from encouraging imprudent risk-taking
and to aid in the development of incentive-based compensation policies
that are consistent with the safety and soundness of the institution.
It has three key principles providing that compensation arrangements at
a banking institution should: (a) Provide employees with incentives
that appropriately balance risk and reward; (b) be compatible with
effective risk management and controls; and (c) be supported by strong
corporate governance, including active and effective oversight by the
institution's board of directors. Similar to the proposed rules, this
guidance applies to senior executives and other employees who, either
individually or as a part of a group, have the ability to expose the
relevant banking institution to a material level of risk. The guidance
suggests several methods of balancing risk and rewards: Risk adjustment
of awards; deferral of payment; longer performance periods; and reduced
sensitivity to short-term performance.
ii. UK Prudential Regulatory Authority Remuneration Code
The SEC notes that for BDs and IAs whose parents are regulated by
foreign authorities, the foreign regulatory framework with respect to
incentive-based compensation may also be relevant for compliance with
the proposed rules.\385\ For example, in 2010, the UK PRA adopted four
remuneration codes that apply to banks and investment firms and share
important similarities with the proposed rules.\386\ For instance, the
SYSC 19A remuneration code imposes a deferral of at least 40 percent
for not less than 3-5 years. For higher earners, at least 60 percent
has to be deferred. The code applies to senior management, risk takers,
staff engaged in control functions, and any employee receiving
compensation that takes them into the same income bracket as senior
management and risk takers, whose professional activities have a
material impact on the firm's risk profile. The code also requires that
at least 50 percent of any bonus must be made in shares, share-linked
instruments or

[[Page 37777]]

other equivalent non-cash instruments of the firm. These shares should
be subject to an appropriate retention period. Firms also need to
disclose details of their remuneration policies at least annually.
---------------------------------------------------------------------------

\385\ For example, 3 Level 1 and Level 2 BDs have parent
institutions that are subject to the UK PRA rules.
\386\ There are four codes: SYSC 19A (covering Deposit Taker and
Investment firms), SYSC 19B (covering Alternative Investment Fund
Managers), SYSC 19C--BIPRU (covering Investment firms), and SYSC 19D
(covering Dual-regulated firms Remuneration Code). See https://www.the-fca.org.uk/remuneration.
---------------------------------------------------------------------------

In July 2014, the Prudential Regulation Authority (PRA) and
Financial Conduct Authority (FCA) published two joint consultation
papers ``aimed at improving individual responsibility and
accountability in the banking sector.'' \387\ The papers seek feedback
on proposed changes to the rules for remuneration for UK banks and PRA-
designated investment firms.\388\ The PRA and FCA's new proposed rules
follow recommendations made by the UK Parliamentary Commission on
Banking Standards, ``Changing Banking for Good,'' published in June
2013, and are a response to the major role played by banks in the
financial crisis in 2007-2008 and allegations of the attempted
manipulation of LIBOR. Their new proposed rules were deemed necessary
because the current rule on individual accountability is ``often
unclear or confused'' \389\ and thus undermines public trust in the
banking sector and the financial regulators. The PRA and FCA proposed
that banks defer bonuses for a minimum of 7 years for senior managers
and 5 years for other material risk-takers. Financial institutions
would be able to recover variable pay even if it was paid out or vested
for up to 7 years after the award date.
---------------------------------------------------------------------------

\387\ See ``Prudential Regulation Authority and Financial
Conduct Authority Consult on Proposals to Improve Responsibility and
Accountability in the Banking Sector,'' Press Release by the
Financial Conduct Authority, (July 30, 2014), available at: https://www.fca.org.uk/news/pra-and-fca-consult-on-proposals-to-improve-responsibility-and-accountability-in-the-banking-sector.
\388\ See ``Strengthening Accountability in Banking: A New
Regulatory Framework for Individuals,'' PRA CP14/13, Consultation
Paper, July 2014, available at: https://www.fca.org.uk/news/cp14-13-strengthening-accountability-in-banking. See also, ``Strengthening
the Alignment of Risk and Reward: New Remuneration Rules,'' PRA
CP14/14, Consultation Paper, July 2014, available at: https://www.fca.org.uk/news/cp14-14-strengthening-the-alignment-of-risk-and-reward.
\389\ See FSA Consultation Paper 14/13: Strengthening
accountability in banking: a new regulatory framework for
individuals (https://www.fca.org.uk/news/cp14-13-strengthening-accountability-in-banking).
---------------------------------------------------------------------------

D. Scope of the Proposed Rule
1. Levels of Covered Institutions
The proposed rule would create a tiered system of covered
institutions based on an institution's average total consolidated
assets during the most recent consecutive four quarters.\390\ There are
three levels of covered institutions: Level 1, Level 2, and Level 3
covered institutions. Some of the proposed rule requirements (e.g.,
deferral of compensation, forfeiture and clawback) would apply
differentially to covered institutions based on their size tier, with
more stringent restrictions on the incentive-based compensation
arrangements at larger institutions (i.e., Level 1 and Level 2 covered
institutions). In general, the importance of financial institutions in
the economy tends to be positively correlated with their size. This is
apparent from the use of implicit ``too-big-to-fail'' policies by
governments and central banks, providing support to large financial
institutions at times of financial crises because of their importance
to the greater financial system.\391\ In a similar vein, the 2010
Federal Banking Agency Guidance prescribes stricter compensation rules
and related risk-management and corporate governance practices for
large and more complex banking institutions.\392\
---------------------------------------------------------------------------

\390\ For IAs, the tiered system would be based on year end
balance sheet assets (excluding non-proprietary assets).
\391\ See, for example, Frederic Mishkin, Financial
Institutions.
\392\ Large banking institutions include, in the case of banking
institutions supervised by (i) The Board, large, complex banking
institutions as identified by the Board for supervisory purposes;
(ii) the OCC, the largest and most complex national banks as defined
in the Large Bank Supervision booklet of the Comptroller's Handbook;
(iii) the FDIC, large, complex insured depository institutions
(IDIs). See, 2010 Federal Banking Agency Guidance, available at:
https://www.federalreserve.gov/newsevents/press/bcreg/20100621a.htm.
---------------------------------------------------------------------------

There are various measures developed to estimate the amount of risk
\393\ posed by an institution to the greater financial system. One
study finds that the degree of leverage, maturity mismatch and the size
of the institution are all related to a measure of systemic importance
and risk.\394\ Another study finds that institution size, degree of
leverage and covariance of the institution's stock with the market
during distress are related to the systemic risk contribution of an
institution.\395\ Moreover, an academic study of the financial crisis
states that the size of an institution is likely to magnify the impact
of failure to the entire financial system.\396\ In terms of defining
systemic importance, bank holding companies with assets over $50
billion are required to disclose to the Board on an annual basis, three
indicators related to their systemic risk: Institution size,
interconnectedness and complexity.\397\
---------------------------------------------------------------------------

\393\ See Bisias et al. 2012. A Survey of Systemic Risk
Analytics. Office of Financial Research, Working Paper.
\394\ See Adrian, T., Brunnermier, M. 2011. COVAR. American
Economic Review, forthcoming. The paper proposes a measure for
systemic risk contribution by financial institutions. The forward-
looking measure of systemic risk contribution is significantly
related to lagged characteristics of financial institutions such as
size, leverage, and maturity mismatch.
\395\ See Brownlees, C., Engle, R. 2015. SRISK: A Conditional
Capital Shortfall Index for Systemic Risk Measurement. Working
Paper. The paper develops a measure of systemic risk contribution of
a financial firm. This measure associates systemic risk with the
capital shortfall a financial institution is expected to experience
conditional on a severe market decline. The measure is a function of
the firm's size, degree of leverage and the expected equity loss
conditional on a market downturn.
\396\ See French et al. 2010. Squam Lake Report: Fixing the
Financial System. Princeton University Press.
\397\ Size is correlated with the two other measures of systemic
importance, complexity and interconnectedness. See FSOC 2015 Annual
Report, available at: https://www.treasury.gov/initiatives/fsoc/studies-reports/Documents/2015%20FSOC%20Annual%20Report.pdf.
---------------------------------------------------------------------------

By setting stricter restrictions on the incentive-based
compensation arrangements at Level 1 and Level 2 covered institutions,
the tiered approach could benefit taxpayers. To the extent that
stricter incentive-based compensation rules are effective at curbing
inappropriate risk-taking, this could lessen the default likelihood for
Level 1 and Level 2 covered institutions, thus increasing the
likelihood that taxpayers would not have to incur costs to rescue
important institutions. Moreover, if the stricter incentive-based
compensation rules lower the likelihood of default for Level 1 and
Level 2 covered institutions, the likelihood of default for smaller
institutions could decrease as well, to the extent that smaller
institutions are exposed to counterparty risks due to their connection
with larger Level 1 and Level 2 covered institutions.
Consolidation requirements aside, the tiered approach also would
not impose as great a compliance burden on smaller Level 3 covered
institutions for which the proposed rule requirements on deferral,
forfeiture and clawback, and some other prohibitions and requirements
do not apply. To the extent that compliance costs have a fixed
component that may have a disproportionate impact on smaller
institutions, excluding Level 3 covered institutions from more
burdensome requirements would not place them at a competitive
disadvantage compared to Level 1 and Level 2 covered institutions.
Moreover, to the extent that executives' incentives become distorted
due to the implicit government guarantee, this is less likely to be the
case for Level 3 covered institutions due to their relatively smaller
size. Thus, the potential benefits of the proposed rule may be less
substantial for smaller covered institutions since such institutions
are less likely to be in a

[[Page 37778]]

position to take risks that may lead to externalities.
However, to the extent that the stricter proposed requirements for
incentive-based compensation arrangements at Level 1 and Level 2
covered institutions induce less than optimal risk-taking incentives
for covered persons from shareholders' point of view, this could result
in a decrease in firm value and hence lower returns for the
shareholders of these institutions. Additionally, the stricter
requirements for Level 1 and Level 2 covered institutions could make it
more difficult to attract and retain human capital, thus creating
competitive disadvantages in the labor market for these institutions.
If these institutions become disadvantaged due to their stricter
compensation requirements, they might be forced to increase overall
compensation to be able to compete for managerial talent with firms
that are not affected by the proposed rules.
As discussed above, besides an institution's average total
consolidated assets, other indicators (for example, the size of that
institution's open counterparty positions in a market) not perfectly
correlated with size could be a proxy for the importance of financial
institutions to the financial sector and the broader economy. If size
is not a good proxy for the importance of a financial institution, then
the proposed rule would likely pose a disproportionate compliance
burden on larger institutions while not covering institutions that may
be more significant to the overall financial system under different
proxies for importance.
The proposed thresholds for identifying Level 1 covered
institutions (over $250 billion) and Level 2 covered institutions
(between $50 billion and $250 billion) are similar to those used by
banking regulators in other contexts. For example, the $250 billion is
used by Basel III as a threshold to identify core banks that must adopt
the Basel standards; and the $50 billion threshold is used in a number
of sections of the Dodd-Frank Act.\398\ The use of these two thresholds
might place a higher compliance burden on institutions that, are close
to, but just above the threshold compared to institutions that are
close, but just below the threshold. For example, a BD that has a size
of $49 billion is likely to be similar in many aspects to a BD that has
a size of $51 billion. Yet, with the current cutoff points, the former
would not be subject to deferral, forfeiture and clawback, and other
prohibitions in the proposed rule, while the latter would be.
---------------------------------------------------------------------------

\398\ For example, sections 165 and 166 of the Dodd-Frank Act
require the Board to establish enhanced prudential standards for
nonbank financial companies supervised by the Board and bank holding
companies with total consolidated assets of $50 billion or more. In
prescribing more stringent prudential standards, the Board may, on
its own or pursuant to a recommendation by the Council in accordance
with section 115, differentiate among companies on an individual
basis or by category, taking into consideration their capital
structure, riskiness, complexity, financial activities (including
the financial activities of their subsidiaries), size, and any other
risk-related factors that the Board deems appropriate.
---------------------------------------------------------------------------

By covering various types of financial institutions (e.g., banks,
BDs, IAs, thrifts, etc.) with at least $1 billion in assets, section
956 and the proposed rule implicitly assume that larger institutions
pose higher risks, including risks that may impact the financial system
at large. This assumption may not hold true for certain institutions.
For example, in the case of BDs and IAs, which may have a much narrower
scope of activities than a comparably sized commercial bank, the
narrower range of activities could limit their impact on the overall
financial system. On the other hand, larger BDs and IAs may pose higher
risks than smaller BDs and IAs. Also, at least one study has suggested
that the interconnectedness of financial institutions generally could
affect multiple financial institutions in a crisis and impact otherwise
unrelated parts of the larger financial system.\399\ Another study
asserts that financial institutions, including broker-dealers, have
become highly interrelated and less liquid in the past decade, thus
increasing the level of risk in the financial sector.\400\
---------------------------------------------------------------------------

\399\ See, for example, Bisias D., M. Flood, A.W. Lo, and S.
Valavanis, 2012. A Survey of Systemic Risk Analytics. Office of
Financial Research, Working paper, available at: https://www.treasury.gov/initiatives/wsr/ofr/Documents/OFRwp0001_BisiasFloodLoValavanis_ASurveyOfSystemicRiskAnalytics.pdf.
On page 9, the authors argue that ``In a world of interconnected and
leveraged institutions, shocks can propagate rapidly throughout the
financial network, creating a self-reinforcing dynamic of forced
liquidations and downward pressure on prices.'' The study discusses
the interconnectedness between financial institutions in general and
does not focus on the potential role of BDs and IAs.
\400\ See Billio M., M. Getmansky, A.W. Lo, and L. Pelizzon.
2012. Econometric Measures of Connectedness and Systemic Risk in the
Finance and Insurance Sectors, Journal of Financial Economics, 104,
535-559. The study examines and finds evidence that banks, brokers,
hedge funds and insurance companies have become highly interrelated
during the last decade, thus increasing the level of systemic risk
in the financial sector. For example, insurance companies have had
little to do with hedge funds until recently when these companies
expanded into markets such as providing insurance for financial
products and credit default swaps. Such activities have potential
implications for systemic risk when conducted on a large scale.
---------------------------------------------------------------------------

2. Senior Executive Officers and Significant Risk-Takers
The requirements under the proposed rule would place differential
restrictions on compensation arrangements of covered persons. Within
each covered institution, the proposed rule would create different
categories of covered persons, which include any executive officer,
employee, director, or principal shareholder that receives incentive-
based compensation. While the proposed rule would apply to directors or
principal shareholders who receive incentive-based compensation, the
SEC's baseline analysis suggests that most of the parent institutions
provide incentive-based compensation to non-employee directors but none
of them provide such compensation arrangements to principal
shareholders that are neither executives nor non-employee directors.
Below, the SEC focuses the discussion of the economic effects of the
proposed rule on two types of covered persons: Senior executive
officers and significant risk-takers.
As discussed above, a senior executive officer is defined as a
covered person who holds the title or, without regard to title, salary,
or compensation, performs the function of one or more of the following
positions at a covered institution for any period of time in the
relevant performance period: President, executive chairman, CEO, CFO,
COO, chief investment officer, chief legal officer, chief lending
officer, chief risk officer, chief compliance officer, chief audit
executive, chief credit officer, chief accounting officer, or head of a
major business line or control function (as defined in the proposed
rule). A significant risk-taker is defined as a covered person, other
than a senior executive officer, who receives compensation of which at
least one-third is incentive-based compensation and is: Either (1)
placed among the highest 5 percent in annual base salary and incentive-
based compensation among all covered persons (excluding senior
executive officers) of a Level 1 covered institution or of any covered
institution affiliate, or (2) placed among the highest 2 percent in
annual base salary and incentive-based compensation among all covered
persons (excluding senior executive officers) of a covered Level 2
covered institution or of any covered institution affiliate, or (3) may
commit or expose 0.5 percent or more of the common equity tier 1
capital, or in the case of a registered securities broker or dealer,
0.5 percent or more of the tentative net capital, of the covered
institution or of any affiliate of the covered institution

[[Page 37779]]

that is itself a covered institution, or (4) is designated as a
significant risk-taker by the SEC or the covered institution.
The proposed rule would impose differential requirements on
compensation arrangements of senior executive officers and significant
risk-takers conditional on the size of the covered institution.
Regarding senior executive officers, at least 60 percent of a senior
executive officer's incentive-based compensation would be required to
be deferred at a Level 1 covered institution, whereas 50 percent would
be the minimum deferral amount for a senior executive officer at a
Level 2 covered institution. Regarding significant risk-takers, 50
percent of a significant-risk-taker's incentive-based compensation at a
Level 1 covered institution would be required to be deferred as
compared to 40 percent for a significant risk-taker's incentive-based
compensation at a Level 2 covered institution. Moreover, the minimum
deferral period for all covered persons at Level 1 covered institutions
would be four years for qualifying incentive-based compensation and two
years for incentive-based compensation received under long-term
incentive plans whereas the deferral period for covered persons at a
Level 2 covered institution would be three years for qualifying
incentive-based compensation and one year for compensation received
under long-term incentive plans.
In general, the proposed rule would impose relatively stricter
requirements for compensation arrangements of individuals who are more
likely to be in a position to execute or authorize actions with
accompanying risks that may have a significant impact on the financial
health of the covered institution or of any covered institution
affiliate. Specifically, the proposed rule would require a higher
percentage of incentive-based compensation to be deferred for senior
executive officers compared to significant risk-takers at covered
institutions. If senior executive officers are in a position to make
decisions that have a more significant impact on the degree of risk a
covered institution takes than significant risk-takers, then the higher
percentages of deferral amounts for senior executive officers appear to
be commensurate with the degree of inappropriate risk-taking in which
they could engage. This would likely provide proportionately stronger
disincentives for inappropriate risk-taking by individuals that are
more likely to be able to expose the covered institution to greater
amounts of risk, thus potentially benefiting taxpayers and other
stakeholders. In general, if certain significant risk-takers (e.g.,
traders with the ability to place significant bets that could endanger
the financial health of the covered institution or of any affiliate of
the covered institution) could engage in more or similarly significant
risk-taking than senior executive officers, the proposed rules would
place less stringent requirements on the compensation arrangements of
such significant risk-takers compared to senior executive officers,
lowering risk-taking disincentives for significant risk-takers and/or
imposing a potential higher cost to senior executive officers. However,
the proposed rules may also create an incentive for senior executive
officers to monitor significant risk-takers in those situations when
they do not directly supervise such significant risk-takers.
While the definition of senior executive officer would be primarily
based on job function, the definition of significant risk-taker would
be based on multiple criteria. To identify significant risk-takers, one
direct approach would require knowledge of their authority to expose
their institution to material amounts of risk. This risk-based approach
has intuitive appeal because it relates the application of the rules to
the potential for risk taking. Such an approach could, however, be
designed in many different ways, including differences relating to
determining the appropriate risk-based measure, whether it should be
applied to individuals or a group (e.g., a trader or a trading desk),
and whether it would be appropriate to subject all trading activity to
the same risk-based measure (e.g., U.S. treasury securities versus
collateralized mortgage obligations). One of the criteria in the
definition of significant risk-takers in the proposed rules is based on
individuals' relative size of annual base salary and incentive-based
compensation within a covered institution and its affiliates. If the
highest paid individuals at BDs and IAs are the ones that could place
BDs and IAs, or their parent institutions, at risk of insolvency, then
the use of this criterion is likely to reasonably identify individuals
that are significant risk-takers and as a result lower the likelihood
of inappropriate risks being undertaken and potentially safeguard the
health of these institutions and the broader economy. If, however, the
highest paid individuals at BDs and IAs are not likely to be able to
expose their parent institution to significant risks, this criterion
may be overly inclusive, resulting in individuals being designated as
significant risk-takers without possessing the ability to inflict
substantial losses on BDs or IAs, or their parent institutions. This
may impose restrictions on the compensation of those individuals and as
a consequence may put BDs and IAs at a disadvantage in hiring or
retaining human capital. BDs and IAs may have to increase the
compensation of affected individuals to offset the restrictions imposed
by the proposed rule.
For IAs that are covered institutions in another capacity and BDs,
the proposed rules would also identify significant risk-takers using a
measure of their ability to expose the covered institution to risks.
More specifically, a person that receives compensation of which at
least one-third is incentive-based compensation and may commit or
expose 0.5 percent or more of the common equity tier 1 capital, or in
the case of a registered securities broker or dealer, 0.5 percent or
more of the tentative net capital, of the covered institution or of any
affiliate of the covered institution would be a significant risk-taker.
As discussed above, the Agencies are proposing the exposure test
because individuals who have the authority to expose covered
institutions to significant amounts of risk can cause material
financial losses to covered institutions. For example, in proposing the
exposure test, the Agencies were cognizant of the significant losses
caused by actions of individuals, or a trading group, at some of the
largest financial institutions during and after the financial crisis
that began in 2007. In the case of a covered institution that is a
subsidiary of another covered institution and is smaller than its
parent, this particular criterion of the significant risk-taker
definition could result in individuals being classified as significant
risk-takers who do not have the ability to expose significant amounts
of the parent's capital to risk.
Additionally, under the proposed definition of significant risk-
taker, a covered person of a BD or IA subsidiary of a parent
institution that is a Level 1 or Level 2 covered institution may be
designated as a significant risk-taker relative to: (i) In the case of
a BD subsidiary, the size of the BD's tentative net capital or; (ii) in
the case of both BD and IA subsidiaries, the tentative net capital or
common equity tier 1 capital of any section 956 affiliate of the BD or
IA, if the covered person has the ability to commit capital of the
affiliate, even if the BD or IA subsidiary has significantly fewer
assets than its parent. Because the BD subsidiary would be treated as a
Level 1 or Level 2 covered institution due to its parent, a covered
person of a BD that is a

[[Page 37780]]

relatively smaller subsidiary would be subject to more stringent
compensation restrictions than would an employee of a comparably sized
BD that is not a subsidiary of a Level 1 or Level 2 covered
institution. As a consequence, if such a designated significant risk-
taker of a smaller BD subsidiary of a Level 1 or Level 2 covered
institution is not in a position to undertake actions that place the
entire institution at risk, then the proposed approach may impose
disproportionately stricter compensation restrictions on such covered
person.
An alternative would be to use an individual's level of
compensation as a proxy for his or her ability or authority to
undertake risks within a corporate structure. The main assumption under
this approach would be that there is a positive link between an
individual's total compensation and that individual's authority to
commit significant amounts of capital at risk at the covered
institution or any affiliate of the covered institution. A benefit of
the total compensation-based approach would be the implementation
simplicity in the identification of significant risk-takers. However,
the main challenge would be the determination of the total compensation
threshold that would appropriately qualify individuals as significant
risk-takers. On one hand, setting the total compensation threshold too
low could impose incentive-based compensation restrictions on
individuals that do not have authority to undertake significant risks.
As a result, it is possible that incentive-based compensation
requirements imposed on individuals that do not have significant risk-
taking authority could lead to a disadvantage in the efforts of the
institutions to attract and retain talent. On the other hand, setting
the total compensation threshold too high could impose incentive-based
compensation restrictions on an incomplete set of significant risk-
takers, limiting the potential benefits of the proposed rule.
3. Consolidation of Subsidiaries
The proposed rule would subject covered institution subsidiaries of
a depository institution holding company that is a Level 1 or Level 2
covered institution to the same requirements as the depository
institution holding company. In this manner, the proposed rule would
capture the effect that risk-taking within the subsidiaries of a
depository institution holding company could have on the parent, and
the negative externalities that could result for taxpayers.
For example, covered persons at a $10 billion BD subsidiary of a
depository institution holding company that is a Level 1 covered
institution would be treated as covered persons of a Level 1 covered
institution and subject to the proposed requirements and prohibitions
applicable to covered persons at a Level 1 covered institution. One
benefit of the proposed approach is the implementation simplicity of
the proposed rule since the parent institution's size would determine
the requirements for all covered persons in the covered institution's
corporate structure. Such an approach also has the advantage that it
may cover situations where the subsidiary could potentially expose the
consolidated institution to substantial risks. This could be the case
if for example the parent institution has provided capital to the
subsidiary and the subsidiary is large enough that its failure would
represent a significant loss for the parent institution. Moreover, such
an approach curbs the possibility that a covered institution might
place significant risk-takers in a smaller unregulated subsidiary, in
order to evade the compensation restrictions of the proposed rule for
individuals with authority to expose the institution to significant
amounts of risk.
There may also be costs associated with the proposed consolidation
approach. The main disadvantage of such approach is that it may impose
requirements and prohibitions on individuals employed in smaller
subsidiaries that are less likely to be in a position to expose the
institution to significant risks. Thus, the assumptions underlying the
rule's consolidation may not be accurate in all cases. The proposed
rules' treatment of subsidiaries would depend on their size and the
size of their parent, and also on the effect that risk-taking within
those subsidiaries could have on the potential failure of the parent
institution and the potential risk that such a failure could impose on
the overall financial system and the subsequent negative externality
that this could create for taxpayers. For example, if the parent
institution does not explicitly provide capital or implicitly guarantee
the subsidiary's positions, the proposed rules would impose similar
requirements on the incentive-based compensation of individuals with
different abilities to expose the institution to risk. Such
compensation requirements may impose costs on individuals in these
subsidiaries, and it might affect the ability of these subsidiaries to
compete for managerial talent with stand-alone companies of the same
size as the subsidiary. If that were the case, the subsidiaries of
larger parent institutions may have to provide additional pay to
individuals to compensate for the relatively stricter compensation
requirements and prohibitions. If these additional compensation
requirements are significantly costly, there may be incentives for
smaller subsidiaries to spin-off from their parents and operate as
stand-alone firms to avoid the stricter compensation requirements that
would be applicable based on the size of the parent institution.
Additionally, the costs of the proposed consolidation approach
would depend on how different the current incentive-based compensation
arrangements of a subsidiary are from those of its parent institution.
If the compensation arrangements of BDs' and IAs' covered persons are
similar to those of their parent institutions (e.g., they use similar
deferral percentages and terms, prohibit hedging, etc.), then the
proposed consolidation approach is not likely to lead to significant
compliance costs for BDs and IAs. The 2010 Federal Banking Agency
Guidance has significantly limited differences in compensation
arrangements between financial institutions and their subsidiaries. If,
however, the compensation arrangements at BDs and IAs more closely
resemble the compensation structures of financial institutions of
similar size, than the proposed rule's consolidation requirement may
lead to significant compliance costs. Unconsolidated Level 3 BDs and
IAs are most likely to be affected by this proposition. The parent
institutions of Level 3 BDs, to the extent that they are owned by one,
are mainly Level 1 and Level 2 covered institutions. Although the SEC
does not have data about the parent institutions of Level 3 IAs, the
SEC expects that they would also be mainly Level 1 and Level 2 covered
institutions. As shown above, compensation practices at Level 3 parent
institutions differ significantly from Level 1 and Level 2 parent
institutions on a number of dimensions: They defer a smaller fraction
of NEOs incentive-based compensation (Table 7A), defer cash less
frequently (Table 7A), and tend to use more options as part of their
incentive-based compensation (Table 6A) compared to Level 1 and Level 2
parent institutions. They also rather infrequently prohibit hedging
with respect to non-employee directors that receive incentive-based
compensation (Table 10A). If the compensation arrangements of
unconsolidated Level 3 BDs and IAs are similar to those of Level 3
parent institutions, under the proposed rule they would need to make
significant

[[Page 37781]]

changes to certain features of their compensation arrangements to be
compliant with the proposed rule. On the other hand, to the extent that
their current compensation practices are not optimal from the
perspective of taxpayers and other stakeholders of such BDs and IAs,
there may be potential benefits. This point holds for the remainder of
the economic analysis where the SEC discusses the potential costs and
benefits to unconsolidated Level 3 BDs and IAs of a larger covered
institution from applying the proposed rule requirements and
prohibitions.
An alternative to the proposed consolidation approach would be to
use the subsidiary's size to determine its status as a Level 1, Level
2, or Level 3 covered institution. For example, a $10 billion BD
subsidiary of a Level 1 depository institution holding company would be
treated as a Level 3 covered institution and covered persons within the
subsidiary would be subject to all requirements and prohibitions
applicable to a Level 3 covered institution. This alternative approach
would not entail the potential costs identified in the proposed
approach described above. However, differential application of the rule
depending on subsidiary size could provide covered institutions with an
incentive to re-organize their operations by placing significant risk-
takers into relatively smaller subsidiaries to bypass the proposed
requirements. This type of behavior, however, might be mitigated in
some circumstances by the proposed rule's prohibition on such indirect
actions: A covered institution must not indirectly, or through or by
any other person, do anything that would be unlawful for such covered
institution to do directly under this part. Moreover, this type of
behavior would be constrained by the fact that the SEC's capital
requirements for broker-dealers require that the broker-dealer itself
carry the necessary capital for all broker-dealer positions.\401\
Additionally, the rule's definition of a significant risk-taker would
treat any employee of the subsidiary with the ability to commit certain
amount of capital or to create risks for the parent institution as a
significant risk-taker of the parent, further limiting the ability of
institutions to bypass the proposed requirements by placing such
individuals into relatively smaller subsidiaries.
---------------------------------------------------------------------------

\401\ See 17 CFR 15c3-1(a).
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E. Potential Costs and Benefits of the Proposed Rule's Requirements and
Prohibitions
In the following sections, the SEC provides an analysis of the
potential costs and benefits associated with the proposed rule's
requirements and prohibitions and possible alternatives.\402\ For
purposes of this analysis, the SEC addresses the potential economic
effects for covered BDs and IAs resulting from the statutory mandate
and from the SEC's exercise of discretion together, recognizing that it
is often difficult to separate the costs and benefits arising from
these two sources. The SEC also requests comment on any economic effect
the proposed requirements may have on covered BDs and IAs. The SEC
appreciates comments that include both qualitative information and data
quantifying the costs and the benefits identified in the analysis or
alternative implementations of the proposed rule.
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\402\ Commenters on the 2011 Proposed Rule suggested more
expansive discussion and analysis of economic effects of the
proposed rulemaking on items such as the ability of covered
institutions to compete for talent acquisition and retention (See,
for example, letters by the U.S. Chamber and FSR), and also on the
effects of the rule on risk taking incentives and its consequences
for covered institutions' ability to compete (See, for example,
FSR). Below, the SEC's economic analysis outlines and discusses
potential economic effects of the various rule provisions, including
items identified in comment letters discussing economic
considerations.
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1. Limitations on Excessive Compensation
The proposed rule would prohibit covered institutions from
establishing or maintaining any type of incentive-based compensation
arrangement, or any feature of any such arrangement, that encourages
inappropriate risk-taking by providing a covered person with excessive
compensation, fees, or benefits or that could lead to material loss for
the institution.
The proposed rule would not define excessive compensation; instead,
it would use a principles-based approach that would provide covered
institutions with the flexibility to structure incentive-based
compensation arrangements that do not constitute excessive compensation
based on several factors that are outlined below. These factors would
include: The total size of a covered person's compensation; the
compensation history of the covered person and other individuals with
comparable expertise at the institution; the financial condition of the
covered institution; compensation practices at comparable institutions
based upon such factors as asset size, geographic location, and the
complexity of the covered institution's operations and assets; for
post-employment benefits, the projected total cost and benefit to the
covered institution; and any connection between the covered person and
any fraudulent act or omission, breach of trust or fiduciary duty, or
insider abuse with regard to the covered institution.
The flexibility that the proposed rule provides would likely
benefit covered institutions by allowing them to tailor the incentive-
based compensation arrangements to the skills and job requirements of
each covered person and to the nature of a particular institution's
business and the risks thereof instead of applying a ``one size fits
all'' approach. The differences in the size, complexity,
interconnectedness, and degree of competition in the market for
managerial talent among the institutions covered by the proposed rule
make excessive compensation difficult to define universally.
As mentioned above, a principles-based approach is likely to
provide greater discretion to covered institutions in tailoring
compensation arrangements that do not provide incentives for
inappropriate risk-taking. Such discretion may potentially allow for
differential interpretation among covered institutions on what
constitutes excessive compensation and as a consequence, differential
compensation arrangements even for similar institutions could be
designed. Given the flexibility inherent under a principles-based
approach, it is also possible that in fact some compensation contracts
to covered persons constitute excessive compensation that could lead to
inappropriate risk-taking, particularly if the compensation setting
process is not efficient or unbiased.\403\ It is also possible that
boards of directors may find it difficult to evaluate whether a
compensation arrangement creates excessive compensation that could lead
to inappropriate risk-taking. As such, it is likely that governance
mechanisms in place would be crucial for institutions to benefit from
the flexibility of the principles-based approach and avoid the
potential costs described above.
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\403\ For example, see Coles, J., Daniel, N., and Naveen, L. Co-
opted Boards. 2014. Review of Financial Studies 27, 1751-1796.
---------------------------------------------------------------------------

An alternative would be a more prescriptive approach in defining
compensation arrangements that constitute excessive compensation. For
example, an explicit definition of excessive compensation could be
provided for covered institutions. As mentioned above, such an approach
has

[[Page 37782]]

the disadvantage of restricting compensation arrangement options for
covered institutions and thus an increased likelihood that inefficient
compensation arrangements would be applied to at least some covered
institutions, given the significant differences among covered
institutions and covered persons.
2. Performance Measures
The proposed rule would require covered institutions to use a
variety of performance measures when determining the incentive-based
compensation of covered persons. Incentive-based compensation
arrangements would be required to include a mix of financial (i.e.,
accounting and stock-based) measures and non-financial measures, with
the ability for non-financial measures to override financial measures
when appropriate. Additionally, any amounts to be awarded under the
arrangement would be subject to adjustment to reflect actual losses,
inappropriate risks taken, compliance deficiencies, or other measures
or aspects of financial and non-financial performance.
There is evidence in the economic literature suggesting that non-
financial measures of performance are incremental predictors of long-
term financial performance relative to financial measures of
performance, and provide important information about executives'
performance.\404\ Moreover, non-financial measures of performance in
compensation arrangements may better capture progress or milestones of
strategic goals that may be unique to specific institutions.\405\ Thus,
the proposed requirement to use a mix of the two types of measures
would likely provide more relevant information to enable covered
institutions to set up incentive compensation arrangements for covered
persons. In addition, the flexibility that the proposed rule would
provide to covered institutions to adjust the compensation awards based
on various factors would allow covered institutions to tailor their
compensation arrangements to their specific circumstances.
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\404\ See, e.g., Banker, R., G. Potter, and D. Srinivasan, 1999.
An Empirical Investigation of an Incentive Plan that Includes
Nonfinancial Performance Measures. The Accounting Review 75, 65-92.
The study examines whether non-financial measures of performance,
specifically customer satisfaction, are incremental predictors of
future performance and whether inclusion of such measures of
performance in compensation contracts is efficient. The study finds
that customer satisfaction is incremental in predicting future
financial performance and inclusion of such performance measure in
compensation contracts leads to improved future performance.
\405\ See, e.g., Ittner, C., D. Larcker, and T. Randall, 2003.
Performance Implications of Strategic Performance Measurement in
Financial Services Firms. Accounting, Organizations and Society 28,
715-741. The study uses a sample of 140 U.S. financial services
firms to examine the relation between measurement system
satisfaction, economic performance, and two general approaches to
strategic performance measurement: Greater measurement diversity and
improved alignment with firm strategy and value drivers. The study
finds evidence that firms making more extensive use of a broad set
of financial and non-financial measures than firms with similar
strategies or value drivers have higher measurement system
satisfaction and stock market returns.
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The baseline analysis suggests that many of the public parent
institutions of some BDs and IAs already use a mix of financial and
non-financial measures in determining the incentive-based compensation
awards of senior executive officers. To the extent that BDs and IAs use
a similar mix of measures to determine the incentive-based compensation
awards of their senior executive officers, the SEC expects the costs of
compliance with this provision of the proposed rule to be relatively
low. If BDs and IAs do not use the same mixture of financial and non-
financial measures as their parents, or do not rely on non-financial
measures when determining the compensation of their senior executive
officers and significant risk-takers, the compliance costs associated
with this particular rule requirement may be significant. Such costs
may be in the form of additional expenditures related to hiring
compensation consultants and/or lawyers to design compensation schemes
and assure the compliance of newly designed compensation schemes with
the proposed rule.
The SEC has attempted to quantify such costs using data reported by
Level 1, Level 2, and Level 3 covered institutions that are parents of
BDs and IAs. Table 14 provides some summary statistics on the use of
compensation consultants and the fees paid to those over the period
2007-2014.\406\ Based on the results in the table, Level 1 and Level 2
covered institutions use on average two compensation consultants, while
Level 3 covered institutions use one compensation consultant on
average. If a Level 1 BD or IA has to hire compensation consultant(s)
to help them meet this rule requirement, it may incur costs of
approximately $185,515 per year. If an unconsolidated Level 2 BD or IA
has to hire compensation consultant(s) to help them meet this rule
requirement, it may incur costs of approximately $77,000 per year.\407\
If an unconsolidated Level 3 BD or IA, because of the consolidation
requirement, has to hire compensation consultant(s) to help meet this
rule requirement, it may incur costs of approximately $18,788 per year.
These costs could be higher if the compensation consultant is asked to
provide additional services other than compensation consulting
services. These costs could be lower, however, if the parent
institutions of BDs and IAs already employ compensation consultants and
could extend their services to meet the proposed rule requirements for
BDs and IAs.
---------------------------------------------------------------------------

\406\ Data used in the table comes from the ISS database.
\407\ We note that while we report the median consulting fee for
covered institutions in Table 14, the average compensation
consultant fees are higher. For example, for Level 1 covered
institutions the average consulting fee is $198,673, for Level 2
covered institutions the average consulting fee is $293,501, and for
Level 3 covered institutions the average consulting fee is $59,828.
The presence of outliers in the compensation consulting fee data and
the small sample size are the reason for the large difference
between average and median consulting fee.

Table 14--The Use and Costs of Compensation Consultants by Certain Level 1, Level 2, and Level 3 Covered
Institutions That Are Parents of BDs and IAs, 2007-2014
----------------------------------------------------------------------------------------------------------------
Median fees
Average for consulting
number of services to Number of
compensation the institutions
consultants compensation
used committee
----------------------------------------------------------------------------------------------------------------
Level 1......................................................... 2 185,515 7
Level 2......................................................... 2 77,000 9
Level 3......................................................... 1 18,788 6
----------------------------------------------------------------------------------------------------------------

[[Page 37783]]

3. Board of Directors
Additionally, the proposed rule would require that the board of
directors of covered institutions oversee a covered institution's
incentive-based compensation program, and approve incentive-based
compensation arrangements for senior executive officers or any material
exceptions or adjustments to incentive-based compensation policies or
arrangements.
Since overseeing and approving executive compensation arrangements
is one of the primary functions of the compensation committee of the
corporate board, the SEC believes that this rule requirement would not
impose significant compliance costs on covered institutions that
already have compensation committees. Moreover, because the baseline
analysis suggests that the majority of the parents of some covered
institutions already employ most of the requirements and limitations of
the proposed rule, it may not be particularly costly for boards of
directors or compensation committees to comply with the proposed rule.
However, there might be additional compliance costs for covered
institutions if the board of directors or the compensation committee
have to exert incremental effort (i.e., meet more frequently) in
designing and approving compensation arrangements. Additionally, if
because of the rule's definition of significant risk-takers the
compensation committee of a covered institution has to cover a much
larger number of employees and consider additional factors than it does
at present, this may increase compliance costs.
For covered BDs and IAs that do not have compensation committees,
the board of directors as a whole may be able to oversee and approve
executive compensation arrangements. Thus, for such BDs and IAs the
compliance costs of this rule requirement could result in more time
being spent for the board of directors on these issues, which might
entail higher directors' fees and possibly additional compensation
consulting costs.
4. Disclosure and Recordkeeping
The proposed rule would require all covered institutions to create
annually and maintain for a period of at least 7 years records that
document the structure of all its incentive-based compensation
arrangements and demonstrate compliance with the proposed rule. At a
minimum, these must include copies of all incentive-based compensation
plans, a record of who is subject to each plan, and a description of
how the incentive-based compensation program is compatible with
effective risk management and controls.
The SEC is proposing an amendment to Exchange Act Rule 17a-4(e)
\408\ and Investment Advisers Act Rule 204-2 \409\ to require that
registered broker-dealers maintain and investment advisers,
respectively, the records required by the proposed rule, in accordance
with the recordkeeping requirements of Exchange Act Rule 17a-4 and
Investment Advisers Act Rule 204-2, respectively. Exchange Rule 17a-4
and Investment Advisers Act Rule 204-2 establish the general formatting
and storage requirements for records that registered broker-dealers and
investment advisers, respectively, are required to keep. For the sake
of consistency with other broker-dealer and investment adviser records,
the SEC believes that registered broker-dealers and investment
advisers, respectively, should also keep the records required by the
proposed rule, in accordance with these requirements.
---------------------------------------------------------------------------

\408\ 17 CFR 240.17a-4(e).
\409\ 17 CFR 275.204-2.
---------------------------------------------------------------------------

The proposed recordkeeping requirement would assist covered BDs and
IAs in monitoring incentive-based compensation awards and payments and
comparing them with actual risk outcomes to determine whether
incentive-based compensation payments to senior executive officers and
significant risk-takers lead to inappropriate risk-taking. The proposed
recordkeeping requirement would also help BDs and IAs to modify the
incentive-based compensation arrangements of senior executive officers
and significant risk-takers, if, over time, incentive-based
compensation paid does not appropriately reflect risk outcomes. These
records would be available to SEC staff for examination, which may
enhance compliance and facilitate oversight.
This proposed requirement would likely impose compliance costs on
covered institutions. The SEC expects the magnitude of the compliance
costs to depend on whether broker-dealers and investment advisers
already have a system in place to generate information regarding their
compensation practices for internal use (e.g., for reports to the board
of directors or the compensation committee) or for required disclosures
under the Exchange Act (for reporting companies). To the extent that
such existing platforms can be expanded to produce the records required
under the proposed rule, the SEC expects this requirement to impose
lower compliance costs on these institutions. The compliance costs
associated with this particular proposed rule requirement would likely
be higher for covered institutions that may not be generating such
information, if for example they are not subject to related reporting
obligations, or may not keep the type and detail of records that would
be required under the proposed rule. Given that all Level 1 and
unconsolidated Level 2 BDs, and most unconsolidated Level 3 BDs and
IAs, are non-reporting companies, the SEC expects that the
recordkeeping costs associated with the rule may be substantial for
these BDs and IAs. The SEC notes, however, that because it does not
have information on the compensation reporting and recordkeeping at the
subsidiary level, the SEC may be overestimating compliance costs for
BDs and IAs with reporting parent institutions. For example, if the
parent institution reports and keeps records of the incentive-based
compensation arrangements at the subsidiary level, and on the same
scale and detail as required by the proposed rule, it is possible that
the compliance costs for such BDs could be lower than the compliance
costs for BDs with non-reporting parent institutions. Since the SEC
does not have data on how many covered IAs have parent institutions, it
is also possible that a significant number of these IAs may be stand-
alone companies and therefore could have higher costs to comply with
the proposed rule compared to covered IAs and BDs that are part of
reporting parent institutions.
According to the 2010 Federal Banking Agency Guidance, a banking
organization should provide an appropriate amount of information
concerning its incentive compensation arrangements for executive and
non-executive employees and related risk-management, control, and
governance processes to shareholders to allow them to monitor and,
where appropriate, take actions to restrain the potential for such
arrangements and processes to encourage employees to take imprudent
risks. Such disclosures should include information relevant to
employees other than senior executive officers. The scope and level of
the information disclosed by the institution should be tailored to the
nature and complexity of the institution and its incentive compensation
arrangements. Thus, private covered institutions that are banking
institutions and apply the policies of the 2010 Federal Banking Agency
Guidance may already be

[[Page 37784]]

collecting the information that would be required by the proposed rule.
The SEC expects the compliance costs to be lower for such covered
institutions, to the extent that there is an overlap between the
information collected under the 2010 Federal Banking Agency Guidance
and the information that would be required for disclosure and
recordkeeping under the proposed rule. The BDs and IAs that are stand-
alone non-reporting firms or have non-reporting parent institutions
that are not banking institutions would most likely be the ones to
incur higher compliance costs of disclosure and recordkeeping.
By requiring covered institutions to create and maintain records of
incentive-based compensation arrangements for covered persons at all
covered BDs and IAs, the proposed recordkeeping requirement is expected
to facilitate the SEC's ability to monitor incentive-based compensation
arrangements and could potentially strengthen incentives for covered
institutions to comply with the proposed rule. As a consequence, an
increase in investor confidence that covered institutions are less
likely to be incentivizing inappropriate actions through compensation
arrangements may occur and potentially result in greater market
participation and allocative efficiency, thereby potentially
facilitating capital formation. As discussed above, it is difficult for
the SEC to estimate compliance costs related to the specific provision.
However, for covered institutions that do not currently have a similar
reporting system in place, there could be significant fixed costs that
may disproportionately burden smaller covered BDs and IAs and hinder
competition. Overall, the SEC does not expect the effects of the
proposed recordkeeping requirements on efficiency, competition and
capital formation to be significant.
5. Reservation of Authority
Under the proposed rule, an Agency may require a Level 3 covered
institution with average total consolidated assets greater than or
equal to $10 billion and less than $50 billion to comply with some or
all of the provisions of Sec. Sec. 5 and 7 through 11of the proposed
rule applicable to Level 1 and Level 2 covered institutions if the
agency determines that such Level 3 covered institution's complexity of
operations or compensation practices are consistent with those of a
Level 1 or Level 2 covered institution.
This proposed rule requirement would allow the SEC to treat senior
executive officers and significant risk-takers at BDs and IAs that have
total consolidated assets below $50 billion as covered persons of a
Level 1 or Level 2 covered institution, because, for example, the
complexity of the BDs' and IAs' operations or risk profile could have a
significant impact on the overall financial system and could generate
negative spillover effects for taxpayers. As a result, the number of
BDs and IAs that would be subject to the portions of the proposed rule
applicable to Level 1 and Level 2 covered institutions may increase
relative to the estimates presented in the baseline.\410\
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\410\ As discussed above in the Baseline section, as of the end
of 2014, there were 33 BDs with total consolidated assets between
$10 and $50 billion. Due to the lack of data, the SEC cannot
determine the number of IAs with total consolidated assets between
$10 and $50 billion.
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The proposed requirement may increase compliance costs for these
BDs and IAs. As shown above, Level 3 parent institutions differ
significantly from Level 1 and Level 2 parent institutions on a number
of dimensions: They tend to defer a smaller fraction of NEOs incentive-
based compensation (Table 7A), tend to defer cash less frequently
(Table 7A), and tend to use more options as part of their incentive-
based compensation (Table 6A) compared to Level 1 and Level 2 parent
institutions. They also use rather infrequently the prohibition of
hedging with respect to non-employee directors that receive incentive-
based compensation (Table 9A). If the compensation arrangements of
Level 3 BDs and IAs are similar to those of Level 3 parent
institutions, then for Level 3 BDs and IAs that are designated as Level
1 or Level 2 covered BDs and IAs by an Agency, the proposed rule is
likely to require significant changes to certain features of their
compensation arrangements to be in compliance.
F. Potential Costs and Benefits of Additional Requirements and
Prohibitions for Level 1 and 2 Covered Institutions
1. Mandatory Deferral
The proposed rule would require a minimum amount of annual
incentive-based compensation to be deferred for a minimum number of
years for senior executive officers and significant risk-takers at
Level 1 and Level 2 covered institutions. For senior executive officers
and significant risk-takers at Level 1 and Level 2 BDs and IAs, such
requirement is expected to establish a minimum accountability horizon
with respect to the outcomes of actions of these individuals, including
the realization of longer-term risks that may be associated with such
actions.
As discussed above, from an economic standpoint, managerial actions
carry associated risks, and the horizon over which such risks unfold is
uncertain. If the risk realization horizon is longer than the
performance period used to measure and compensate the performance of
senior executive officers and significant risk-takers, they may have an
incentive to undertake projects that deliver strong short-term
performance at the potential expense of long-term value. A minimum
compensation deferral period aims to curb incentives for such undesired
behavior by increasing senior executive officers' and significant risk-
takers' accountability for the potential adverse outcomes of their
actions that may be realized in the long run, which in turn may
discourage short-termism and inappropriate risk-taking and as a
consequence lower the likelihood of default for the covered institution
and the potential risk such a default could pose to the greater
financial system.
As discussed above, the proposed minimum deferral periods required
by the proposed rule for Level 1 and Level 2 BDs and IAs covered
institutions would relate to the horizons over which the risks in these
institutions may be realized. The deferral periods are likely to
overlap with a traditional business cycle to identify outcomes
associated with a senior executive officer's or significant risk-
taker's performance and risk-taking activities. As noted, the business
cycle reflects periods of economic expansion or recession, which
typically underpin the performance of the financial sector. There might
be specific facts and circumstances (for example, the variety of assets
held, the changing nature of those assets over time, the normal
turnover in assets held by financial institutions, and the complexity
of the business models of BDs and IAs) that may affect the horizon over
which risks may be realized for particular covered institutions, so a
uniform deferral period may be more or less aligned with the horizon
over which a particular covered institution realizes certain risks.
With regard to the type of incentive-based compensation instruments
to be deferred, the rule proposes to require deferred compensation to
consist of substantial amounts of both cash and equity-linked
instruments. Whereas deferred equity-linked compensation would be
subject to both upside potential (for example, if the stock price of
the firm increases during the deferral period) and downside risk, the
cash component of deferred compensation

[[Page 37785]]

would be mainly subject to downside risk, thus resembling the payoff
structure of a debt security. More specifically, the cash component of
deferred compensation would not appreciate in value if firm performance
during the deferral period is positive, but would be subject to
downward adjustment, forfeiture, and clawback if, for example, the
executive has engaged in inappropriate risk-taking that results in poor
performance during the performance, deferral and post-deferral periods
respectively. This asymmetry in the payoff structure of the cash
component of deferred compensation is expected to provide incentives
for responsible risk-taking by covered persons thus lowering the
likelihood of default at these institutions as well as the
corresponding risk to the greater financial system posed by certain
large, complex, and interconnected institutions.\411\ Economic studies
suggest a negative relation between pre-crisis levels of managerial
debt holdings and measures of default risk during the crisis for bank
holding companies--bank holding companies whose executives held larger
debt holdings were less likely to default.\412\
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\411\ The academic literature provides evidence regarding the
effect of compensation instruments resembling a debtholder's payoff
and the effect of such compensation instruments on various aspects
of the agency costs of debt. For example, there is evidence of a
negative relation between levels of inside debt and the cost of
debt; see Anantharaman et al. 2013. Inside debt and the design of
corporate debt contracts. Management Science 60, 1260-1280. Also,
studies have documented a negative relation between inside debt and
restrictiveness of debt covenants and demand for accounting
conservatism, and a positive relation between CEO inside debt and
firm liquidation values; see Chen, F., Y. Dou, and X. Wang. 2010.
Executive Inside Debt Holdings and Creditors' Demand for Pricing and
Non-Pricing Protections. Working Paper. With respect to the
mechanism through which inside debt holdings lead to lower firm
risk, evidence suggests that such firms apply more conservative
investment as well as financing choices. Inside debt in particular
has been shown to be negatively related to future stock return
volatility, a market-based measure of risk; see Cassell, Cory A.,
Shawn X. Huang, Juan Manuel Sanchez, and Michael D. Stuart. 2012.
The relation between CEO inside debt holdings and the riskiness of
firm investment and financial policies. Journal of Financial
Economics 103, 588-610.
It must be noted that the academic literature proxies for such
debt-like compensation instruments mostly through pensions and other
forms of deferred compensation. Such instruments may not fully
resemble the characteristics of deferred cash under the rule,
particularly with respect to the horizon of deferral as well as the
vesting schedules (pro-rata vs. cliff-vesting).
\412\ See Bennett et al. (2015). Inside Debt, Bank Default Risk,
and Performance during the Crisis. Journal of Financial
Intermdiation 24, 487-513. The study examines the relation between
pre-crisis levels of inside equity vs. inside debt holdings by bank
holding company CEOs and risk and performance of these BHCs during
the crisis. The findings reveal a negative relation between pre-
crisis CEO inside debt holdings and default risk during the crisis,
and higher supervisory ratings for these BHCs before the crisis.
---------------------------------------------------------------------------

As mentioned above, the deferral requirements of the proposed rule
for senior executive officers and significant risk-takers at the
largest covered institutions are also consistent with international
standards on compensation. Having standards that are generally
consistent across jurisdictions would ensure that covered institutions
in the United States, compared to their non-U.S. peers, are on a level
playing field in the global competition for talent.
The mandatory deferral requirements of the proposed rule may impose
significant costs on affected BDs and IAs.\413\ As a consequence of the
mandatory deferral requirement, the wealth of covered persons would be
likely less diversified and more tied to prolonged periods of a covered
institution's performance. This potential deterioration of wealth
diversification may induce covered persons to demand an increase in pay
which could result in higher compensation-related costs for covered
institutions.\414\ This increase in compensation costs may be necessary
in order for covered institutions to be able to both attract and retain
human talent. The SEC notes, however, that there may be other factors
affecting the ability of a covered institution to attract and retain
human talent, such as the supply of talent and non-pecuniary benefits
of employment at covered institutions. These factors may exacerbate or
mitigate the potential increase in compensation costs. For example, if
senior executive officers and significant risk-takers value non-
pecuniary job benefits such as prestige, networking, and visibility,
these benefits may offset the costs associated with deterioration in
the diversification of their portfolios.
---------------------------------------------------------------------------

\413\ Several commenters raised accounting related issues with
respect to covered institutions' financial statements under the
proposed rule (see, e.g., KPMG, CEC) and tax related issues with
respect to individuals affected by the proposed rule (see, e.g.,
KPMG, MFA, SIFMA, CEC, PEGCC).
\414\ Three commenters argued that the proposed rule could
result in unintended consequences such as higher fixed compensation
or other benefits (See FSR, WLF, U.S. Chamber).
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As a result of the proposed compensation deferral requirement,
covered persons at BDs and IAs may be incentivized to curb
inappropriate risk-taking given the increased accountability over their
actions. There could be situations, however, where bonus deferral could
actually lead to an increase in risk-taking incentives.\415\ For
example, if firm performance during the deferral period significantly
declines and causes a significant loss in the value of deferred
compensation, senior executive officers and significant risk-takers
could potentially have an incentive to engage in high-risk actions in
an effort to recoup at least some of the value of their deferred
compensation.
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\415\ See Leisen, D. (2014). Does Bonus Deferral Reduce Risk
Taking? Working Paper. The paper develops a model comparing risk-
taking incentives from bonuses with and without deferral. The
results challenge the common belief that bonus deferral
unequivocally leads to reduced risk-taking incentives; under certain
conditions, deferral of bonus could lead to stronger risk-taking
incentives during the deferral period.
---------------------------------------------------------------------------

As discussed above, deferral of the cash component of compensation
resembles the payoff structure of debt and as a consequence may expose
managerial compensation to risk without a corresponding upside. Whereas
this may provide incentives to covered persons to avoid actions that
would expose a covered institution to higher likelihood of default and
for important institutions risks to the financial system, such
incentives may result in misalignment of interests between managers and
shareholders and potentially harm shareholder value. Several studies
suggest that managers with significant debt instruments in their
compensation arrangement tend to undertake a more conservative approach
in managing their firms.\416\ The significant use of debt in
compensation arrangements is viewed negatively by shareholders: Stock
prices of companies whose executives hold significant debt positions
experience a decrease upon disclosure of such compensation
arrangements.\417\ Thus, whereas the utilization of debt-like
instruments in compensation arrangements in important institutions may
lower the risk to the greater financial system, this may come at the
expense of shareholder value at these institutions. One commenter
suggested that the proposed rule could cause covered institutions to
perform in a less competitive way given lower incentives for risk-
taking.\418\
---------------------------------------------------------------------------

\416\ See Anantharaman, D., V.W. Fang, and G. Gong. 2014. Inside
Debt and the Design of Corporate Debt Contracts. Management Science
60, 1260-1280; Chen et al. (2010); and Cassell et al. (2012).
\417\ See Wei, C., and Yermack, D. (2011).
\418\ See FSR.
---------------------------------------------------------------------------

Alternatively, the Agencies could have proposed higher deferral
percentages and/or longer deferral horizons. Some commenters \419\
suggested more stringent deferral requirements, such as a longer
deferral

[[Page 37786]]

horizon,\420\ a higher percentage subject to deferral,\421\ and holding
the entire deferred amount back until the end of the deferral
period.\422\ For example, the Agencies could have selected a seven-year
deferral for senior executive officers and a five-year horizon deferral
horizon for significant risk-takers, similar to the rules that the
Prudential Regulation Authority has recently proposed in the UK. Such
long deferral periods may have allowed for longer-term risks to
materialize and thus be accounted for when calculating managerial
compensation. On the other hand, as mentioned above, longer deferral
periods could result in inappropriate risk-taking if firm performance
during the deferral period significantly declines and causes a
significant loss in the value of deferred compensation. Additionally, a
longer deferral period increases the probability that financial
performance is impacted by actions or factors that are not related to
covered persons' actions and as such result in an inefficient
compensation contract. Moreover, lengthening of the deferral period is
likely to lead to increased liquidity issues for covered persons since
their compensation cannot be cashed out on a timely basis to meet their
liquidity needs. Finally, it is also possible that further prolonging
of the deferral period could create incentives for institutions to
shift away from incentive-based compensation and increase the fixed
component of compensation. A potential consequence from such action may
be distortion of value-enhancing incentives that are generated through
incentive-based compensation. Another potential cost from deferral
requirements that are more strict could be that affected institutions
may not be able to compete and as a consequence lose talent to other
sectors that are not subject to the proposed rule.
---------------------------------------------------------------------------

\419\ It should be noted that comments were based on the 2011
Proposed Rule's 3-year deferral period (as opposed to the 4-year
deferral period currently proposed).
\420\ See AFR, Public Citizen, Chris Barnard, AFSCME, AFL-CIO,
Senator Brown.
\421\ See AFR, Public Citizen, AFSCME.
\422\ See AFR, Senator Brown, Public Citizen.
---------------------------------------------------------------------------

Another alternative could be shorter deferral periods (e.g.,
deferral period of less than four years for the qualifying incentive-
based compensation of senior executive officers at Level 1 covered
institutions; for example, 3 years as in the 2011 Proposed Rule) and/or
smaller deferral percentages (e.g., deferral of less than 60 percent of
qualifying incentive-based compensation for senior executive officers
at Level 1 covered institutions; for example, 50 percent as in the 2011
Proposed Rule). A shorter deferral period and/or smaller deferral
percentage amount, however, may not provide adequate incentives to
covered persons to engage in responsible risk-taking. On the other
hand, if the risk realization horizon is actually shorter than the
deferral horizon proposed in the rule, then using a shorter deferral
period would avoid exposing covered persons' wealth to risks that do
not result from their actions and would also impose lower liquidity
constraints on undiversified executives. From the baseline analysis of
current compensation practices, it appears that all of the Level 1
public parent institutions and most of the Level 2 public parent
institutions of BDs and IAs already have deferral policies in place
similar to the proposed rule requirements. Currently, about 50 percent
to 75 percent of incentive-based compensation is deferred for a period
of about three years, and the deferral includes NEOs, non-NEOs and
significant risk-takers.
If the compensation structure of BDs and IAs is similar to that of
their parent institutions, and the compensation structure of private
institutions is similar to that of public institutions, for the covered
BDs and IAs the implementation of the deferred aspect of the proposed
rule is unlikely to lead to significant compliance costs. The only
potentially significant compliance costs that such covered institutions
could incur with respect to the deferral requirement is related to the
deferral of cash compensation, which currently only 20 percent to 25
percent of Level 1 and Level 2 covered institutions defer, and the
prohibition on accelerated vesting, which very few of the Level 2
covered parent institutions currently use. On the other hand, if the
compensation practices of parent institutions are significantly
different than those at their subsidiaries, covered BDs and IAs could
experience significant compliance costs when implementing the proposed
deferral rule. Since the SEC does not have data on how many covered IAs
have parent institutions, it is also possible that a significant number
of these IAs may be stand-alone companies and therefore could have
higher costs to comply with the proposed rule compared to covered IAs
and BDs that are part of reporting parent institutions. As discussed
above, the SEC has data regarding the incentive-based compensation
arrangements at the depository institution holding company parents of
Level 1 and unconsolidated Level 2 and unconsolidated Level 3 BDs and
IAs because many of those bank holding companies are public reporting
companies under the Exchange Act. The SEC lacks information regarding
the compensation arrangements of BDs and IAs that are not so
affiliated, and hence the SEC cannot accurately assess the compliance
costs for those issuers. The same holds true if the incentive-based
compensation practices at BDs and IAs are generally different than
those at banking institutions, which most of their parent institutions
are. Lastly, because some BDs and IAs are subsidiaries of private
parent institutions, if there is a significant difference in the
compensation practices between public and private covered institutions
such private BDs and IAs could face larger compliance costs. To better
assess the effects of deferral on compliance costs for BDs and IAs the
SEC requests comments on these issues.
2. Options
For senior executive officers and significant risk-takers at Level
1 and Level 2 covered institutions, the proposed rule would limit the
amount of stock option-based compensation that can qualify for
mandatory deferral at 15 percent, effectively placing a cap on the use
of stock options as part of the incentive-based compensation
arrangements for senior executive officers and significant risk-takers
at Level 1 and Level 2 covered institutions.\423\ This implies that 45
percent of incentive-based compensation would have to be in some other
form to fulfill the 60 percent deferral amount for a senior executive
officer or significant risk-taker at a Level 1 and Level 2 covered
institution. As discussed in the Broad Economic Considerations section,
the payoff structure from stock options is asymmetric and thus
generates incentives for executives to undertake risks. For the
financial services industry in general, economic studies find that
higher levels of stock options in compensation arrangements of publicly
traded bank CEOs are positively related to multiple measures of risk,
such as equity volatility.\424\ Thus, limiting the

[[Page 37787]]

use of stock options in compensation arrangements could result, on
average, in lower risk-taking incentives for senior executive officers
and significant risk-takers at Level 1 and Level 2 covered
institutions. As previously noted, however, the link between stock
options and risk-taking is not indisputable. For example, a study that
examined the effect of a decrease in the provision of stock options in
compensation arrangements due to an unfavorable change in accounting
rules regarding option expensing, did not identify decreased risk-
taking by executives as a response to a decrease in stock options
awards.\425\
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\423\ If stock options awarded are not part of incentive-based
compensation, there is no limit to such awards.
\424\ See Mehran, H., Rosenberg, J. 2009. The Effect of CEO
Stock Options on Bank Investment Choice, Borrowing, and Capital.
Federal Reserve Bank of New York. The study finds a positive
relation between the use of stock options in bank CEO compensation
arrangements and risk-taking as evident by higher levels of equity
and asset volatility. The paper also finds that the increased risk
exposure in these banks comes from riskier project choices rather
than increased use of leverage.
See DeYoung, R., Peng, E., Yan, M. 2013. Executive Compensation
and Business Policy Choices at U.S. Commercial Banks. Journal of
Financial and Quantitative Analysis 48, 165-196.
See Chen, C., Steiner, T., Whyte, A. 2006. Does stock option-
based executive compensation induce risk-taking? An analysis of the
banking industry. Journal of Banking and Finance 30, 915-945. The
paper examines whether option-based compensation is related to
various measures of risk for a sample of commercial banks. Option-
based compensation is positively related to various market measures
of risk such as systematic and idiosyncratic risk. However,
causality cannot be inferred; risk also has an effect on the
structure of compensation arrangements.
\425\ See Hayes, R., Lemmon, M., Qiu, M., 2012. `Stock options
and managerial incentives for risk taking: Evidence from FAS 123R'.
Journal of Financial Economics 105, 174-190. This study examines the
effect of changes in option-based compensation, due to a change in
the accounting treatment of stock options in 2005, on risk-taking
behavior. Firms significantly reduce the use of stock options in
compensation arrangements as a response to the unfavorable treatment
of stock options in financial statements. However, the study finds
little evidence that the decline in option usage resulted in less
risky investment and financial policies.
---------------------------------------------------------------------------

The unique characteristics of the financial services sector
compared to the rest of the economy--significantly higher
leverage,\426\ interconnectedness with other institutions and markets,
and the possibility for negative externalities--may create a conflict
of interest between shareholders (managers) of important financial
institutions and taxpayers with respect to the optimal level of risk-
taking. In other words, shareholders may enjoy the upside of risk-
taking actions whereas taxpayers and other stakeholders have to bear
the costs associated with such risk-taking. While the literature does
not specifically reference BDs and IAs, but rather the financial
services sector more generally, the SEC believes that the global point
may be applicable to BDs and IAs given that these entities constitute a
segment of the financial services sector. In addition, many BDs and IAs
that would be covered by the proposed rule are subsidiaries of bank
holding companies and as such these studies may be relevant for them.
Thus, for BDs and IAs the use of options in compensation arrangements
could potentially amplify this conflict of interest as it provides
covered persons with an asymmetric payoff structure and an incentive to
undertake risks that may be optimal from shareholders' point of view
but may provide risk-taking incentives to management that could lead to
higher likelihood of default at these institutions and potentially
increase the risk to the greater financial system. Consequently,
capping the use of stock options and curbing covered persons'
incentives for inappropriate risk-taking at BDs and IAs could decrease
their likelihood of default, better align managers' incentives with
those of a broader group of stakeholders and limit potential negative
externalities generated by the default of particularly important
institutions.\427\ However, although BDs and IAs are financial
institutions, any generalization based on the findings in the
literature may not be very accurate because BDs and IAs also have some
differences with respect to other financial institutions. For example,
BDs and IAs differ from other financial institutions with respect to
business models, nature of the risks posed by the institutions, and the
nature and identity of the persons affected by those risks.
---------------------------------------------------------------------------

\426\ See Bolton, P., Mehran, H., Shapiro, J. 2011. Executive
Compensation and Risk Taking. Federal Reserve Bank of New York Staff
Reports, available at: https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr456.pdf. The report shows the
significant difference between the composition of financing for the
average non-financial firm (having about 40% of debt on its balance
sheet), as opposed to the average financial institution (having at
least 90% of debt on its balance sheet).
\427\ See French et al., 2010. The Squam Lake Report: Fixing the
Financial System. Journal of Applied Corporate Finance 22, 8-21; and
McCormack, J., Weiker, J. 2010. Rethinking `Strength of Incentives'
for Executives of Financial Institutions. Journal of Applied
Corporate Finance 22, 25-72.
---------------------------------------------------------------------------

To the extent that the asymmetric payoff structure of options
encourages covered persons at BDs and IAs to undertake risks that are
also suboptimal from a shareholders' point of view, the proposed rule's
limitation on the use of options as part of compensation arrangements
may also improve incentive alignment between executives and
shareholders. However, as discussed in the Broad Economic
Considerations section, executives may be reluctant to undertake value-
increasing but risky projects due to the undiversified nature of their
wealth and as such may engage in actions that lower firm value (i.e.,
forgo risky but value-increasing projects). For example, an economic
study found that low sensitivity of compensation to risk resulted in a
loss of firm value due to suboptimal risk-taking by executives in these
companies.\428\ Mechanisms that are put in place to curb such undesired
behavior by executives include incentive-based compensation components
whose value is generally increasing in risk, such as stock options.
Thus, risk-taking incentives induced by options may be valuable in
order to provide covered persons at BDs and IAs with incentives to take
risks that are desirable by shareholders. As a consequence, a potential
cost of the proposed limit to the use of stock options in incentive-
based compensation arrangements at covered institutions is the
potential for such limit to generate sub-optimally low risk-taking
incentives for the covered persons at BDs and IAs, potentially leading
to lower shareholder values for these institutions.
---------------------------------------------------------------------------

\428\ See Low, A., 2009. Managerial risk-taking behavior and
equity-based compensation. Journal of Financial Economics 92, 470-
490. The study examines changes in risk-taking by CEOs whose firms
have become more protected from a takeover due to a change in anti-
takeover laws. The study finds that CEOs with compensation
arrangements with a low sensitivity of compensation to volatility
decrease risk-taking following the adoption of the anti-takeover
law, and that such a decrease in risk-taking activity is value
destroying. The study also shows that as a response, firms increase
the sensitivity of CEO compensation to volatility to encourage risk-
taking following the adoption of the anti-takeover law.
---------------------------------------------------------------------------

Limiting the amount of stock option based compensation that can
qualify for mandatory deferral at 15 percent suggests that a covered
institution could theoretically award up to 55 percent of its annual
incentive-based compensation in the form of stock options (for senior
executive officers and significant risk-takers at Level 1 and Level 2
covered institutions). Based on the SEC's baseline analysis, it appears
that the use of options is increasingly infrequent in incentive-based
compensation arrangements at public parent institutions of BDs and IAs.
Stock options at Level 1 covered institutions represent about 4 percent
of total incentive-based compensation, while at Level 2 covered
institutions they represent about 20 percent.
If the compensation structure of BDs and IAs is similar to that of
their parent institutions, and the compensation structure of private
institutions is similar to that of public institutions, the specific
restriction imposed by the proposed rule would be unlikely to affect
the usage of options at Level 1 or unconsolidated Level 2 BDs and IAs
and would likely result in insignificant compliance costs. On the other
hand, if the compensation practices of parent institutions are
significantly different from those at their subsidiaries, covered BDs
and IAs could experience

[[Page 37788]]

significant compliance costs when implementing the specific requirement
of the proposed rule. Since the SEC does not have data on how many
covered IAs have parent institutions, it is also possible that a
significant number of these IAs may be stand-alone companies and
therefore could have higher costs to comply with this specific
requirement of the proposed rule compared to covered IAs and BDs that
are part of reporting parent institutions.
As discussed above, BDs and IAs could also incur direct economic
costs such as decrease in firm value if the proposed rule leads to
lower than optimal use of options in senior executive officers and
significant risk-takers incentive-based compensation arrangements. The
same holds true if the compensation of BDs and IAs is generally
different than that of banking institutions, which most of their parent
institutions are. Lastly, because some BDs and IAs are subsidiaries of
private parent institutions, if there is a significant difference in
the compensation practices of public and private covered institutions
such BDs and IAs could face large compliance costs and direct economic
costs. The SEC does not have data for the use of options at
subsidiaries of Level 1 or Level 2 parents, and thus cannot quantify
the impact of the proposed rule on those institutions. To better assess
the effects of options on compliance costs for BDs and IAs, the SEC
requests comments on the use of options in the compensation structures
of BDs and IAs below.
The Agencies could have selected as an alternative not to place a
limit on the use of stock options to meet the minimum required deferral
amount requirement for a performance period. Such an alternative would
provide covered persons at BDs and IAs with more incentives to
undertake risks compared to the alternative the SEC has chosen in the
proposed rule. Taxpayers would potentially be worse off under the
alternative since the combination of high leverage and government
guarantees, coupled with additional risk-taking incentives from stock
options could lead to inappropriate risk-taking from taxpayers' point
of view. Such an alternative likely would have led to a higher
probability of default at covered institutions. For important
institutions, such an alternative would also increase the likelihood of
risks at the institution also propagating to the greater financial
system. On the other hand, it is possible that shareholders would
potentially prefer increased risk-taking and as a consequence
compensation arrangements that encourage such behavior. From the SEC's
baseline analysis, provided that BDs and IAs have similar compensation
arrangements as their parents, the proposed rule should not
significantly affect existing compensation arrangements of covered
institutions.
3. Long-Term Incentive Plans
For senior executive officers and significant risk-takers at Level
1 and Level 2 covered institutions the proposed rule would require a
minimum deferral period and a minimum deferral percentage amount of
incentive-based compensation awarded through long-term incentive plans
(LTIPs), where LTIPs are characterized by having a performance
measurement period of at least three years. The proposed rule would
require deferral of 60 percent (50 percent) of LTIP awards for senior
executive officers of Level 1 (Level 2) covered institutions, and
deferral of 50 percent (40 percent) of LTIP awards for significant
risk-takers of Level 1 (Level 2) covered institutions. The deferral
period for deferred LTIPs must be at least two years for covered
persons of Level 1 covered institutions and at least one year for
covered persons of Level 2 covered institutions.
LTIPs are designed to reward long-term performance, performance
that is usually measured over the three-years following the beginning
of the performance period.\429\ Thus, these plans reward long-term
performance outcomes and as such generate incentives for long-term
value. LTIP awards can be in the form of cash or stock and these awards
occur at the end of the performance period. The amount of the award
depends on the degree to which the company meets some predetermined
performance milestones. These performance milestones can include a
variety of accounting-based performance measures, such as sales and
earnings, and research shows that the choice of performance measures is
related to company specific strategic goals.\430\ Requiring a minimum
percentage of LTIP awards to be deferred would lengthen the period over
which senior executive officers and significant risk-takers receive
compensation under these plans and subject such compensation to
downward adjustment during the performance measurement period (prior to
the award) as well as forfeiture and clawback during the deferral and
post-deferral periods respectively. Some studies have criticized LTIPs
for having short performance periods.\431\ The limited economic
literature on LTIPs currently does not provide a clear indication of
the effect of LTIPs on excessive risk-taking. The only study that
investigates the role of LTIPs \432\ suggests that companies that use
them experience improvement in operating performance and their NEOs do
not appear to take higher risks. Similar to the discussion on the
benefits and costs of mandatory deferral of other forms of incentive-
based compensation, deferral of the LTIP award could allow for long-
term risks taken by BD and IA senior executive officers and significant
risk-takers to materialize and thus for their compensation to be more
appropriately adjusted for the risks they have taken. LTIP deferral may
decrease risk-taking because covered persons may have an incentive to
manage the institution such that they receive their full compensation
under these plans. If the additional deferral of LTIPs lowers risk-
taking incentives at covered BDs and IAs to suboptimally low levels,
then firm value at these institutions could suffer as a consequence.
However, if the additional deferral of LTIPs mitigates incentives for
inappropriate risk-taking at covered BDs and IAs, then such outcome
would lower the likelihood of default at these institutions, better
align managers' incentives with those of a broader group of
stakeholders, and also lower the likelihood of negative externalities.
---------------------------------------------------------------------------

\429\ See Frederic W. Cook & Co., Inc. The 2014 Top 250 Report:
Long-term incentive grant practices for executives.
\430\ See Li and Wang (2014).
\431\ See The alignment gap between creating value, performance
measurement, and long-term incentive design, IRRCI research report,
2014.
\432\ See Li and Wang, 2014.
---------------------------------------------------------------------------

As an alternative, the Agencies could have selected a larger
fraction of LTIPs to be deferred (e.g., more than 60 percent for senior
executive officer at a Level 1 covered institution) and increased the
LTIPs' deferral period (e.g., for more than two years for senior
executive officers and significant risk-takers at Level 1 covered
institutions). A longer deferral period for LTIPs would prolong the
exposure of senior executive officers' and significant risk-takers'
compensation to adverse outcomes of their actions. If outcomes of some
inappropriate risks are only realized in the longer-term, then
prolonging the deferral period for LTIPs would provide incentives to
senior executive officers and significant risk-takers to avoid such
actions. On the other hand, such an alternative might have exposed
senior executive officers and significant risk-takers to outcomes of
actions that they are less likely to have been responsible for.
Additionally, long deferral period for LTIPs could create potential

[[Page 37789]]

liquidity issues for senior executive officers and significant risk-
takers since their compensation cannot be cashed out on a timely basis
to meet their liquidity needs.\433\ It is also possible that a long
deferral period for LTIPs would create incentives for institutions to
pay higher fixed pay and as a consequence distort the value-enhancing
incentives that are generated through variable pay.
---------------------------------------------------------------------------

\433\ Interest rates charged to covered persons on loans used to
cover their liquidity needs could proxy for the related cost stated
in the text. Such costs are likely to be determined by multiple
factors (for example, the macroeconomic environment) and vary over
time and by individuals making them difficult to quantify.
---------------------------------------------------------------------------

As another alternative, the Agencies could have decided to exclude
LTIPs from the amount of incentive-based compensation that is to be
deferred in a given year. Such an alternative could have excluded a
major part of covered persons' incentive-based compensation
arrangements from the deferred amount. LTIPs typically have a
performance period of three years, which is shorter than the deferral
period proposed in the rulemaking. Under this alternative, not
including LTIPs as part of the deferred amount may have limited the
ability of the proposed rule to curb inappropriate risk-taking.
However, if the current use of LTIPs by covered institutions is
consistent with generating optimal risk-taking incentives from the
perspective of certain shareholders, then not subjecting LTIPs to
mandatory deferral would maintain these value-enhancing incentives.
4. Downward Adjustment and Forfeiture
For senior executive officers and significant risk-takers at Level
1 and Level 2 covered institutions, the rule proposes placing at risk
of downward adjustment all incentive-based compensation amounts not yet
awarded for the current performance period and at risk of forfeiture
all deferred but not yet vested incentive-based compensation. As the
analysis in the baseline section suggests, the triggers for downward
adjustment and forfeiture consist of adverse outcomes such as poor
financial performance due to significant deviations from approved risk
parameters, inappropriate risk-taking (regardless of the impact on
financial performance), risk management or control failures, and non-
compliance with regulatory and supervisory standards resulting in
either legal action against the covered institution or a restatement to
correct a material error. The compensation of covered persons with
either direct accountability or failure of awareness of an undesirable
action would be subject to downward adjustment and/or forfeiture.
With regard to the determination of the compensation amount to be
downward adjusted or forfeited, the proposed rule would condition the
magnitude of the adjustment or forfeiture amounts on both the intent
and the participation of covered persons in the event(s) triggering the
review, as well as the magnitude of costs generated by the related
actions (including financial performance, fines and litigation and
related reputational damage). Compensation would be subject to downward
adjustment and forfeiture during the performance period and the
deferral period, respectively. As a consequence, this requirement would
provide incentives to senior executive officers and significant risk-
takers at BDs and IAs to avoid inappropriate risk-taking since they
could be penalized in situations where inappropriate risks had been
undertaken, regardless of whether such risks resulted in poor
performance.
The downward adjustment or forfeiture amounts is conditional on the
intent, responsibility and the magnitude of the financial loss caused
to the covered institution by inappropriate actions of covered persons.
In other words, the penalty imposed on the covered person would
increase with the intent, responsibility and the magnitude of financial
loss generated. This ``progressiveness'' characteristic in the proposed
rule requirement would imply that the covered person's incentive-based
compensation award would be increasingly at stake. Thus, covered
persons would be expected to have incentives to avoid excessive risk-
taking in order to secure at least part of incentive-based compensation
award.
Additionally, provided that senior executive officers and
significant risk-takers at BDs and IAs may be deemed accountable and
risk their compensation for inappropriate actions that were undertaken
by other executives or significant risk-takers, they may have an
incentive to establish an effective governance system that would
monitor risk exposure. Such an incentive and the corresponding actions
would strengthen risk oversight within the covered institution and
potentially lower the probability that any inappropriate action taken
might go undetected. To this point, a recent economic study indicates
that bank holding companies with strong risk controls, as proxied by
the presence of an independent and strong risk committee, were found to
be exposed to lower tail risk, lower amount of underperforming loans,
and had better operating and financial performance during the financial
crisis.\434\
---------------------------------------------------------------------------

\434\ See Ellul, A., Yerramilli, V. 2013. Stronger Risk
Controls, Lower Risk: Evidence from U.S. Bank Holding Companies.
Journal of Finance 68, 1757-1803.
---------------------------------------------------------------------------

On the other hand, the risk of downward adjustment and forfeiture
could increase uncertainty on covered persons' expectations for
receiving the compensation. A possibility exists that risks a covered
person believes ex-ante to be appropriate may be classified as ex-post
inappropriate and thus trigger downward adjustment or forfeiture of
related compensation. Such uncertainty about the interpretation of
appropriate risk-taking could generate incentives for managers to take
approaches with respect to risk-taking that are not optimal from the
perspective of shareholders. Such an avoidance of risks, if it occurs,
could lead to lower firm value and losses for shareholders.
Based on the SEC's baseline analysis of current compensation
practices, it appears that all of the Level 1 public parent
institutions and most of the Level 2 public parent institutions already
employ forfeiture with respect to deferred compensation. The forfeiture
rules are based on various triggers and apply to NEOs, non-NEOs and
significant risk-takers. Thus, if the compensation structure of BDs and
IAs is similar to that of their parent institutions, and the
compensation structure of private institutions is similar to that of
public institutions, the implementation of the proposed rule related to
forfeiture would be unlikely to lead to significant compliance costs.
On the other hand, if the compensation practices of parent institutions
are significantly different than those at their subsidiaries (e.g., BDs
and IAs do not use downward adjustment and forfeiture in their
compensation packages), covered BDs and IAs could experience
significant compliance costs when implementing this specific
requirement of the proposed rule. Since the SEC does not have data on
how many covered IAs have parent institutions, it is also possible that
a significant number of these IAs may be stand-alone companies and
therefore could have higher costs to comply with this specific
requirement of the proposed rule compared to covered IAs and BDs that
are part of reporting parent institutions. BDs and IAs could also incur
direct economic costs such as decrease in firm value if the proposed
rule requirements regarding downward adjustment or forfeiture lead to
less risk-taking than is optimal from shareholders' point of view. The
same

[[Page 37790]]

holds true if the compensation of BDs and IAs is generally different
than that of banking institutions, which most of their parent
institutions are.
Lastly, because some BDs and IAs are subsidiaries of private parent
institutions, if there is a significant difference in the compensation
practices of public and private covered institutions such BDs and IAs
could face large compliance costs and direct economic costs. The SEC
does not have data for the use of downward adjustment and forfeiture at
subsidiaries of Level 1 or Level 2 parents, and thus cannot quantify
the impact of the rule for those institutions. To better assess the
effects of downward adjustment and forfeiture on compliance costs for
BDs and IAs. The SEC requests comments below.
5. Clawback
For senior executive officers and significant risk-takers at Level
1 and Level 2 covered institutions, the proposed rule would require
clawback provisions in incentive-based compensation arrangements to
provide for the recovery of paid compensation for up to seven years
following the vesting date of such compensation. Such a clawback
requirement would be triggered when senior executive officers and
significant risk-takers are determined to have engaged in fraud,
intentional misrepresentation of information used to determine a
covered person's incentive-based compensation, or misconduct resulting
in significant financial or reputational harm to the covered
institution. Other existing provisions of law contain clawback
requirements that potentially have some overlap with those in the
proposed rulemaking. Thus, certain covered institutions may have
experience with recovering executive compensation via clawback. For
example, section 304 of the Sarbanes Oxley Act (``SOX'') contains a
recovery provision that is triggered when a restatement occurs as a
result of issuer misconduct. This provision applies only to the chief
executive officer (``CEO'') and chief financial officer (``CFO'') and
the amount of required recovery is limited to compensation received in
the year following the first improper filing.\435\ The Interim Final
Rules under section 111 of the Emergency Economic Stabilization Act of
2008 (``EESA'') required institutions receiving assistance under TARP
to mandate Senior Executive Officers to repay compensation if awards
based on statements of earnings, revenues, gains, or other criteria
that were later found to be materially inaccurate.\436\ Relative to
either SOX or EESA, the clawback requirement of the proposed rule is
more expansive in that its application is not only limited to CEOs and
CFOs but would cover any senior executive officer and significant risk-
taker in a Level 1 or Level 2 covered institution. In addition to the
broader scope of the clawback provision in the proposed rule regarding
covered persons, there is also a broader scope with respect to the
circumstances that would trigger clawback. More specifically, the
proposed rule includes misconduct that resulted in reputational or
financial harm to the covered institution as a trigger for clawback.
---------------------------------------------------------------------------

\435\ See 15 U.S.C. 7243.
\436\ Under EESA a ``Senior Executive Officer'' was defined as
an individual who is one of the top five highly paid executives
whose compensation was required to be disclosed pursuant to the
Securities Exchange Act of 1934. See Department of Treasury, TARP
Standards for Compensation and Corporate Governance; Interim Final
Rule (June 15, 2009), available at https://www.gpo.gov/fdsys/pkg/FR-2009-06-15/pdf/E9-13868.pdf.
---------------------------------------------------------------------------

The inclusion of the clawback provision in the incentive-based
compensation of senior executive officers and significant risk-takers
at BDs and IAs could increase the horizon of accountability with
respect to the identified actions that are likely to bring harm to the
covered institution. As a consequence of the clawback horizon, senior
executive officers and significant risk-takers are likely to have lower
incentives to engage in actions that may put the covered institution at
risk in the longer run. Moreover, the proposed rule may also increase
incentives to senior executive officers and significant risk-takers to
put in place stronger mechanisms such as governance in an effort to
protect their incentive-based compensation from events that may trigger
a clawback. Finally, in addition to lowering the incentives of senior
executive officers and significant risk-takers for undesirable actions
that may harm the covered institution, stakeholders of the covered
institution are also expected to benefit from the clawback provision
since in the event of an action triggering a clawback, any recovered
incentive-based compensation amount would accrue to the institution.
The fact that incentive-based compensation is to a large extent
determined by reported performance, coupled with the lowered incentives
for covered persons to intentionally misrepresent information, can lead
to improved financial reporting quality for covered institutions. Thus,
indirectly the potential to claw back incentive-based compensation that
is awarded on erroneous financial information could generate incentives
for high quality reporting. The literature finds that market penalties
for reporting failures, as captured by restatements of financial
reports, i.e., financial reports of (extremely) low quality, are non-
trivial and may translate into an increase in the cost of capital for
such firms.\437\ To the extent that the quality of financial reporting
increases as a result of the proposed rule, capital formation may be
fostered since the improved information environment may lead to a
decrease in the cost of raising capital for covered institutions.\438\
---------------------------------------------------------------------------

\437\ See Palmrose, Z., Richardson, V., Scholz, S. 2004.
Determinants of Market Reactions to Restatement Announcements.
Journal of Accounting and Economics 37, 59-89. This study observes
an average abnormal return of -9% over the 2-day restatement
announcement window for a sample of restatements announced over the
1995-1999 period.
See Hribar, P., Jenkins, N. 2004. The Effect of Accounting
Restatements on Earnings Revisions and the Estimated Cost of
Capital. Review of Accounting Studies 9, 337-356. This study
observes a significant increase in the cost of capital for firms
that restated their financial reports due to lower perceived
earnings quality and an increase in investors' required rate of
return.
\438\ See Francis, J., LaFond, R., Olsson, P., Schipper, K.
2005. The Market Pricing of Accruals Quality. Journal of Accounting
and Economics 39, 295-327. This study observes a negative relation
between measures of earnings quality and costs of debt and equity.
The study focuses on the accrual component of earnings to infer
earnings quality since this component of earnings involves more
discretion in its estimation and is more prone to be manipulated by
firms.
---------------------------------------------------------------------------

However, the relatively long clawback horizon may generate
uncertainty regarding incentive-based compensation of senior executive
officers and significant risk-takers. For example, that could be the
case if certain actions that trigger a clawback are outside of a
covered person's control. As a response to the potentially increased
uncertainty, senior executive officers and significant risk-takers may
demand higher levels of overall compensation, or substitution of
incentive-based compensation with other forms of compensation such as
salary. Such potential may distort incentives for risk-taking and as a
consequence lower shareholder value. Also, the increased allocation of
resources to the production of high-quality financial reporting may
divert resources from other activities that may be value enhancing.
Finally, covered persons may have a decreased incentive to pursue those
projects that would require more complex accounting judgments, perhaps
lowering shareholder value.\439\
---------------------------------------------------------------------------

\439\ For example, if an executive is under pressure to meet an
earnings target, rather than manage earnings through accounting
judgments, the executive may elect to reduce or defer to a future
period research and development or advertising expenses. This could
improve reported earnings in the short-term, but could result in a
suboptimal level of investment that adversely affects performance in
the long run. See Chan, L., Chen, K., Chen, T., Yu, Y. 2012. The
effects of firm-initiated clawback provisions on earnings quality
and auditor behavior. Journal of Accounting and Economics 54, 180-
196.

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[[Page 37791]]

Moreover, the potential compliance costs related with the
implementation of the clawback provision could be significant. For
example, covered institutions may have to rely on the work of outside
experts to estimate the amount of incentive-based compensation to be
clawed back following a clawback trigger.
Based on the SEC's baseline analysis, it appears that all of the
Level 1 covered institutions and most of the Level 2 covered
institutions already employ clawback policies with respect to deferred
compensation. The clawback policies are based on various triggers and
apply to NEOs, non-NEOs and significant risk-takers. Thus, if the BDs
and IAs have similar policies on clawback, and the compensation
structure of private institutions is similar to that of public
institutions, the implementation of the proposed clawback rule would
unlikely lead to significant compliance costs. On the other hand, if
the compensation practices of parent institutions are significantly
different than those at their subsidiaries (e.g., BDs and IAs do not
include clawback policies in their compensation packages), covered BDs
and IAs could experience significant compliance costs when implementing
the proposed rule. The same holds true if the compensation of BDs and
IAs is generally different than that of banking institutions, which
most of their parent institutions are. Additionally, since the SEC does
not have data on how many covered IAs have parent institutions, it is
also possible that a significant number of these IAs may be stand-alone
companies and therefore could have higher costs to comply with this
specific requirement of the proposed rule compared to covered IAs and
BDs that are part of reporting parent institutions.
The SEC has attempted to quantify such costs using data in Table
14. We note that these costs are not necessarily going to be in
addition to the compliance costs discussed above, as covered
institutions may hire a compensation consultant to help them with
several requirements in the proposed rules.
Lastly, because some BDs and IAs are subsidiaries of private parent
institutions, if there is a significant difference in the compensation
practices of public and private covered institutions such BDs and IAs
could face large compliance costs. The SEC does not have data for the
use of clawback at subsidiaries of Level 1 or Level 2 parents, and thus
cannot quantify the impact of the rule on those institutions. To better
assess the effects of clawback on compliance costs for BDs and IAs the
SEC requests detailed comments below.
6. Hedging
The proposed rule would prohibit the purchase of any instrument by
a Level 1 or Level 2 covered institution to hedge against any decrease
in the value of a covered person's incentive-based compensation. As
discussed above, introducing a minimum mandatory deferral period for
incentive-based compensation aims at increasing long-term managerial
accountability, including long-term risk implications associated with
covered persons' actions. Using instruments to hedge against decreases
in firm value would provide downside insurance to covered persons'
wealth, including equity holdings that are part of deferred
compensation. If the value of (deferred) incentive-based compensation
is protected from potential downside through a hedging transaction,
this is likely to increase the covered person's tolerance to risk.
Thus, the effect of compensation deferral would likely be
weakened.\440\ For BDs and IAs that currently initiate hedges on behalf
of their covered persons, a benefit from the prohibition on hedging is
that the incentives of covered persons to exert effort could be
strengthened given the same compensation contract. This in turn would
imply a stronger alignment between executives' and taxpayers' and other
stakeholders' interests for the same amount of performance-based pay.
---------------------------------------------------------------------------

\440\ See Bebchuk, L., Fried. J. Paying for long-term
performance. University of Pennsylvania Law Review 158, 1915-1959.
The paper argues that potential benefits from tying executive
compensation to long-term shareholder value are weakened when
executives are allowed to hedge against downside risk.
See also Gao, H. 2010. Optimal compensation contracts when
managers can hedge. Journal of Financial Economics 97, 218-238. This
study shows that the ability to hedge against potential downside
makes the executive more risk tolerant. In other words, holding the
compensation arrangement constant, hedging is predicted to weaken
the sensitivity of compensation to performance and also the
sensitivity of compensation to risk. However, the study also shows
that for executives who can engage in low-cost hedging transactions,
compensation contracts tend to provide higher sensitivity of
executive pay to both performance and volatility.
---------------------------------------------------------------------------

While the proposed rule intends to eliminate firm initiated
hedging, a personal hedging transaction by covered persons would still
be permitted (unless the institution prohibits such transactions from
occurring). Thus, a covered person at BDs and IAs could potentially
substitute the firm-initiated hedge with a personal hedging \441\
contract and restore any changes in incentives from the prohibition of
the firm-initiated hedge.
---------------------------------------------------------------------------

\441\ Refer to Tables 7a and 7b for statistics regarding the
complete prohibition of hedging by parent institutions of BDs and
IAs.
---------------------------------------------------------------------------

To the extent that the covered person's compensation contract is
not adjusted as a response to the elimination of the hedge, the covered
person would face stronger incentives to exert effort whereas her
tolerance for risk-taking would decrease with the prohibition on
hedging. Whether the resulting lower risk-taking tolerance is
beneficial for BDs and IAs is difficult to determine. On one hand, if
the covered persons' risk-taking incentives are at an optimal level
with the hedging transaction in place, then eliminating the hedge may
reduce their risk-taking incentives to levels that could be detrimental
for shareholder value. If this were the case, however, the
institution's compensation committees could adjust compensation
structures in a manner to achieve pre-prohibition risk-taking
incentives if the distortion from hedging prohibition is deemed to be
detrimental to firm value; however, some provisions of the proposed
rule could potentially constrain board of directors' flexibility to
make such adjustments.\442\ On the other hand, if covered persons had
incentives to undertake undesirable risks given the downside protection
provided by the hedge, then eliminating such protection could lead them
to engage in risk-taking which could lead to higher firm values.
---------------------------------------------------------------------------

\442\ For example, boards of directors or compensation
committees at covered BDs and IAs would be constrained from
increasing the risk-taking incentives of covered persons through the
additional provision of stock options, if banning hedging lowers
risk-taking incentives to a sub-optimal level.
---------------------------------------------------------------------------

Based on the SEC's baseline analysis, it appears that most Level 1
covered institutions (70 percent) and Level 2 covered institutions (60
percent) are already using prohibition on hedging with respect to
executive compensation of executives and significant risk-takers.
Additionally, 70 percent of Level 1 covered institutions and 100
percent of Level 2 covered institutions already prohibit hedging with
respect to executive compensation of non-employee directors. If BDs and
IAs have similar policies as their parent institutions, and the
compensation structure of private institutions is similar to that of
public institutions, the

[[Page 37792]]

implementation of the proposed rule in its part related to the
prohibition of hedging is unlikely to lead to significant compliance
costs. The cost of compliance with the proposed requirement of the rule
would mostly affect the few BDs and IAs whose parent institutions do
not currently implement such a prohibition. On the other hand, if the
compensation practices of parent institutions are significantly
different than those at their subsidiaries (e.g., BDs and IAs do not
prohibit hedging), covered BDs and IAs could experience significant
compliance costs when implementing the proposed rule. Since the SEC
does not have data on how many covered IAs have parent institutions, it
is also possible that a significant number of these IAs may be stand-
alone companies and therefore could have higher costs to comply with
this specific requirement of the proposed rule compared to covered IAs
and BDs that are part of reporting parent institutions. BDs and IAs
could also incur direct economic costs such as decrease in firm value
if the proposed prohibition on hedging leads to less risk-taking than
is optimal. The same holds true if the compensation of BDs and IAs is
generally different than that of banking institutions, which most of
their parent institutions are. If BDs and IAs do not prohibit hedging
and this provides incentives to their covered persons to undertake
undesirable risks because of the downside protection provided by the
hedge, then applying the rule provisions could lead to more appropriate
risk-taking.
Lastly, because some BDs and IAs are subsidiaries of private parent
institutions, if there is a significant difference between the
compensation practices of public and private covered institutions such
BDs and IAs could face large compliance costs and direct economic
costs. The SEC does not have data for a prohibition of hedging at
subsidiaries of Level 1 or Level 2 private parents, and thus cannot
quantify the impact of the rule on those institutions. To better assess
the effects of the prohibition on hedging on compliance costs for BDs
and IAs the SEC requests comments below.
As an alternative, some commenters suggested disclosure of hedging
transactions instead of prohibition.\443\ One commenter suggested
instead of prohibiting the use of hedging instruments to require full
disclosure of all outside transactions in financial markets by covered
persons, including hedging transactions, to the extent that these
transactions affect pay-performance sensitivity.\444\ This disclosure
should be made to the compensation committee of the board of directors
and the appropriate regulator, and the board of directors should attest
to the fact that these transactions do not distort proper risk-reward
balance in the compensation arrangement. According to the commenter,
sometimes covered persons may have legitimate purposes for engaging in
hedging transactions such as when they are exposed excessively to the
riskiness of the covered institution and need to rebalance their
personal portfolio. Such an alternative, however, might not prevent
covered persons from unwinding the effect of the mandatory deferral.
For example, it would not be easy to disentangle hedging transactions
that diminish individuals' exposure to the riskiness of the covered
institutions from transactions that reverse the effect of the deferral.
Additionally, the compensation committee might not have the expertise
to evaluate complex derivatives transactions.
---------------------------------------------------------------------------

\443\ See CFP, FSR, SIFMA.
\444\ See CFP.
---------------------------------------------------------------------------

7. Maximum Incentive-Based Compensation Opportunity
The proposed rule would prohibit Level 1 and Level 2 covered
institutions from awarding incentive-based compensation to senior
executive officers and significant risk-takers in excess of 125 percent
(for senior executive officers) or 150 percent (for significant risk-
takers) of the target amount for that incentive-based compensation.
Placing a cap on the amount by which the incentive-based compensation
award can exceed the target would essentially limit the upside pay
potential due to performance and a potential impact of such restriction
could be to lower risk-taking incentives by senior executive officers
and significant risk-takers. That could be the case because the cap on
incentive-based compensation implies that managers would not be
rewarded for performance once the cap is reached.
As discussed above, high levels of upside leverage could lead to
senior executive officers and significant risk-takers taking
inappropriate risks to maximize the potential for large amounts of
incentive-based compensation. Given the positive link between risk and
expected payoffs from managerial actions, a potential impact of such
restriction could be to lower risk-taking incentives by senior
executive officers and significant risk-takers. Whether such an effect
is beneficial or not for covered BDs and IAs firm value is likely to
depend on many factors including the level of the incentive-based
compensation targets set in compensation arrangements. If the proposed
cap excessively lowers appropriate risk-taking incentives, then firm
value could suffer. Moreover, another potential cost from the proposed
restriction is that effort inducing incentives may be diminished once
the cap is achieved, possibly misaligning the interests of shareholders
with those of managers. On the other hand, if the cap on incentive-
based compensation awards eliminates a range of payoffs that could only
be achieved by actions associated with taking suboptimally high risks,
then such a restriction would improve firm value.
As the baseline analysis shows, the maximum incentive-based
compensation opportunity for Level 1 parent institutions is on average
155 percent and that for Level 2 parent institutions is on average 190
percent. Both are significantly higher than would be permitted under
the proposed rule. If BDs and IAs have similar policies as their parent
institutions, and the compensation structure of private institutions is
similar to that of public institutions, the implementation of the
proposed rule in its part related to maximum incentive-based
compensation opportunity could lead to significant compliance costs.
The cost could result from changing the current practices and, as a
result, potentially having to compensate senior executive officers and
significant risk-takers for the decreased ability to earn compensation
in excess of the target amount. If the current compensation practices
with regard to maximum incentive-based compensation opportunity are
optimal, it is possible than affected BDs and IAs could experience loss
of human capital. On the other hand, as discussed above, if the cap on
incentive-based compensation awards eliminates a range of payoffs that
could only be achieved by actions associated with taking suboptimally
high risks, then such a restriction would improve firm value. Since the
SEC does not have data on how many covered IAs have parent
institutions, it is also possible that a significant number of these
IAs may be stand-alone companies and therefore could have higher costs
to comply with this specific requirement of the proposed rule compared
to covered IAs and BDs that are part of reporting parent institutions.
Additionally, because some BDs and IAs are subsidiaries of private
parent institutions, if there is a significant difference between the
compensation practices of public and private covered

[[Page 37793]]

institutions such BDs and IAs could face large compliance costs when
applying this rule requirement. The SEC does not have data on the use
of maximum incentive-based compensation opportunity at subsidiaries of
Level 1 or Level 2 private parents, and thus cannot quantify the impact
of the rule on those institutions. To better assess the effects of the
proposed limitations to the maximum incentive-based compensation
opportunity on compliance costs for BDs and IAs the SEC requests
comments below.
8. Acceleration of Payments
The proposed rule would prohibit the acceleration of payment of
deferred regulatory incentive-based compensation except in cases of
death or disability of covered persons at Level 1 and Level 2 covered
institutions. This would prevent covered institutions from undermining
the effect from the mandatory deferral of incentive-based compensation
by accelerating the deferred payments to covered persons. It could,
however, negatively affect covered persons that decide to leave the
institution in search for other employment opportunities. In such
cases, these covered persons might have to forgo a significant portion
of their compensation.
As the analysis in the Baseline section shows, most Level 1 parent
institutions (approximately 70 percent) already prohibit acceleration
of payments to their executives, while very few of the Level 2 parent
institutions do. The only exceptions are in cases of death or
disability. Given that current practices of BDs' and IAs' Level 1
parent institutions already apply most of the prohibitions required by
the proposed rule (except employment termination), if those BDs and IAs
have similar policies as their parent institutions, and the
compensation structure of private institutions is similar to that of
public institutions, the implementation of the proposed with respect to
the prohibition on the acceleration of payments is unlikely to lead to
significant compliance costs. The cost of compliance with the
requirement of the rule will mostly affect the BDs and IAs whose parent
institutions are Level 2 covered institutions or Level 1 covered
institutions that do not currently implement such a prohibition. On the
other hand, if the compensation practices of parent institutions are
significantly different than those at their subsidiaries (e.g., BDs and
IAs do not prohibit acceleration of payments), covered BDs and IAs
could experience significant compliance costs when implementing the
proposed rule. Additionally, since the SEC does not have data on how
many covered IAs have parent institutions, it is also possible that a
significant number of these IAs may be stand-alone companies and
therefore could have higher costs to comply with this specific
requirement of the proposed rule compared to covered IAs and BDs that
are part of reporting parent institutions.
Lastly, because some BDs and IAs are subsidiaries of private parent
institutions, if there is a significant difference in the compensation
practices of public and private covered institutions such BDs and IAs
could face large compliance costs when applying this rule requirement.
The SEC does not have data for the prohibition of acceleration of
payments at subsidiaries of Level 1 or Level 2 parents, and thus cannot
quantify the impact of the rule on those institutions. The SEC requests
comment on the effects of the prohibition on acceleration of payments
may have on compliance costs for BDs and IAs.
9. Relative Performance Measures
The proposed rule would prohibit the sole use of relative
performance measures in incentive-based compensation arrangements at
Level 1 and Level 2 covered institutions. Although relative performance
measures are widely used to filter out uncontrollable events that are
outside of management control and can reduce the efficiency of the
compensation arrangement, a peer group could be opportunistically
selected to justify compensation awards at a covered institution. To
the extent that covered persons may influence peer selection,
opportunism in choosing a performance benchmark may translate into
covered persons selectively choosing benchmark firms in order to
increase or justify increases in their compensation awards.
Evidence on whether such practices take place is mixed. For
example, one study examined the selection of peer firms used as
benchmarks in setting compensation for a wide range of firms and showed
that, on average, chosen peer firms provided higher levels of
compensation to their executives. The study asserts that managers tend
to choose higher paying firms as peers to justify increases in the
level of their own compensation.\445\ The same study also found that
the choice of highly paid peers is more prevalent when the CEO is also
the chair of the board of directors, re-enforcing the argument for
opportunism in peer selection. Another study found that executives
attempt to justify increases in their compensation by choosing
relatively larger firms as their peers since larger firms are likely to
offer higher compensation to their executives.\446\ However, the study
also showed that boards of directors exercise conservative discretion
in using information from benchmark firms when setting compensation
practices. Finally, a third related study \447\ suggests that firms
choose peers with (relatively) highly paid CEOs when their own CEO is
highly talented, a finding that is not consistent with opportunism
regarding the choice of peers in compensation setting. Overall,
empirical studies suggest that opportunism in the peer group selection
may exist, particularly in companies where the CEO may exert influence
over her compensation setting process. By restricting the sole use of
relative performance measures in compensation arrangements, the
proposed rule would curb the ability of covered persons to engage in
such opportunistic behavior, which would benefit covered BDs and IAs.
---------------------------------------------------------------------------

\445\ See Faulkender, M., Yang, J. 2010. Inside the black box:
The role and composition of compensation peer groups. Journal of
Financial Economics 96, 257-270. The study suggests that companies
appear to select highly paid peers as a benchmark for their CEO's
pay to justify higher CEO compensation. The study also suggests that
such an effect is stronger when governance is weaker: In companies
where the CEO is also the chairman of the board, has longer tenure,
and when directors are busier serving on multiple boards.
\446\ See Bizjak, J., Lemmon, M., Nguyen, T. 2011. Are all CEOs
above average? An empirical analysis of compensation peer groups and
pay design. Journal of Financial Economics 100, 538-555. The study
suggests that companies use compensation peer groups that are larger
or provide higher pay in order to inflate pay in their own company
and this practice is more prevalent for companies outside of the
S&P500. However, the study also shows that boards exercise
discretion in adjusting compensation due to the peer group effect;
pay increases only close about one-third of the gap between company
CEO and peer group CEO pay.
\447\ See Albuquerque, A., De Franco, G., Verdi, R. 2013. Peer
Choice in CEO Compensation. Journal of Financial Economics 108, 160-
181. The study examines whether companies that benchmark CEO pay
against highly paid peer CEOs is driven by incentives to increase
CEO pay. Whereas the study suggests that benchmarking pay against
highly paid peer CEOs is driven by opportunism, such practice mostly
represents increased compensation for CEO talent.
---------------------------------------------------------------------------

As mentioned above, the proposed rule would prohibit the sole use
of relative performance measures in determining compensation at covered
institutions. Constraining the use of relative performance measures in
incentive-based compensation contracts has potential costs. Absolute
firm performance is typically driven by multiple factors and not all of
these factors are under the covered persons' control. If incentive-
based compensation is tied to measures of absolute firm performance,
then at least

[[Page 37794]]

a part of incentive-based compensation will be tied to events out of
covered persons' control. This could generate uncertainty about
compensation outcomes for covered persons, reducing the efficiency of
the incentive-based compensation arrangement. Whereas the proposed rule
would not prohibit the use of relative performance measures, if the
proposed limitation regarding the use of performance measures in
determining compensation awards leads to less filtering out of the
uncontrollable risk component of performance, then covered institutions
may increase overall pay to compensate covered persons for bearing
uncontrollable risk.
The SEC's baseline analysis of current compensation practices
suggests that most Level 1 and Level 2 covered institutions use a mix
of absolute and relative performance measures. If BDs and IAs have
similar policies as their parent institutions, and the compensation
structure of private institutions is similar to that of public
institutions, the SEC does not expect this rule requirement to generate
significant compliance costs for covered institutions. The cost of
compliance with the proposed rule would mostly affect the few BDs and
IAs whose parent institutions do not currently implement such a
requirement. On the other hand, if the compensation practices of parent
institutions are significantly different than those at their
subsidiaries (e.g., they do not use absolute performance measures, or
use mostly absolute measures), covered BDs and IAs could experience
significant compliance costs when implementing the proposed rule. Since
the SEC does not have data on how many covered IAs have parent
institutions, it is also possible that a significant number of these
IAs may be stand-alone companies and therefore could have higher costs
to comply with this specific requirement of the proposed rule compared
to covered IAs and BDs that are part of reporting parent institutions.
The same holds true if the compensation of BDs and IAs is generally
different than that of banking institutions, which most of their parent
institutions are.
The SEC has attempted to quantify such costs based on the estimates
in Table 14. The SEC also notes that these costs are not necessarily
going to be in addition to the compliance costs discussed above, as
covered institutions may hire a compensation consultant to help them
with several requirements in the proposed rules. These costs could be
lower, however, if the parent institutions of BDs and IAs already
employ compensation consultants and could extend their services to meet
the proposed rule requirements for BDs and IAs. Lastly, because some
BDs and IAs are subsidiaries of private parent institutions, if there
is a significant difference in the compensation practices of public and
private covered institutions such BDs and IAs could face large
compliance costs. The SEC does not have data for the prohibition of the
sole use of relative performance measures at subsidiaries of Level 1 or
Level 2 parents, and thus cannot quantify the impact of the rule on
those institutions. To better assess the effects of this prohibition on
compliance costs for BDs and IAs. The SEC requests detailed comments
below.
10. Volume-Driven Incentive-Based Compensation
For covered persons at Level 1 and Level 2 covered institutions,
the proposed rule would prohibit incentive-based compensation
arrangements that are based solely on the volume of transactions being
generated without regard to transaction quality or compliance of the
covered person with sound risk management. Such a compensation contract
would provide incentives for employees to maximize the number of
transactions since that outcome would lead to maximizing their
compensation. A compensation contract that solely uses volume as the
performance indicator is likely to provide employees with incentives
for inappropriate risk-taking since employees benefit from one aspect
of performance but do not bear the negative consequences of their
actions--the associated costs and risks incurred to generate revenue/
volume. There is limited academic literature addressing the effect of
volume-driven compensation on employee incentives. A study examined the
behavior of loan officers at a major commercial bank when compensation
switched from a fixed salary structure to a performance-based structure
where the measure of performance was set as loan origination
volume.\448\ The study found a 31 percent increase in loan approvals,
holding other factors related to the probability of loan approvals
constant. The study also found that the 12-month probability of default
in originating loans increased by 27.9 percent. Whereas the study did
not conclude whether the bank was better or worse off due to the
introduction of the compensation scheme, the authors found that
interest rates charged to lower quality loans did not reflect the
increased riskiness of the borrowers. Another related study \449\ finds
that loan officers who are incentivized based on lending volume rather
than on the quality of their loan portfolio originate more loans of
lower average quality. The study also finds that due to the presence of
career concerns or reputational motivations, loan officers with lending
volume incentives do not indiscriminately approve all applications.
Whereas the study examines the effects of volume-driven compensation on
employees that are not likely to be covered by the proposed rule, it
confirms intuition that providing incentives for volume maximization
may lead to behaviors that do not necessarily maximize firm value.
---------------------------------------------------------------------------

\448\ See Agarwal, S., Ben-David, I. 2014. Do Loan Officers'
Incentives Lead to Lax Lending Standards? NBER Working Paper. This
study examines changes in lending practices in one of the largest
U.S. commercial banks when loan officers' compensation structure was
altered from fixed salary to volume-based pay. The study suggests
that following the change in the compensation structure, loan
origination became more aggressive as evident by higher origination
rates, larger loan sizes, and higher default rates. The study
estimates that 10% of the loans under the volume-based compensation
structure were likely to have negative net present value.
\449\ See Cole, S., Kanz, M., Klapper, L. 2015. Incentivizing
Calculated Risk-Taking: Evidence from an Experiment with Commercial
Bank Loan Officers. Journal of Finance 70, 537-575. The study
examines the effect of different incentive-based compensation
arrangements on loan originators behavior in screening and approving
loans in an Indian commercial bank. In general, the study finds that
the structure of incentive-based arrangements for loan officers
affects their decisions; the performance metric used in compensation
arrangements of loan officers as well as whether pay is deferred
affect loan officers screening and approval incentives and
corresponding decisions.
---------------------------------------------------------------------------

It is unclear to the SEC whether volume-driven incentive-based
compensation arrangements are utilized by IAs and BDs given the nature
of the business conducted by IAs and BDs. Assuming that these
incentive-based compensation arrangements are relevant to IAs and BDs,
restricting the sole use of volume-driven compensation practices may
curb incentives that reward employees of BDs and IAs on only partial
outcomes of their actions; partial in the sense that costs and risks
associated with those actions are not part of the performance
indicators used to determine their compensation. As a consequence, to
the extent that BDs and IAs contribute significantly to the overall
risk profile of their parent institutions, covered persons' incentives
would likely become aligned with the interests of stakeholders,
including taxpayers, since covered persons would bear both the benefits
and the costs from their actions. Likewise, the prohibition on the sole
use of volume-driven compensation practices is also likely to

[[Page 37795]]

limit covered persons' incentives for inappropriate risk-taking.
The effect of this proposed rule on BDs and IAs cannot be
unambiguously determined because of the lack of data on the current use
of volume-driven compensation practices. If BDs and IAs have already
instituted similar policies with respect to senior executive officers
and significant risk-takers, the SEC does not expect this rule
requirement to generate significant compliance costs for covered
institutions. On the other hand, if covered BDs and IAs' compensation
practices with respect to senior executive officers and significant
risk-takers rely exclusively on volume-driven transactions, covered BDs
and IAs could experience significant compliance costs when implementing
the proposed rule. To better assess the effects of this prohibition on
compliance costs for BDs and IAs the SEC requests comments below.
11. Risk Management
The proposed rule would include specific requirements with regard
to risk management functions to qualify a covered person's incentive-
based compensation arrangement at Level 1 and Level 2 covered
institutions as compatible with the rule. Specifically, the proposed
rule would require that a Level 1 or Level 2 covered institution have a
risk management framework for its incentive-based compensation
arrangement that is independent of any lines of business, includes an
independent compliance program that provides for internal controls,
testing, monitoring, and training, with written policies and procedures
consistent with the proposed rules, and is commensurate with the size
and complexity of a covered institution's operations. Moreover, the
proposed rule would require that covered persons engaged in control
functions be provided with the authority to influence the risk-taking
of the business areas they monitor and be compensated in accordance
with the achievement of performance objectives linked to their control
functions and independent of the performance of the business areas they
monitor. Finally, a Level 1 or Level 2 covered institution would be
required to provide independent monitoring of all incentive-based
compensation plans, events related to forfeiture and downward
adjustment and decisions of forfeiture and downward adjustment reviews,
and compliance of the incentive-based compensation program with the
covered institution's policies and procedures.
The proposed requirements may strengthen the risk management and
control functions of covered BDs and IAs, which could result in lower
levels of inappropriate risk-taking. Academic literature suggests that
stronger risk controls in bank holding companies resulted in lower risk
exposure, as evident by lower tail-risk and lower fraction of non-
performing loans; and better performance, as evident by better
operating performance and stock return performance, during the
crisis.\450\ This study also shows that the risk management function is
stronger for larger banks, banks with larger derivative trading
operations and banks whose CEOs compensation is more closely tied to
stock volatility. Additionally, the study shows that stronger risk
function, as measured by this study, was associated with better firm
performance only during crisis years, whereas the same relation did not
hold during non-crisis periods. As such, a strong and independent risk
management function can curtail tail risk exposures at banks and
potentially enhance value, particularly during crisis years. Another
study shows that lenders with a relatively powerful risk manager, as
measured by the level of the risk manager's compensation relative to
the top named executives' level of compensation, experienced lower loan
default rates. Thus, the evidence in the study seems to suggest that
powerful risk executives curb risk-taking with respect to loan
origination.\451\
---------------------------------------------------------------------------

\450\ See Ellul, A., Yerramilli, V. 2013. Stronger Risk
Controls, Lower Risk: Evidence from U.S. Bank Holding Companies.
Journal of Finance 68, 1757-1803.
\451\ See Keys, B., Mukherjee, T., Seru, A., Vig, Vikrant. 2009.
Financial regulation and securitization: Evidence from subprime
loans. Journal of Monetary Economics 56, 700-720.
---------------------------------------------------------------------------

It is also possible that the proposed requirements may not have an
effect on the current level of risk-taking at BDs and IAs. For example,
if risk-taking is driven by the culture of the institution, then
governance characteristics (including risk management functions) may
reflect the choice of control functions that match the inherent risk-
taking appetite in the institution.\452\ A potential downside of
applying a strict risk management control function over covered BDs and
IAs is that it could lead to decreased risk-taking and potential loss
of value for those BDs and IAs that already employ an optimal risk
management function. For such BDs and IAs, the implementation of the
rule requirements with respect to risk management could result in lower
than optimal risk-taking by covered persons.
---------------------------------------------------------------------------

\452\ See Cheng, I., Hong, H., Scheinkman, J. 2015. Yesterday's
Heroes: Compensation and Risk at Financial Firms. Journal of Finance
70, 839-879.
---------------------------------------------------------------------------

Based on the SEC's baseline analysis, it appears that all Level 1
parent institutions and most Level 2 parent institutions (67 percent)
of BDs already have an independent risk management and control function
(e.g., a risk committee) and compensation monitoring function (e.g., a
fully independent compensation committee) \453\ that could apply the
rule requirements. Similarly, all of the Level 1 and Level 2 parent
institutions of IAs have risk committees and substantial portion (80
percent and above) have fully independent compensation committees. The
SEC, however, does not have information on whether risk committees
review and monitor the incentive-based compensation plans. The SEC's
analysis suggests that there are some Level 1 covered institutions (30
percent) and Level 2 covered institutions (20 percent) where CROs
review compensation packages.
---------------------------------------------------------------------------

\453\ A risk committee is ``fully independent'' for purposes of
this discussion if it consists only of directors that are not
employees of the corporation.
---------------------------------------------------------------------------

If BDs and IAs have similar policies as their parent institutions,
and the risk management structure of private institutions is similar to
that of public institutions, the implementation of the proposed rule in
its part related to risk management and control is unlikely to lead to
significant compliance costs for the majority of covered BDs and IAs
because, as mentioned in the previous paragraph, a large percentage of
the parent institutions already have fully independent risk committees.
Some BDs with Level 2 parent institutions and some IAs with Level 1 and
Level 2 parent institutions may face high compliance costs because
their parent institutions currently do not employ risk management and
compensation monitoring practices similar to the one prescribed by the
proposed rule. On the other hand, if the risk management practices of
parent institutions are significantly different from those at their
subsidiaries (e.g., BDs and IAs do not have risk management and control
functions), covered BDs and IAs could experience significant compliance
costs when implementing the proposed rule. Since the SEC does not have
data on how many covered IAs have parent institutions, it is also
possible that a significant number of these IAs may be stand-alone
companies and therefore could have higher costs to comply with this
specific requirement of the proposed rule compared to covered IAs and
BDs that are part of reporting parent institutions. BDs and IAs could
also incur direct economic costs such as decrease in firm value if the
proposed

[[Page 37796]]

rule requirements regarding risk management lead to less risk-taking
than is optimal. The same holds true if the risk management and
controls of BDs and IAs is generally different than that of banking
institutions, which most of their parent institutions are.
Lastly, because some BDs and IAs are subsidiaries of private parent
institutions, if there is a significant difference in the risk
management practices of public and private covered institutions such
BDs and IAs could face large compliance costs and direct economic
costs. The SEC does not have data for the risk management and control
functions at subsidiaries of Level 1 or Level 2 parents, and thus
cannot quantify the impact of the rule on those institutions. To better
assess the effects of these rule requirements on compliance costs for
BDs and IAs the SEC requests comments below.
The SEC has attempted to quantify the potential compliance costs
for BDs and IAs associated with the proposed rule's requirements
regarding the existence and structure of compensation committees and
risk committees. BDs and IAs that are currently not in compliance with
the proposed committee requirements, either because such a committee
does not exist or because the composition of such committee is not
consistent with the rule requirements, may have to elect additional
individuals in order to either establish the required committees or
alter the structure of such committees to be in compliance with the
rule's requirements. Table 15 provides estimates of the average annual
total compensation of non-employee (i.e. independent) directors for
Level 1 and Level 2 parents of BDs and Level 1 and Level 2 parents of
IAs covered by the proposed rule.\454\ Assuming that the cost estimates
in the table approximate the compensation requirements for independent
members of compensation and/or risk committees, the incremental
compliance costs of electing an additional non-employee director to
comply with this specific provision of the rule for BDs and IAs that
currently do not meet the rule's requirements could be approximately
$333,086 and $309,513 annually per independent director for a Level 1
BDs and IAs, respectively, and approximately $208,009 and $194,563
annually per independent director for unconsolidated Level 2 BDs and
IAs, respectively.
---------------------------------------------------------------------------

\454\ Data is taken from 2015 proxy statements.

Table 15--Average Total Annual Compensation of a Non-Employee Director
for Level 1 and Level 2 Covered Institutions
------------------------------------------------------------------------
Average total
annual
compensation
of a non-
employee
director
------------------------------------------------------------------------
BD parents:
Level 1 covered institutions.......................... $333,086
Level 2 covered institutions.......................... 208,009
IA parents:
Level 1 covered institutions.......................... 309,513
Level 2 covered institutions.......................... 194,563
------------------------------------------------------------------------

The SEC considers these estimates an upper bound of potential costs
that BDs and IAs may incur to comply with these requirements of the
proposed rule. It is possible that some BDs and IAs are able to
reshuffle existing personnel in order to comply with the rule's
requirements (e.g., use existing directors to create a risk committee
or fully independent compensation committee) and as such would not
incur any of the costs described in the analysis.
12. Governance, Policies and Procedures
For Level 1 and Level 2 covered institutions, the proposed rule
would include specific corporate governance requirements to support the
design and implementation of compensation arrangements that provide
balanced risk-taking incentives to affected individuals. More
specifically, the proposed rule would require the existence of a
compensation committee composed solely of directors who are not senior
executive officers, input from the corresponding risk and audit
committees and risk management on the effectiveness of risk measures
and adjustments used to balance incentive-based compensation
arrangements, and a written assessment, submitted at least annually to
the compensation committee from the management of the covered
institution, regarding the effectiveness of the covered institution's
incentive-based compensation program and related compliance and control
processes and an independent written assessment of the effectiveness of
the covered institution's incentive-based compensation program and
related compliance and control processes in providing risk-taking
incentives that are consistent with the risk profile of the covered
institution, submitted on an annual or more frequent basis by the
internal audit or risk management function of the covered institution,
developed independently of the covered institution's management.
The proposed governance requirements would benefit covered BDs and
IAs by further ensuring that the design of compensation arrangements is
independent of the persons receiving compensation under these
arrangements, thus curbing potential conflicts of interest. It could
also facilitate the optimal design of compensation arrangements by
incorporating relevant information from committees whose mandate is
risk oversight. For example, by having a fully independent compensation
committee that designs compensation arrangements and a risk committee
that reviews those compensation arrangements to make sure they are
consistent with the institution's optimal risk policy, a BD or IA may
be able to devise compensation arrangements that provide a better link
between pay and performance for covered persons.
Based on the SEC's baseline analysis, it appears that the majority
of Level 1 and Level 2 covered parent institutions already have a fully
independent compensation committee. The SEC does not have information
whether BDs and IAs that are subsidiaries have compensation committees
and boards of directors. In 2012, the SEC adopted rules requiring
exchanges to adopt listing standards requiring a board compensation
committee that satisfies independence standards that are more stringent
than those in the proposed rule.\455\ Therefore, all covered parent
institutions with listed securities on national exchanges, or any
covered BDs and IAs with listed securities, should have compensation
committees that would satisfy the proposed rule's compensation
committee independence requirements. Thus, this proposed requirement
should place no additional burden on those IAs and BDs that have listed
securities on national exchanges, or have governance structures similar
to those of their listed parent institutions.
---------------------------------------------------------------------------

\455\ 17 CFR parts 229 and 240.
---------------------------------------------------------------------------

For those BDs and IAs that have compensation committees, the SEC
does not have information whether management of the covered BDs and IAs
submits to the compensation committee on an annual or more frequent
basis a written assessment of the effectiveness of the covered
institution's incentive-based compensation program and related
compliance and control processes in providing risk-taking incentives
that are consistent with the risk profile of the covered institution.

[[Page 37797]]

Additionally, the SEC does not have information on whether the
compensation committee obtains input from the covered institution's
risk and audit committees, or groups performing similar functions. If
covered BDs and IAs have already instituted similar policies with
respect to the proposed rule's governance requirements, the SEC does
not expect this proposed requirement to generate significant compliance
costs for them.
On the other hand, if covered BDs and IAs' governance practices are
significantly different (e.g., they do not have independent
compensation committees, or the compensation committees do not obtain
input from the risk and audit committees), then covered BDs and IAs
could experience significant compliance costs when implementing the
proposed rule. Similarly, for BDs and IAs that do not have securities
listed on a national exchange or have governance structures different
from those of their parent institutions with listed securities, this
rule proposal may result in significant costs. Also, since the SEC does
not have data on how many covered IAs have parent institutions, or
whether the IAs themselves or their parents have listed securities, it
is also possible that a significant number of these IAs may be stand-
alone companies that do not have independent compensation committees,
and therefore could have higher costs to comply with the proposed rule
compared to covered IAs and BDs that are part of reporting parent
institutions with independent compensation committees. To better assess
the effects of the proposed rule requirement on compliance costs for
BDs and IAs, the SEC requests comments below.
For Level 1 and Level 2 covered BDs and IAs, the proposed rule
would require the development and implementation of policies and
procedures relating to its incentive-based compensation programs that
would require among other things, specifying the substantive and
procedural criteria for the application of the various policies such as
forfeiture and clawback, identifying and describing the role of
employees, committees, or groups with authority to make incentive-based
compensation decisions, and description of the monitoring mechanism
over incentive-based compensation arrangements.
The SEC does not have information about whether covered BDs and IAs
have policies and procedures in place as required by the proposed rule.
If BDs and IAs have already instituted similar policies, the SEC does
not expect this rule requirement to generate significant compliance
costs for them. On the other hand, if the covered BDs and IAs do not
have such policies and procedures, or if their policies and procedures
are significantly different than what the proposed rule requires, then
covered BDs and IAs could experience significant compliance costs when
implementing the proposed rule. To better assess the effects of these
rule requirements on compliance costs for BDs and IAs the SEC requests
comments below.
13. Additional Disclosure and Recordkeeping
All covered institutions would be required to create annually and
maintain for a period of at least 7 years records that document the
structure of all incentive-based compensation arrangements and
demonstrate compliance with the proposed rules. Level 1 and Level 2
covered institutions would be required to create annually and maintain
for at least 7 years records that document additional information, such
as identification of the senior executive officers and significant
risk-takers within the covered institution, the incentive-based
compensation arrangements of these individuals including deferral
details, and any material changes in incentive-based compensation
arrangements and policies. Level 1 and Level 2 covered institutions
must create and maintain such records in a manner that allows for an
independent audit of incentive-based compensation arrangements,
policies, and procedures.
The SEC is proposing an amendment to Exchange Act Rule 17a-4(e)
\456\ and Investment Advisers Act Rule 204-2 \457\ to require that
registered broker-dealers and investment advisers maintain the records
required by the proposed rule for registered Level 1 and Level 2
broker-dealers and investment advisers, in accordance with the
recordkeeping requirements of Exchange Act Rule 17a-4 and Investment
Advisers Act Rule 204-2, respectively. Exchange Act Rule 17a-4 and
Investment Advisers Act Rule 204-2 establish the general formatting and
storage requirements for records that registered broker-dealers and
investment advisers are required to keep. For the sake of consistency
with other broker-dealer and investment adviser records, the SEC
believes that registered broker-dealers and investment advisers should
also keep the records required by the proposed rule for registered
Level 1 and Level 2 broker-dealers and investment advisers, in
accordance with these requirements.
---------------------------------------------------------------------------

\456\ 17 CFR 240.17a-4(e).
\457\ 17 CFR 275.204-2.
---------------------------------------------------------------------------

Such recordkeeping requirements would provide information
availability to the SEC in examining and confirming the design and
implementation of compensation arrangements for a prolonged period of
time. This may enhance compliance and facilitate oversight.
The proposed requirement may increase compliance costs for covered
BDs and IAs. The SEC expects that the magnitude of the compliance costs
would depend on whether covered BDs and IAs are part of reporting
companies or not. Most Level 1 and Level 2 BDs are subsidiaries of
reporting parent institutions. Reporting covered institutions provide
compensation and disclosure analysis and compensation tables for their
named executive officers in their annual reports, and disclose the
incentive-based compensation arrangements for named executive officers
in the annual proxy statement. In addition, reporting companies have to
make an assessment each year whether they need to make Item 402(s)
disclosure, which, among other things includes disclosure of
compensation policies and practices that present material risks to the
company and the board of directors' role in risk oversight. Thus, given
that reporting covered institutions create certain records and provide
certain disclosures for their annual reports and proxy statements and
for internal purposes (e.g., for reports to the board of directors or
the compensation committee) that are similar to those required by the
proposed rule, the BDs and IAs that are subsidiaries of such parent
institutions may experience lower disclosure and recordkeeping compared
to BDs and IAs of non-reporting parent institutions or institutions
that do not provide such disclosures. Even BDs and IAs of reporting
companies, however, would have to incur costs associated with
disclosure and recordkeeping of information required by the proposed
rule that currently is not disclosed by their parent institutions, such
as identification of significant risk-takers details on deferral of
incentive-based compensation. The SEC also notes that because it does
not have information on the compensation reporting and recordkeeping at
the subsidiary level, the SEC may be underestimating compliance costs
for BDs with reporting parent institutions. For example, even if the
parent institution reports and keeps records of the incentive-based
compensation arrangements, this might not be done on the same scale and
detail at the subsidiary level.

[[Page 37798]]

The compliance costs associated with this particular rule
requirement may be higher for non-reporting covered institutions, since
they may not be disclosing such information and as such may not be
keeping the type of records required. However, according to 2010
Federal Banking Agency Guidance, a banking institution should provide
an appropriate amount of information concerning its incentive
compensation arrangements for executive and non-executive employees and
related risk-management, control, and governance processes to
shareholders to allow them to monitor and, where appropriate, take
actions to restrain the potential for such arrangements and processes
to encourage employees to take imprudent risks. Such disclosures should
include information relevant to employees other than senior executives.
The scope and level of the information disclosed by the institution
should be tailored to the nature and complexity of the institution and
its incentive-based compensation arrangements. The SEC expects the
compliance costs to be lower for such covered institutions. Since the
SEC does not have data on how many covered IAs have parent
institutions, it is also possible that a significant number of these
IAs may be stand-alone companies and therefore could have higher costs
to comply with this specific requirement of the proposed rule compared
to covered IAs and BDs that are part of reporting parent institutions.
By requiring Level 1 and Level 2 covered institutions to create and
maintain records of incentive-based compensation arrangements for
covered persons, the proposed recordkeeping requirement is expected to
facilitate the SEC's ability to monitor incentive-based compensation
arrangements and could potentially strengthen incentives for covered
institutions to comply with the proposed rule. As a consequence, an
increase in investor confidence that covered institutions are less
likely to be incentivizing inappropriate actions through compensation
arrangements may occur and potentially result to greater market
participation and allocative efficiency, thereby potentially
facilitating capital formation. As discussed above, it is difficult for
the SEC to estimate compliance costs related to the specific provision.
However, for covered institutions that do not currently have a similar
reporting system in place, there could be significant fixed costs that
could disproportionately burden smaller covered BDs and IAs and hinder
competition. Overall, the SEC does not expect that the effects of the
proposed recordkeeping requirements on efficiency, competition and
capital formation to be significant.
H. Request for Comment
The SEC requests comments regarding its analysis of the potential
economic effects of the proposed rule. With regard to any comments, the
SEC notes that such comments are of particular assistance to the SEC if
accompanied by supporting data and analysis of the issues addressed in
those comments. For example, the SEC is interested in receiving
estimates, data, or analyses on incentive-based compensation at BDs and
IAs for all aspects of the proposed rule, including thresholds, on the
overall economic impact of the proposed rule, and on any other aspect
of this economic analysis. The SEC also is interested in comments on
the benefits and costs it has identified and any benefits and costs it
may have overlooked.
1. In the SEC's baseline analysis, the SEC uses data from publicly
held covered institutions as a proxy for incentive-based compensation
arrangements at privately held institutions. The SEC requests comment
on the validity of the assumption that privately held institutions
employ similar compensation practices to publicly held institutions.
The SEC also requests data or analysis with respect to incentive-based
compensation arrangements of covered persons at privately held covered
institutions.
2. The SEC does not have comprehensive data on incentive-based
compensation arrangements for affected individuals, other than those
senior executive officers who are named executive officers (NEOs) and
some significant risk-takers, for either public or privately held
covered institutions. The SEC requests data or analysis related to
compensation practices of all senior executive officers and significant
risk-takers at covered BDs and IAs as defined in the proposed rule.
3. The SEC uses incentive-based compensation arrangements of NEOs
at the parent level as a proxy for incentive-based compensation
arrangements of covered persons at covered BDs and IAs that are
subsidiaries. The SEC requests comment on the validity of the
assumption that incentive-based compensation arrangements for senior
executive officers at the parent level is similar to incentive-based
compensation arrangements followed at the subsidiary level for other
senior executive officers or for significant risk-takers. The SEC also
requests any data or related analysis on this issue.
4. Are the economic effects with respect to the asset thresholds
($50 billion and $250 billion) utilized to scale the proposed
requirements for covered BDs and IAs adequately outlined in the
analysis? The SEC also invites comment on the economic consequences of
any alternative asset thresholds, as well as economic consequences of
potential alternative measures.
5. The proposed consolidation approach would impose restrictions on
covered persons' incentive-based compensation arrangements in BDs and
IAs that are subsidiaries of depositary institution holding companies
based on the size of their parent institution. Are the economic effects
from the proposed consolidation approach adequately described in the
analysis? Are there specific circumstances, such as certain
organizational structures, that would deem such a consolidation
approach more or less effective?
6. Are there additional effects with respect to the proposed
definition of significant risk-takers to be considered? Are there
alternative ways to identify significant risk-takers and what would be
the economic consequences of alternative ways to identify significant
risk-takers?
7. Are the economic effects on the proposed minimum deferral
periods and the proposed minimum deferral percentage amounts adequately
described in the analysis? What would be the economic effects of any
alternative? The SEC also requests literature or evidence regarding the
length and amount of deferral of incentive-based compensation that
would lead to incentive-based compensation arrangements that best
address the underlying risks at covered institutions.
8. Are the economic effects from the proposed vesting schedule for
deferred incentive-based compensation adequately described in the
analysis? What would be the economic effects from any alternatives?
9. Are there additional economic effects to be considered from the
proposed prohibition of increasing a senior executive officer or
significant risk-taker's unvested deferred incentive-based
compensation? What would be the economic effects of any alternatives?
10. The proposed rule would require deferred qualifying incentive-
based compensation to be composed of substantial amounts of both
deferred cash and equity-like instruments for covered persons. Are the
economic effects of the proposed rule adequately described in the
analysis? Would explicitly specifying the mix between

[[Page 37799]]

cash and equity-like instruments to be included in the deferral amount
be preferred? What would be the economic effects of such an
alternative? Are there additional alternatives to be considered?
11. For senior executive officers and significant risk-takers at
Level 1 and Level 2 covered institutions, the total amount of options
that may be used to meet the minimum deferral amount requirements is
limited to no more than 15 percent of the amount of total incentive-
based compensation awarded for a given performance period. Indirectly,
this policy choice would place a cap on the amount of options that
covered BDs and IAs may provide to affected persons as part of their
incentive-based compensation arrangement. Are the economic effects of
the provision adequately described in the analysis? What would be the
economic effects from any alternatives?
12. Are the triggers for forfeiture or downward adjustment review
effective for both senior executive officers and significant risk-
takers? Are some of the triggers more effective for significant risk-
takers while others are more effective for senior executive officers?
What other triggers would be effective for forfeiture or downward
adjustment review?
13. Are the economic effects from the 125 percent (150 percent)
limit on the amount by which incentive-based compensation may exceed
the target amount for senior executive officers (significant risk-
takers) at covered BDs and IAs adequately described in the analysis?
Are there alternatives to be considered? What would be the economic
effect of such alternatives?
14. Are the economic effects regarding the prohibition of the sole
use of industry peer performance benchmarks for incentive-based
compensation performance measurement adequately described in the
analysis? The SEC also requests data on relative performance measures
used by covered BDs and IAs and/or related analysis that may further
inform this policy choice.
15. The SEC requests any relevant data or analysis regarding the
potential effect of the proposed rule on the ability of covered BDs and
IAs to attract and retain managerial talent.
16. In general, are there alternative courses of action to be
considered that would enhance accountability and limit the potential
for inappropriate risk-taking by covered persons at BDs and IAs? What
would be the economic effects of such alternatives? Are there specific
circumstances, such as certain types of shareholders and other
stakeholders, that would make these alternative approaches more or less
effective? For example, should such alternative approaches distinguish
between the effects on short-term shareholders and the effects on long-
term shareholders?
17. In recent years, several foreign regulators have implemented
regulations concerning incentive-based compensation similar to those in
the proposed rule. The SEC requests data or analysis regarding the
economic effects of those regulations and whether they are similar to
or different from the likely economic effects of the proposed rule.

J. Small Business Regulatory Enforcement Fairness Act

For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996 (``SBREFA'') \458\ the SEC must advise the OMB whether the
proposed regulation constitutes a ``major'' rule. Under SBREFA, a rule
is considered ``major'' where, if adopted, it results or is likely to
result in: (1) An annual effect on the economy of $100 million or more;
(2) a major increase in costs or prices for consumers or individual
industries; or (3) significant adverse effect on competition,
investment or innovation.
---------------------------------------------------------------------------

\458\ Public Law 104-121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C. and 15 U.S.C. and as a
note to 5 U.S.C. 601).
---------------------------------------------------------------------------

The SEC requests comment on the potential impact of the proposed
amendment on the economy on an annual basis. Commenters are requested
to provide empirical data and other factual support for their views to
the extent possible.

List of Subjects

12 CFR Part 42

Banks, banking, Compensation, National banks, Reporting and
recordkeeping requirements.

12 CFR Part 236

Banks, Bank holding companies, Compensation, Foreign banking
organizations, Reporting and recordkeeping requirements, Savings and
loan holding companies.

12 CFR Part 372

Banks, banking, Compensation, Foreign banking.

12 CFR Parts 741 and 751

Compensation, Credit unions, Reporting and recording requirements.

12 CFR Part 1232

Administrative practice and procedure, Banks, Compensation,
Confidential business information, Government-sponsored enterprises,
Reporting and recordkeeping requirements.

17 CFR Part 240

Reporting and recordkeeping requirements, Securities.

17 CFR Part 275

Reporting and recordkeeping requirements, Securities.

17 CFR Part 303

Incentive-based compensation arrangements, Reporting and
recordkeeping requirements, Securities.

Department of the Treasury: Office of the Comptroller of the Currency

12 CFR Chapter I

Authority and Issuance

For the reasons set forth in the joint preamble, the OCC proposes
to amend 12 CFR chapter I of the Code of Federal Regulations as
follows:

0
1. Add part 42 to read as follows:

PART 42--INCENTIVE-BASED COMPENSATION ARRANGEMENTS

Sec.
42.1 Authority, scope, and initial applicability.
42.2 Definitions.
42.3 Applicability.
42.4 Requirements and prohibitions applicable to all covered
institutions.
42.5 Additional disclosure and recordkeeping requirements for Level
1 and Level 2 covered institutions.
42.6 Reservation of authority for Level 3 covered institutions.
42.7 Deferral, forfeiture and downward adjustment, and clawback
requirements for Level 1 and Level 2 covered institutions.
42.8 Additional prohibitions for Level 1 and Level 2 covered
institutions.
42.9 Risk management and controls requirements for Level 1 and Level
2 covered institutions.
42.10 Governance requirements for Level 1 and Level 2 covered
institutions.
42.11 Policies and procedures requirements for Level 1 and Level 2
covered institutions.
42.12 Indirect actions.
42.13 Enforcement.

Authority: 12 U.S.C. 1 et seq. 1, 93a, 1462a, 1463, 1464, 1818,
1831p-1, and 5641.

Sec. 42.1 Authority, scope, and initial applicability.

(a) Authority. This part is issued pursuant to section 956 of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (12 U.S.C.
5641), sections 8 and 39 of the Federal Deposit Insurance Act (12
U.S.C. 1818 and 1831p-1), sections 3, 4, and 5 of the Home Owners' Loan
Act (12 U.S.C. 1462a, 1463, and 1464), and section

[[Page 37800]]

5239A of the Revised Statutes (12 U.S.C. 93a).
(b) Scope. This part applies to a covered institution with average
total consolidated assets greater than or equal to $1 billion that
offers incentive-based compensation to covered persons.
(c) Initial applicability--(1) Compliance date. A covered
institution must meet the requirements of this part no later than [Date
of the beginning of the first calendar quarter that begins at least 540
days after a final rule is published in the Federal Register]. Whether
a covered institution is a Level 1, Level 2, or Level 3 covered
institution at that time will be determined based on average total
consolidated assets as of [Date of the beginning of the first calendar
quarter that begins after a final rule is published in the Federal
Register].
(2) Grandfathered plans. A covered institution is not required to
comply with the requirements of this part with respect to any
incentive-based compensation plan with a performance period that begins
before [Compliance Date as described in Sec. 42.1(c)(1)].
(d) Preservation of authority. Nothing in this part in any way
limits the authority of the OCC under other provisions of applicable
law and regulations.

Sec. 42.2 Definitions.

For purposes of this part only, the following definitions apply
unless otherwise specified:
(a) Affiliate means any company that controls, is controlled by, or
is under common control with another company.
(b) Average total consolidated assets means the average of the
total consolidated assets of a national bank; a Federal savings
association; a Federal branch or agency of a foreign bank; a subsidiary
of a national bank, Federal savings association, or Federal branch or
agency; or a depository institution holding company, as reported on the
national bank's, Federal savings association's, Federal branch or
agency's, subsidiary's, or depository institution holding company's
regulatory reports, for the four most recent consecutive quarters. If a
national bank, Federal savings association, Federal branch or agency,
subsidiary, or depository institution holding company has not filed a
regulatory report for each of the four most recent consecutive
quarters, the national bank, Federal savings association, Federal
branch or agency, subsidiary, or depository institution holding
company's average total consolidated assets means the average of its
total consolidated assets, as reported on its regulatory reports, for
the most recent quarter or consecutive quarters, as applicable. Average
total consolidated assets are measured on the as-of date of the most
recent regulatory report used in the calculation of the average.
(c) To award incentive-based compensation means to make a final
determination, conveyed to a covered person, of the amount of
incentive-based compensation payable to the covered person for
performance over a performance period.
(d) Board of directors means the governing body of a covered
institution that oversees the activities of the covered institution,
often referred to as the board of directors or board of managers. For a
Federal branch or agency of a foreign bank, ``board of directors''
refers to the relevant oversight body for the Federal branch or agency,
consistent with its overall corporate and management structure.
(e) Clawback means a mechanism by which a covered institution can
recover vested incentive-based compensation from a covered person.
(f) Compensation, fees, or benefits means all direct and indirect
payments, both cash and non-cash, awarded to, granted to, or earned by
or for the benefit of, any covered person in exchange for services
rendered to a covered institution.
(g) Control means that any company has control over a bank or over
any company if--
(1) The company directly or indirectly or acting through one or
more other persons owns, controls, or has power to vote 25 percent or
more of any class of voting securities of the bank or company;
(2) The company controls in any manner the election of a majority
of the directors or trustees of the bank or company; or
(3) The OCC determines, after notice and opportunity for hearing,
that the company directly or indirectly exercises a controlling
influence over the management or policies of the bank or company.
(h) Control function means a compliance, risk management, internal
audit, legal, human resources, accounting, financial reporting, or
finance role responsible for identifying, measuring, monitoring, or
controlling risk-taking.
(i) Covered institution means:
(1) A national bank, Federal savings association, or Federal branch
or agency of a foreign bank with average total consolidated assets
greater than or equal to $1 billion; and
(2) A subsidiary of a national bank, Federal savings association,
or Federal branch or agency of a foreign bank that:
(i) Is not a broker, dealer, person providing insurance, investment
company, or investment adviser; and
(ii) Has average total consolidated assets greater than or equal to
$1 billion.
(j) Covered person means any executive officer, employee, director,
or principal shareholder who receives incentive-based compensation at a
covered institution.
(k) Deferral means the delay of vesting of incentive-based
compensation beyond the date on which the incentive-based compensation
is awarded.
(l) Deferral period means the period of time between the date a
performance period ends and the last date on which the incentive-based
compensation awarded for such performance period vests.
(m) Depository institution holding company means a top-tier
depository institution holding company, where ``depository institution
holding company'' has the same meaning as in section 3 of the Federal
Deposit Insurance Act (12 U.S.C. 1813).
(n) Director of a covered institution means a member of the board
of directors.
(o) Downward adjustment means a reduction of the amount of a
covered person's incentive-based compensation not yet awarded for any
performance period that has already begun, including amounts payable
under long-term incentive plans, in accordance with a forfeiture and
downward adjustment review under Sec. 42.7(b).
(p) Equity-like instrument means:
(1) Equity in the covered institution or of any affiliate of the
covered institution; or
(2) A form of compensation:
(i) Payable at least in part based on the price of the shares or
other equity instruments of the covered institution or of any affiliate
of the covered institution; or
(ii) That requires, or may require, settlement in the shares of the
covered institution or of any affiliate of the covered institution.
(q) Forfeiture means a reduction of the amount of deferred
incentive-based compensation awarded to a covered person that has not
vested.
(r) Incentive-based compensation means any variable compensation,
fees, or benefits that serve as an incentive or reward for performance.
(s) Incentive-based compensation arrangement means an agreement
between a covered institution and a covered person, under which the
covered institution provides incentive-

[[Page 37801]]

based compensation to the covered person, including incentive-based
compensation delivered through one or more incentive-based compensation
plans.
(t) Incentive-based compensation plan means a document setting
forth terms and conditions governing the opportunity for and the
payment of incentive-based compensation payments to one or more covered
persons.
(u) Incentive-based compensation program means a covered
institution's framework for incentive-based compensation that governs
incentive-based compensation practices and establishes related
controls.
(v) Level 1 covered institution means:
(1) A covered institution that is a subsidiary of a depository
institution holding company with average total consolidated assets
greater than or equal to $250 billion;
(2) A covered institution with average total consolidated assets
greater than or equal to $250 billion that is not a subsidiary of a
covered institution or of a depository institution holding company; and
(3) A covered institution that is a subsidiary of a covered
institution with average total consolidated assets greater than or
equal to $250 billion.
(w) Level 2 covered institution means:
(1) A covered institution that is a subsidiary of a depository
institution holding company with average total consolidated assets
greater than or equal to $50 billion but less than $250 billion;
(2) A covered institution with average total consolidated assets
greater than or equal to $50 billion but less than $250 billion that is
not a subsidiary of a covered institution or of a depository
institution holding company; and
(3) A covered institution that is a subsidiary of a covered
institution with average total consolidated assets greater than or
equal to $50 billion but less than $250 billion.
(x) Level 3 covered institution means:
(1) A covered institution with average total consolidated assets
greater than or equal to $1 billion but less than $50 billion; and
(2) A covered institution that is a subsidiary of a covered
institution with average total consolidated assets greater than or
equal to $1 billion but less than $50 billion.
(y) Long-term incentive plan means a plan to provide incentive-
based compensation that is based on a performance period of at least
three years.
(z) Option means an instrument through which a covered institution
provides a covered person the right, but not the obligation, to buy a
specified number of shares representing an ownership stake in a company
at a predetermined price within a set time period or on a date certain,
or any similar instrument, such as a stock appreciation right.
(aa) Performance period means the period during which the
performance of a covered person is assessed for purposes of determining
incentive-based compensation.
(bb) Principal shareholder means a natural person who, directly or
indirectly, or acting through or in concert with one or more persons,
owns, controls, or has the power to vote 10 percent or more of any
class of voting securities of a covered institution.
(cc) Qualifying incentive-based compensation means the amount of
incentive-based compensation awarded to a covered person for a
particular performance period, excluding amounts awarded to the covered
person for that particular performance period under a long-term
incentive plan.
(dd) [Reserved].
(ee) Regulatory report means:
(1) For a national bank or Federal savings association, the
consolidated Reports of Condition and Income (``Call Report'');
(2) For a Federal branch or agency of a foreign bank, the Reports
of Assets and Liabilities of U.S. Branches and Agencies of Foreign
Banks--FFIEC 002;
(3) For a depository institution holding company--
(i) The Consolidated Financial Statements for Bank Holding
Companies (``FR Y-9C'');
(ii) In the case of a savings and loan holding company that is not
required to file an FR Y-9C, the Quarterly Savings and Loan Holding
Company Report (``FR 2320''), if the savings and loan holding company
reports consolidated assets on the FR 2320, as applicable; or
(iii) In the case of a savings and loan holding company that does
not file an FRY-9C or report consolidated assets on the FR2320, a
report submitted to the Board of Governors of the Federal Reserve
System pursuant to 12 CFR 236.2(ee); and
(4) For a covered institution that is a subsidiary of a national
bank, Federal savings association, or Federal branch or agency of a
foreign bank, a report of the subsidiary's total consolidated assets
prepared by the subsidiary, national bank, Federal savings association,
or Federal branch or agency in a form that is acceptable to the OCC.
(ff) Section 956 affiliate means an affiliate that is an
institution described in Sec. 42.2(i), 12 CFR 236.2(i), 12 CFR
372.2(i), 12 CFR 741.2(i), 12 CFR 1232.2(i), or 17 CFR 303.2(i).
(gg) Senior executive officer means a covered person who holds the
title or, without regard to title, salary, or compensation, performs
the function of one or more of the following positions at a covered
institution for any period of time in the relevant performance period:
President, chief executive officer, executive chairman, chief operating
officer, chief financial officer, chief investment officer, chief legal
officer, chief lending officer, chief risk officer, chief compliance
officer, chief audit executive, chief credit officer, chief accounting
officer, or head of a major business line or control function.
(hh) Significant risk-taker means:
(1) Any covered person at a Level 1 or Level 2 covered institution,
other than a senior executive officer, who received annual base salary
and incentive-based compensation for the last calendar year that ended
at least 180 days before the beginning of the performance period of
which at least one-third is incentive-based compensation and is--
(i) A covered person of a Level 1 covered institution who received
annual base salary and incentive-based compensation for the last
calendar year that ended at least 180 days before the beginning of the
performance period that placed the covered person among the highest 5
percent in annual base salary and incentive-based compensation among
all covered persons (excluding senior executive officers) of the Level
1 covered institution together with all individuals who receive
incentive-based compensation at any section 956 affiliate of the Level
1 covered institution;
(ii) A covered person of a Level 2 covered institution who received
annual base salary and incentive-based compensation for the last
calendar year that ended at least 180 days before the beginning of the
performance period that placed the covered person among the highest 2
percent in annual base salary and incentive-based compensation among
all covered persons (excluding senior executive officers) of the Level
2 covered institution together with all individuals who receive
incentive-based compensation at any section 956 affiliate of the Level
2 covered institution; or
(iii) A covered person of a covered institution who may commit or
expose 0.5 percent or more of the common equity tier 1 capital, or in
the case of a registered securities broker or dealer, 0.5 percent or
more of the tentative net capital, of the covered institution or of any
section 956 affiliate of the covered

[[Page 37802]]

institution, whether or not the individual is a covered person of that
specific legal entity; and
(2) Any covered person at a Level 1 or Level 2 covered institution,
other than a senior executive officer, who is designated as a
``significant risk-taker'' by the OCC because of that person's ability
to expose a covered institution to risks that could lead to material
financial loss in relation to the covered institution's size, capital,
or overall risk tolerance, in accordance with procedures established by
the OCC, or by the covered institution.
(3) For purposes of this part, an individual who is an employee,
director, senior executive officer, or principal shareholder of an
affiliate of a Level 1 or Level 2 covered institution, where such
affiliate has less than $1 billion in total consolidated assets, and
who otherwise would meet the requirements for being a significant risk-
taker under paragraph (hh)(1)(iii) of this section, shall be considered
to be a significant risk-taker with respect to the Level 1 or Level 2
covered institution for which the individual may commit or expose 0.5
percent or more of common equity tier 1 capital or tentative net
capital. The Level 1 or Level 2 covered institution for which the
individual commits or exposes 0.5 percent or more of common equity tier
1 capital or tentative net capital shall ensure that the individual's
incentive compensation arrangement complies with the requirements of
this part.
(4) If the OCC determines, in accordance with procedures
established by the OCC, that a Level 1 covered institution's
activities, complexity of operations, risk profile, and compensation
practices are similar to those of a Level 2 covered institution, the
Level 1 covered institution may apply paragraph (hh)(1)(i) of this
section to covered persons of the Level 1 covered institution by
substituting ``2 percent'' for ``5 percent''.
(ii) Subsidiary means any company that is owned or controlled
directly or indirectly by another company
(jj) Vesting of incentive-based compensation means the transfer of
ownership of the incentive-based compensation to the covered person to
whom the incentive-based compensation was awarded, such that the
covered person's right to the incentive-based compensation is no longer
contingent on the occurrence of any event.

Sec. 42.3 Applicability.

(a) When average total consolidated assets increase--(1) In
general--(A) Covered institution subsidiaries of depository institution
holding companies. A national bank or Federal savings association that
is a subsidiary of a depository institution holding company shall
become a Level 1, Level 2, or Level 3 covered institution when the
depository institution holding company's average total consolidated
assets increase to an amount that equals or exceeds $250 billion, $50
billion, or $1 billion, respectively.
(B) Covered institutions that are not subsidiaries of a depository
institution holding company. A national bank, Federal savings
association, or Federal branch or agency of a foreign bank that is not
a subsidiary of a national bank, Federal savings association, Federal
branch or agency, or depository institution holding company shall
become a Level 1, Level 2, or Level 3 covered institution when the
national bank, Federal savings association, or Federal branch or
agency's average total consolidated assets increase to an amount that
equals or exceeds $250 billion, $50 billion, or $1 billion,
respectively.
(C) Subsidiaries of covered institutions. A subsidiary of a
national bank, Federal savings association, or Federal branch or agency
of a foreign bank that is not a broker, dealer, person providing
insurance, investment company, or investment adviser shall become a
Level 1, Level 2, or Level 3 covered institution when the national
bank, Federal savings association, or Federal branch or agency becomes
a Level 1, Level 2, or Level 3 covered institution, respectively,
pursuant to paragraph (a)(1)(A) or (B) of this section.
(2) Compliance date. A national bank, Federal savings association,
Federal branch or agency of a foreign bank, or a subsidiary thereof,
that becomes a Level 1, Level 2, or Level 3 covered institution
pursuant to paragraph (a)(1) of this section shall comply with the
requirements of this part for a Level 1, Level 2, or Level 3 covered
institution, respectively, not later than the first day of the first
calendar quarter that begins not later than 540 days after the date on
which the national bank, Federal savings association, Federal branch or
agency, or subsidiary becomes a Level 1, Level 2, or Level 3 covered
institution, respectively. Until that day, the Level 1, Level 2, or
Level 3 covered institution will remain subject to the requirements of
this part, if any, that applied to the institution on the day before
the date on which it became a Level 1, Level 2, or Level 3 covered
institution.
(3) Grandfathered plans. A national bank, Federal savings
association, Federal branch or agency of a foreign bank, or a
subsidiary thereof, that becomes a Level 1, Level 2, or Level 3 covered
institution under paragraph (a)(1) of this section is not required to
comply with requirements of this part applicable to a Level 1, Level 2,
or Level 3 covered institution, respectively, with respect to any
incentive-based compensation plan with a performance period that begins
before the date described in paragraph (a)(2) of this section. Any such
incentive-based compensation plan shall remain subject to the
requirements under this part, if any, that applied to the national
bank, Federal savings association, Federal branch or agency of a
foreign bank, or subsidiary at the beginning of the performance period.
(b) When total consolidated assets decrease--(1) Covered
institutions that are subsidiaries of depository institution holding
companies. A Level 1, Level 2, or Level 3 covered institution that is a
subsidiary of a depository institution holding company will remain
subject to the requirements applicable to such covered institution at
that level under this part unless and until the total consolidated
assets of the depository institution holding company, as reported on
the depository institution holding company's regulatory reports, fall
below $250 billion, $50 billion, or $1 billion, respectively, for each
of four consecutive quarters.
(2) Covered institutions that are not subsidiaries of depository
institution holding companies. A Level 1, Level 2, or Level 3 covered
institution that is a not subsidiary of a depository institution
holding company will remain subject to the requirements applicable to
such covered institution at that level under this part unless and until
the total consolidated assets of the covered institution, as reported
on the covered institution's regulatory reports, fall below $250
billion, $50 billion, or $1 billion, respectively, for each of four
consecutive quarters.
(3) Subsidiaries of covered institutions. A Level 1, Level 2, or
Level 3 covered institution that is a subsidiary of a national bank,
Federal savings association, or Federal branch or agency of a foreign
bank that is a covered institution will remain subject to the
requirements applicable to such national bank, Federal savings
association, or Federal branch or agency at that level under this part
unless and until the total consolidated assets of the national bank,
Federal savings association, Federal branch or agency, or depository
institution holding company of the national bank, Federal savings
association, or Federal branch or agency, as reported on its regulatory
reports, fall below $250 billion, $50

[[Page 37803]]

billion, or $1 billion, respectively, for each of four consecutive
quarters.
(4) Calculations. The calculations under this paragraph (b) of this
section will be effective on the as-of date of the fourth consecutive
regulatory report.
(c) Compliance of covered institutions that are subsidiaries of
covered institutions. A covered institution that is a subsidiary of
another covered institution may meet any requirement of this part if
the parent covered institution complies with that requirement in a way
that causes the relevant portion of the incentive-based compensation
program of the subsidiary covered institution to comply with that
requirement.

Sec. 42.4 Requirements and prohibitions applicable to all covered
institutions.

(a) In general. A covered institution must not establish or
maintain any type of incentive-based compensation arrangement, or any
feature of any such arrangement, that encourages inappropriate risks by
the covered institution:
(1) By providing a covered person with excessive compensation,
fees, or benefits; or
(2) That could lead to material financial loss to the covered
institution.
(b) Excessive compensation. Compensation, fees, and benefits are
considered excessive for purposes of paragraph (a)(1) of this section
when amounts paid are unreasonable or disproportionate to the value of
the services performed by a covered person, taking into consideration
all relevant factors, including, but not limited to:
(1) The combined value of all compensation, fees, or benefits
provided to the covered person;
(2) The compensation history of the covered person and other
individuals with comparable expertise at the covered institution;
(3) The financial condition of the covered institution;
(4) Compensation practices at comparable institutions, based upon
such factors as asset size, geographic location, and the complexity of
the covered institution's operations and assets;
(5) For post-employment benefits, the projected total cost and
benefit to the covered institution; and
(6) Any connection between the covered person and any fraudulent
act or omission, breach of trust or fiduciary duty, or insider abuse
with regard to the covered institution.
(c) Material financial loss. An incentive-based compensation
arrangement at a covered institution encourages inappropriate risks
that could lead to material financial loss to the covered institution,
unless the arrangement:
(1) Appropriately balances risk and reward;
(2) Is compatible with effective risk management and controls; and
(3) Is supported by effective governance.
(d) Performance measures. An incentive-based compensation
arrangement will not be considered to appropriately balance risk and
reward for purposes of paragraph (c)(1) of this section unless:
(1) The arrangement includes financial and non-financial measures
of performance, including considerations of risk-taking, that are
relevant to a covered person's role within a covered institution and to
the type of business in which the covered person is engaged and that
are appropriately weighted to reflect risk-taking;
(2) The arrangement is designed to allow non-financial measures of
performance to override financial measures of performance when
appropriate in determining incentive-based compensation; and
(3) Any amounts to be awarded under the arrangement are subject to
adjustment to reflect actual losses, inappropriate risks taken,
compliance deficiencies, or other measures or aspects of financial and
non-financial performance.
(e) Board of directors. A covered institution's board of directors,
or a committee thereof, must:
(1) Conduct oversight of the covered institution's incentive-based
compensation program;
(2) Approve incentive-based compensation arrangements for senior
executive officers, including the amounts of all awards and, at the
time of vesting, payouts under such arrangements; and
(3) Approve any material exceptions or adjustments to incentive-
based compensation policies or arrangements for senior executive
officers.
(f) Disclosure and recordkeeping requirements. A covered
institution must create annually and maintain for a period of at least
seven years records that document the structure of all its incentive-
based compensation arrangements and demonstrate compliance with this
part. A covered institution must disclose the records to the OCC upon
request. At a minimum, the records must include copies of all
incentive-based compensation plans, a record of who is subject to each
plan, and a description of how the incentive-based compensation program
is compatible with effective risk management and controls.
(g) Rule of construction. A covered institution is not required to
report the actual amount of compensation, fees, or benefits of
individual covered persons as part of the disclosure and recordkeeping
requirements under this part.

Sec. 42.5 Additional disclosure and recordkeeping requirements for
Level 1 and Level 2 covered institutions.

(a) A Level 1 or Level 2 covered institution must create annually
and maintain for a period of at least seven years records that
document:
(1) The covered institution's senior executive officers and
significant risk-takers, listed by legal entity, job function,
organizational hierarchy, and line of business;
(2) The incentive-based compensation arrangements for senior
executive officers and significant risk-takers, including information
on percentage of incentive-based compensation deferred and form of
award;
(3) Any forfeiture and downward adjustment or clawback reviews and
decisions for senior executive officers and significant risk-takers;
and
(4) Any material changes to the covered institution's incentive-
based compensation arrangements and policies.
(b) A Level 1 or Level 2 covered institution must create and
maintain records in a manner that allows for an independent audit of
incentive-based compensation arrangements, policies, and procedures,
including, those required under Sec. 42.11.
(c) A Level 1 or Level 2 covered institution must provide the
records described in paragraph (a) of this section to the OCC in such
form and with such frequency as requested by the OCC.

Sec. 42.6 Reservation of authority for Level 3 covered institutions.

(a) In general. The OCC may require a Level 3 covered institution
with average total consolidated assets greater than or equal to $10
billion and less than $50 billion to comply with some or all of the
provisions of Sec. Sec. 42.5 and 42.7 through 42.11 if the OCC
determines that the Level 3 covered institution's complexity of
operations or compensation practices are consistent with those of a
Level 1 or Level 2 covered institution.
(b) Factors considered. Any exercise of authority under this
section will be in writing by the OCC in accordance with procedures
established by the OCC and will consider the activities,

[[Page 37804]]

complexity of operations, risk profile, and compensation practices of
the Level 3 covered institution, in addition to any other relevant
factors.

Sec. 42.7 Deferral, forfeiture and downward adjustment, and clawback
requirements for Level 1 and Level 2 covered institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will not be considered to appropriately balance
risk and reward, for purposes of Sec. 42.4(c)(1), unless the following
requirements are met.
(a) Deferral. (1) Qualifying incentive-based compensation must be
deferred as follows:
(i) Minimum required deferral amount. (A) A Level 1 covered
institution must defer at least 60 percent of a senior executive
officer's qualifying incentive-based compensation awarded for each
performance period.
(B) A Level 1 covered institution must defer at least 50 percent of
a significant risk-taker's qualifying incentive-based compensation
awarded for each performance period.
(C) A Level 2 covered institution must defer at least 50 percent of
a senior executive officer's qualifying incentive-based compensation
awarded for each performance period.
(D) A Level 2 covered institution must defer at least 40 percent of
a significant risk-taker's qualifying incentive-based compensation
awarded for each performance period.
(ii) Minimum required deferral period. (A) For a senior executive
officer or significant risk-taker of a Level 1 covered institution, the
deferral period for deferred qualifying incentive-based compensation
must be at least 4 years.
(B) For a senior executive officer or significant risk-taker of a
Level 2 covered institution, the deferral period for deferred
qualifying incentive-based compensation must be at least 3 years.
(iii) Vesting of amounts during deferral period--(A) Pro rata
vesting. During a deferral period, deferred qualifying incentive-based
compensation may not vest faster than on a pro rata annual basis
beginning no earlier than the first anniversary of the end of the
performance period for which the amounts were awarded.
(B) Acceleration of vesting. A Level 1 or Level 2 covered
institution must not accelerate the vesting of a covered person's
deferred qualifying incentive-based compensation that is required to be
deferred under this part, except in the case of death or disability of
such covered person.
(2) Incentive-based compensation awarded under a long-term
incentive plan must be deferred as follows:
(i) Minimum required deferral amount. (A) A Level 1 covered
institution must defer at least 60 percent of a senior executive
officer's incentive-based compensation awarded under a long-term
incentive plan for each performance period.
(B) A Level 1 covered institution must defer at least 50 percent of
a significant risk-taker's incentive-based compensation awarded under a
long-term incentive plan for each performance period.
(C) A Level 2 covered institution must defer at least 50 percent of
a senior executive officer's incentive-based compensation awarded under
a long-term incentive plan for each performance period.
(D) A Level 2 covered institution must defer at least 40 percent of
a significant risk-taker's incentive-based compensation awarded under a
long-term incentive plan for each performance period.
(ii) Minimum required deferral period. (A) For a senior executive
officer or significant risk-taker of a Level 1 covered institution, the
deferral period for deferred long-term incentive plan amounts must be
at least 2 years.
(B) For a senior executive officer or significant risk-taker of a
Level 2 covered institution, the deferral period for deferred long-term
incentive plan amounts must be at least 1 year.
(iii) Vesting of amounts during deferral period--(A) Pro rata
vesting. During a deferral period, deferred long-term incentive plan
amounts may not vest faster than on a pro rata annual basis beginning
no earlier than the first anniversary of the end of the performance
period for which the amounts were awarded.
(B) Acceleration of vesting. A Level 1 or Level 2 covered
institution must not accelerate the vesting of a covered person's
deferred long-term incentive plan amounts that is required to be
deferred under this part, except in the case of death or disability of
such covered person.
(3) Adjustments of deferred qualifying incentive-based compensation
and deferred long-term incentive plan compensation amounts. A Level 1
or Level 2 covered institution may not increase deferred qualifying
incentive-based compensation or deferred long-term incentive plan
amounts for a senior executive officer or significant risk-taker during
the deferral period. For purposes of this paragraph, an increase in
value attributable solely to a change in share value, a change in
interest rates, or the payment of interest according to terms set out
at the time of the award is not considered an increase in incentive-
based compensation amounts.
(4) Composition of deferred qualifying incentive-based compensation
and deferred long-term incentive plan compensation for Level 1 and
Level 2 covered institutions--(i) Cash and equity-like instruments. For
a senior executive officer or significant risk-taker of a Level 1 or
Level 2 covered institution that issues equity or is an affiliate of a
covered institution that issues equity, any deferred qualifying
incentive-based compensation or deferred long-term incentive plan
amounts must include substantial portions of both deferred cash and
equity-like instruments throughout the deferral period.
(ii) Options. If a senior executive officer or significant risk-
taker of a Level 1 or Level 2 covered institution receives incentive-
based compensation for a performance period in the form of options, the
total amount of such options that may be used to meet the minimum
deferral amount requirements of paragraph (a)(1)(i) or (a)(2)(i) of
this section is limited to no more than 15 percent of the amount of
total incentive-based compensation awarded to the senior executive
officer or significant risk-taker for that performance period.
(b) Forfeiture and downward adjustment--(1) Compensation at risk--
(i) A Level 1 or Level 2 covered institution must place at risk of
forfeiture all unvested deferred incentive-based compensation of any
senior executive officer or significant risk-taker, including unvested
deferred amounts awarded under long-term incentive plans.
(ii) A Level 1 or Level 2 covered institution must place at risk of
downward adjustment all of a senior executive officer's or significant
risk-taker's incentive-based compensation amounts not yet awarded for
the current performance period, including amounts payable under long-
term incentive plans.
(2) Events triggering forfeiture and downward adjustment review. At
a minimum, a Level 1 or Level 2 covered institution must consider
forfeiture and downward adjustment of incentive-based compensation of
senior executive officers and significant risk-takers described in
paragraph (b)(3) of this section due to any of the following adverse
outcomes at the covered institution:
(i) Poor financial performance attributable to a significant
deviation from the risk parameters set forth in the covered
institution's policies and procedures;

[[Page 37805]]

(ii) Inappropriate risk taking, regardless of the impact on
financial performance;
(iii) Material risk management or control failures;
(iv) Non-compliance with statutory, regulatory, or supervisory
standards that results in:
(A) Enforcement or legal action against the covered institution
brought by a federal or state regulator or agency; or
(B) A requirement that the covered institution report a restatement
of a financial statement to correct a material error; and
(v) Other aspects of conduct or poor performance as defined by the
covered institution.
(3) Senior executive officers and significant risk-takers affected
by forfeiture and downward adjustment. A Level 1 or Level 2 covered
institution must consider forfeiture and downward adjustment for a
senior executive officer or significant risk-taker with direct
responsibility, or responsibility due to the senior executive officer's
or significant risk-taker's role or position in the covered
institution's organizational structure, for the events related to the
forfeiture and downward adjustment review set forth in paragraph (b)(2)
of this section.
(4) Determining forfeiture and downward adjustment amounts. A Level
1 or Level 2 covered institution must consider, at a minimum, the
following factors when determining the amount or portion of a senior
executive officer's or significant risk-taker's incentive-based
compensation that should be forfeited or adjusted downward:
(i) The intent of the senior executive officer or significant risk-
taker to operate outside the risk governance framework approved by the
covered institution's board of directors or to depart from the covered
institution's policies and procedures;
(ii) The senior executive officer's or significant risk-taker's
level of participation in, awareness of, and responsibility for, the
events triggering the forfeiture and downward adjustment review set
forth in paragraph (b)(2) of this section;
(iii) Any actions the senior executive officer or significant risk-
taker took or could have taken to prevent the events triggering the
forfeiture and downward adjustment review set forth in paragraph (b)(2)
of this section;
(iv) The financial and reputational impact of the events triggering
the forfeiture and downward adjustment review set forth in paragraph
(b)(2) of this section to the covered institution, the line or sub-line
of business, and individuals involved, as applicable, including the
magnitude of any financial loss and the cost of known or potential
subsequent fines, settlements, and litigation;
(v) The causes of the events triggering the forfeiture and downward
adjustment review set forth in paragraph (b)(2) of this section,
including any decision-making by other individuals; and
(vi) Any other relevant information, including past behavior and
past risk outcomes attributable to the senior executive officer or
significant risk-taker.
(c) Clawback. A Level 1 or Level 2 covered institution must include
clawback provisions in incentive-based compensation arrangements for
senior executive officers and significant risk-takers that, at a
minimum, allow the covered institution to recover incentive-based
compensation from a current or former senior executive officer or
significant risk-taker for seven years following the date on which such
compensation vests, if the covered institution determines that the
senior executive officer or significant risk-taker engaged in:
(1) Misconduct that resulted in significant financial or
reputational harm to the covered institution;
(2) Fraud; or
(3) Intentional misrepresentation of information used to determine
the senior executive officer or significant risk-taker's incentive-
based compensation.

Sec. 42.8 Additional prohibitions for Level 1 and Level 2 covered
institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will be considered to provide incentives that
appropriately balance risk and reward for purposes of Sec. 42.4(c)(1)
only if such institution complies with the following prohibitions.
(a) Hedging. A Level 1 or Level 2 covered institution must not
purchase a hedging instrument or similar instrument on behalf of a
covered person to hedge or offset any decrease in the value of the
covered person's incentive-based compensation.
(b) Maximum incentive-based compensation opportunity. A Level 1 or
Level 2 covered institution must not award incentive-based compensation
to:
(1) A senior executive officer in excess of 125 percent of the
target amount for that incentive-based compensation; or
(2) A significant risk-taker in excess of 150 percent of the target
amount for that incentive-based compensation.
(c) Relative performance measures. A Level 1 or Level 2 covered
institution must not use incentive-based compensation performance
measures that are based solely on industry peer performance
comparisons.
(d) Volume driven incentive-based compensation. A Level 1 or Level
2 covered institution must not provide incentive-based compensation to
a covered person that is based solely on transaction revenue or volume
without regard to transaction quality or compliance of the covered
person with sound risk management.

Sec. 42.9 Risk management and controls requirements for Level 1 and
Level 2 covered institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will be considered to be compatible with effective
risk management and controls for purposes of Sec. 42.4(c)(2) only if
such institution meets the following requirements.
(a) A Level 1 or Level 2 covered institution must have a risk
management framework for its incentive-based compensation program that:
(1) Is independent of any lines of business;
(2) Includes an independent compliance program that provides for
internal controls, testing, monitoring, and training with written
policies and procedures consistent with Sec. 42.11; and
(3) Is commensurate with the size and complexity of the covered
institution's operations.
(b) A Level 1 or Level 2 covered institution must:
(1) Provide individuals engaged in control functions with the
authority to influence the risk-taking of the business areas they
monitor; and
(2) Ensure that covered persons engaged in control functions are
compensated in accordance with the achievement of performance
objectives linked to their control functions and independent of the
performance of those business areas.
(c) A Level 1 or Level 2 covered institution must provide for the
independent monitoring of:
(1) All incentive-based compensation plans in order to identify
whether those plans provide incentives that appropriately balance risk
and reward;
(2) Events related to forfeiture and downward adjustment reviews
and decisions of forfeiture and downward adjustment reviews in order to
determine consistency with Sec. 42.7(b); and
(3) Compliance of the incentive-based compensation program with the
covered institution's policies and procedures.

[[Page 37806]]

Sec. 42.10 Governance requirements for Level 1 and Level 2 covered
institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will not be considered to be supported by effective
governance for purposes of Sec. 42.4(c)(3), unless:
(a) The covered institution establishes a compensation committee
composed solely of directors who are not senior executive officers to
assist the board of directors in carrying out its responsibilities
under Sec. 42.4(e); and
(b) The compensation committee established pursuant to paragraph
(a) of this section obtains:
(1) Input from the risk and audit committees of the covered
institution's board of directors, or groups performing similar
functions, and risk management function on the effectiveness of risk
measures and adjustments used to balance risk and reward in incentive-
based compensation arrangements;
(2) A written assessment of the effectiveness of the covered
institution's incentive-based compensation program and related
compliance and control processes in providing risk-taking incentives
that are consistent with the risk profile of the covered institution,
submitted on an annual or more frequent basis by the management of the
covered institution and developed with input from the risk and audit
committees of its board of directors, or groups performing similar
functions, and from the covered institution's risk management and audit
functions; and
(3) An independent written assessment of the effectiveness of the
covered institution's incentive-based compensation program and related
compliance and control processes in providing risk-taking incentives
that are consistent with the risk profile of the covered institution,
submitted on an annual or more frequent basis by the internal audit or
risk management function of the covered institution, developed
independently of the covered institution's management.

Sec. 42.11 Policies and procedures requirements for Level 1 and Level
2 covered institutions.

A Level 1 or Level 2 covered institution must develop and implement
policies and procedures for its incentive-based compensation program
that, at a minimum:
(a) Are consistent with the prohibitions and requirements of this
part;
(b) Specify the substantive and procedural criteria for the
application of forfeiture and clawback, including the process for
determining the amount of incentive-based compensation to be clawed
back;
(c) Require that the covered institution maintain documentation of
final forfeiture, downward adjustment, and clawback decisions;
(d) Specify the substantive and procedural criteria for the
acceleration of payments of deferred incentive-based compensation to a
covered person, consistent with Sec. 42.7(a)(1)(iii)(B) and
(a)(2)(iii)(B));
(e) Identify and describe the role of any employees, committees, or
groups authorized to make incentive-based compensation decisions,
including when discretion is authorized;
(f) Describe how discretion is expected to be exercised to
appropriately balance risk and reward;
(g) Require that the covered institution maintain documentation of
the establishment, implementation, modification, and monitoring of
incentive-based compensation arrangements, sufficient to support the
covered institution's decisions;
(h) Describe how incentive-based compensation arrangements will be
monitored;
(i) Specify the substantive and procedural requirements of the
independent compliance program consistent with Sec. 42.9(a)(2); and
(j) Ensure appropriate roles for risk management, risk oversight,
and other control function personnel in the covered institution's
processes for:
(1) Designing incentive-based compensation arrangements and
determining awards, deferral amounts, deferral periods, forfeiture,
downward adjustment, clawback, and vesting; and
(2) Assessing the effectiveness of incentive-based compensation
arrangements in restraining inappropriate risk-taking.

Sec. 42.12 Indirect actions.

A covered institution must not indirectly, or through or by any
other person, do anything that would be unlawful for such covered
institution to do directly under this part.

Sec. 42.13 Enforcement.

The provisions of this part shall be enforced under section 505 of
the Gramm-Leach-Bliley Act and, for purposes of such section, a
violation of this part shall be treated as a violation of subtitle A of
title V of such Act.

Federal Reserve Board

12 CFR Chapter II

Authority and Issuance

For the reasons set forth in the joint preamble, the Board proposes
to amend 12 CFR chapter II as follows:
0
2. Add part 236 to read as follows:

PART 236--INCENTIVE-BASED COMPENSATION ARRANGEMENTS (REGULATION JJ)

Sec.
236.1 Authority, scope, and initial applicability.
236.2 Definitions.
236.3 Applicability.
236.4 Requirements and prohibitions applicable to all covered
institutions.
236.5 Additional disclosure and recordkeeping requirements for Level
1 and Level 2 covered institutions.
236.6 Reservation of authority for Level 3 covered institutions.
236.7 Deferral, forfeiture and downward adjustment, and clawback
requirements for Level 1 and Level 2 covered institutions.
236.8 Additional prohibitions for Level 1 and Level 2 covered
institutions.
236.9 Risk management and controls requirements for Level 1 and
Level 2 covered institutions.
236.10 Governance requirements for Level 1 and Level 2 covered
institutions.
236.11 Policies and procedures requirements for Level 1 and Level 2
covered institutions.
236.12 Indirect actions.
236.13 Enforcement.

Authority: 12 U.S.C. 24, 321-338a, 1462a, 1467a, 1818, 1844(b),
3108, and 5641.

Sec. 236.1 Authority, scope, and initial applicability.

(a) Authority. This part is issued pursuant to section 956 of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (12 U.S.C.
5641), section 5136 of the Revised Statutes (12 U.S.C. 24), the Federal
Reserve Act (12 U.S.C. 321-338a), section 8 of the Federal Deposit
Insurance Act (12 U.S.C. 1818), section 5 of the Bank Holding Company
Act of 1956 (12 U.S.C. 1844(b)), sections 3 and 10 of the Home Owners'
Loan Act of 1933 (12 U.S.C. 1462a and 1467a), and section 13 of the
International Banking Act of 1978 (12 U.S.C. 3108).
(b) Scope. This part applies to a covered institution with average
total consolidated assets greater than or equal to $1 billion that
offers incentive-based compensation to covered persons.
(c) Initial applicability--(1) Compliance date. A covered
institution must meet the requirements of this part no later than [Date
of the beginning of the first calendar quarter that begins at least 540
days after a final rule is published in the Federal Register]. Whether
a covered institution is a Level 1, Level 2, or Level 3 covered
institution at that time will be determined based on average total
consolidated assets as of [Date of the beginning of the first calendar
quarter that begins after a final

[[Page 37807]]

rule is published in the Federal Register].
(2) Grandfathered plans. A covered institution is not required to
comply with the requirements of this part with respect to any
incentive-based compensation plan with a performance period that begins
before [Compliance Date as described in Sec. 236.1(c)(1)].
(d) Preservation of authority. Nothing in this part in any way
limits the authority of the Board under other provisions of applicable
law and regulations.

Sec. 236.2 Definitions.

For purposes of this part only, the following definitions apply
unless otherwise specified:
(a) Affiliate means any company that controls, is controlled by, or
is under common control with another company.
(b) Average total consolidated assets means the average of a
regulated institution's total consolidated assets, as reported on the
regulated institution's regulatory reports, for the four most recent
consecutive quarters. If a regulated institution has not filed a
regulatory report for each of the four most recent consecutive
quarters, the regulated institution's average total consolidated assets
means the average of its total consolidated assets, as reported on its
regulatory reports, for the most recent quarter or consecutive
quarters, as applicable. Average total consolidated assets are measured
on the as-of date of the most recent regulatory report used in the
calculation of the average.
(c) To award incentive-based compensation means to make a final
determination, conveyed to a covered person, of the amount of
incentive-based compensation payable to the covered person for
performance over a performance period.
(d) Board of directors means the governing body of a covered
institution that oversees the activities of the covered institution,
often referred to as the board of directors or board of managers. For a
foreign banking organization, ``board of directors'' refers to the
relevant oversight body for the firm's U.S. branch, agency or
operations, consistent with the foreign banking organization's overall
corporate and management structure.
(e) Clawback means a mechanism by which a covered institution can
recover vested incentive-based compensation from a covered person.
(f) Compensation, fees, or benefits means all direct and indirect
payments, both cash and non-cash, awarded to, granted to, or earned by
or for the benefit of, any covered person in exchange for services
rendered to a covered institution.
(g) Control means that any company has control over a bank or over
any company if--
(1) The company directly or indirectly or acting through one or
more other persons owns, controls, or has power to vote 25 percent or
more of any class of voting securities of the bank or company;
(2) The company controls in any manner the election of a majority
of the directors or trustees of the bank or company; or
(3) The Board determines, after notice and opportunity for hearing,
that the company directly or indirectly exercises a controlling
influence over the management or policies of the bank or company.
(h) Control function means a compliance, risk management, internal
audit, legal, human resources, accounting, financial reporting, or
finance role responsible for identifying, measuring, monitoring, or
controlling risk-taking.
(i) Covered institution means a regulated institution with average
total consolidated assets greater than or equal to $1 billion.
(j) Covered person means any executive officer, employee, director,
or principal shareholder who receives incentive-based compensation at a
covered institution.
(k) Deferral means the delay of vesting of incentive-based
compensation beyond the date on which the incentive-based compensation
is awarded.
(l) Deferral period means the period of time between the date a
performance period ends and the last date on which the incentive-based
compensation awarded for such performance period vests.
(m) [Reserved].
(n) Director of a covered institution means a member of the board
of directors.
(o) Downward adjustment means a reduction of the amount of a
covered person's incentive-based compensation not yet awarded for any
performance period that has already begun, including amounts payable
under long-term incentive plans, in accordance with a forfeiture and
downward adjustment review under Sec. 236.7(b).
(p) Equity-like instrument means:
(1) Equity in the covered institution or of any affiliate of the
covered institution; or
(2) A form of compensation:
(i) Payable at least in part based on the price of the shares or
other equity instruments of the covered institution or of any affiliate
of the covered institution; or
(ii) That requires, or may require, settlement in the shares of the
covered institution or of any affiliate of the covered institution.
(q) Forfeiture means a reduction of the amount of deferred
incentive-based compensation awarded to a covered person that has not
vested.
(r) Incentive-based compensation means any variable compensation,
fees, or benefits that serve as an incentive or reward for performance.
(s) Incentive-based compensation arrangement means an agreement
between a covered institution and a covered person, under which the
covered institution provides incentive-based compensation to the
covered person, including incentive-based compensation delivered
through one or more incentive-based compensation plans.
(t) Incentive-based compensation plan means a document setting
forth terms and conditions governing the opportunity for and the
payment of incentive-based compensation payments to one or more covered
persons.
(u) Incentive-based compensation program means a covered
institution's framework for incentive-based compensation that governs
incentive-based compensation practices and establishes related
controls.
(v) Level 1 covered institution means a covered institution with
average total consolidated assets greater than or equal to $250 billion
and any subsidiary of a Level 1 covered institution that would itself
be a covered institution.
(w) Level 2 covered institution means a covered institution with
average total consolidated assets greater than or equal to $50 billion
that is not a Level 1 covered institution and any subsidiary of a Level
2 covered institution that would itself be a covered institution.
(x) Level 3 covered institution means a covered institution with
average total consolidated assets greater than or equal to $1 billion
that is not a Level 1 covered institution or Level 2 covered
institution.
(y) Long-term incentive plan means a plan to provide incentive-
based compensation that is based on a performance period of at least
three years.
(z) Option means an instrument through which a covered institution
provides a covered person the right, but not the obligation, to buy a
specified number of shares representing an ownership stake in a company
at a predetermined price within a set time period or on a date certain,
or any similar instrument, such as a stock appreciation right.

[[Page 37808]]

(aa) Performance period means the period during which the
performance of a covered person is assessed for purposes of determining
incentive-based compensation.
(bb) Principal shareholder means a natural person who, directly or
indirectly, or acting through or in concert with one or more persons,
owns, controls, or has the power to vote 10 percent or more of any
class of voting securities of a covered institution.
(cc) Qualifying incentive-based compensation means the amount of
incentive-based compensation awarded to a covered person for a
particular performance period, excluding amounts awarded to the covered
person for that particular performance period under a long-term
incentive plan.
(dd) Regulated institution means:
(1) A state member bank, as defined in 12 CFR 208.2(g);
(2) A bank holding company, as defined in 12 CFR 225.2(c), that is
not a foreign banking organization, as defined in 12 CFR 211.21(o), and
a subsidiary of such a bank holding company that is not a depository
institution, broker-dealer, or investment adviser;
(3) A savings and loan holding company, as defined in 12 CFR
238.2(m), and a subsidiary of a savings and loan holding company that
is not a depository institution, broker-dealer, or investment adviser;
(4) An organization operating under section 25 or 25A of the
Federal Reserve Act (``Edge or Agreement Corporation'');
(5) A state-licensed uninsured branch or agency of a foreign bank,
as defined in section 3 of the Federal Deposit Insurance Act (12 U.S.C.
1813); and
(6) The U.S. operations of a foreign banking organization, as
defined in 12 CFR 211.21(o), excluding any Federal branch or agency and
any state insured branch of the foreign banking organization, and a
U.S. subsidiary of such foreign banking organization that is not a
depository institution, broker-dealer, or investment adviser.
(ee) Regulatory report means:
(1) For a state member bank, Consolidated Reports of Condition and
Income (``Call Report'');
(2) For a bank holding company that is not a foreign banking
organization, Consolidated Financial Statements for Bank Holding
Companies (``FR Y-9C'');
(3) For a savings and loan holding company, FR Y-9C; if a savings
and loan holding company is not required to file an FR Y-9C, Quarterly
Savings and Loan Holding Company Report (``FR 2320''), if the savings
and loan holding company reports consolidated assets on the FR 2320;
(4) For a savings and loan holding company that does not file a
regulatory report within the meaning of Sec. 236.2(ee)(3), a report of
average total consolidated assets filed with the Board on a quarterly
basis.
(5) For an Edge or Agreement Corporation, Consolidated Report of
Condition and Income for Edge and Agreement Corporations (``FR
2886b'');
(6) For a state-licensed uninsured branch or agency of a foreign
bank, Reports of Assets and Liabilities of U.S. Branches and Agencies
of Foreign Banks--FFIEC 002;
(7) For the U.S. operations of a foreign banking organization, a
report of average total consolidated U.S. assets filed with the Board
on a quarterly basis; and
(8) For a regulated institution that is a subsidiary of a bank
holding company, savings and loan holding company, or a foreign banking
organization, a report of the subsidiary's total consolidated assets
prepared by the bank holding company, savings and loan holding company,
or subsidiary in a form that is acceptable to the Board.
(ff) Section 956 affiliate means an affiliate that is an
institution described in Sec. 236.2(i), 12 CFR 42.2(i), 12 CFR
372.2(i), 12 CFR 741.2(i), 12 CFR 1232.2(i), or 17 CFR 303.2(i).
(gg) Senior executive officer means a covered person who holds the
title or, without regard to title, salary, or compensation, performs
the function of one or more of the following positions at a covered
institution for any period of time in the relevant performance period:
President, chief executive officer, executive chairman, chief operating
officer, chief financial officer, chief investment officer, chief legal
officer, chief lending officer, chief risk officer, chief compliance
officer, chief audit executive, chief credit officer, chief accounting
officer, or head of a major business line or control function.
(hh) Significant risk-taker means:
(1) Any covered person at a Level 1 or Level 2 covered institution,
other than a senior executive officer, who received annual base salary
and incentive-based compensation for the last calendar year that ended
at least 180 days before the beginning of the performance period of
which at least one-third is incentive-based compensation and is--
(i) A covered person of a Level 1 covered institution who received
annual base salary and incentive-based compensation for the last
calendar year that ended at least 180 days before the beginning of the
performance period that placed the covered person among the highest 5
percent in annual base salary and incentive-based compensation among
all covered persons (excluding senior executive officers) of the Level
1 covered institution together with all individuals who receive
incentive-based compensation at any section 956 affiliate of the Level
1 covered institution;
(ii) A covered person of a Level 2 covered institution who received
annual base salary and incentive-based compensation for the last
calendar year that ended at least 180 days before the beginning of the
performance period that placed the covered person among the highest 2
percent in annual base salary and incentive-based compensation among
all covered persons (excluding senior executive officers) of the Level
2 covered institution together with all individuals who receive
incentive-based compensation at any section 956 affiliate of the Level
2 covered institution; or
(iii) A covered person of a covered institution who may commit or
expose 0.5 percent or more of the common equity tier 1 capital, or in
the case of a registered securities broker or dealer, 0.5 percent or
more of the tentative net capital, of the covered institution or of any
section 956 affiliate of the covered institution, whether or not the
individual is a covered person of that specific legal entity; and
(2) Any covered person at a Level 1 or Level 2 covered institution,
other than a senior executive officer, who is designated as a
``significant risk-taker'' by the Board because of that person's
ability to expose a covered institution to risks that could lead to
material financial loss in relation to the covered institution's size,
capital, or overall risk tolerance, in accordance with procedures
established by the Board, or by the covered institution.
(3) For purposes of this part, an individual who is an employee,
director, senior executive officer, or principal shareholder of an
affiliate of a Level 1 or Level 2 covered institution, where such
affiliate has less than $1 billion in total consolidated assets, and
who otherwise would meet the requirements for being a significant risk-
taker under paragraph (hh)(1)(iii) of this section, shall be considered
to be a significant risk-taker with respect to the Level 1 or Level 2
covered institution for which the individual may commit or expose 0.5
percent or more of common equity tier 1 capital or tentative net
capital. The Level 1 or Level 2 covered institution for which the
individual commits or exposes 0.5 percent or more of common equity tier
1 capital or tentative net capital shall ensure that

[[Page 37809]]

the individual's incentive compensation arrangement complies with the
requirements of this part.
(4) If the Board determines, in accordance with procedures
established by the Board, that a Level 1 covered institution's
activities, complexity of operations, risk profile, and compensation
practices are similar to those of a Level 2 covered institution, the
Level 1 covered institution may apply paragraph (hh)(1)(i) of this
section to covered persons of the Level 1 covered institution by
substituting ``2 percent'' for ``5 percent''.
(ii) Subsidiary means any company that is owned or controlled
directly or indirectly by another company; provided that the following
are not subsidiaries for purposes of this part:
(1) Any merchant banking investment that is owned or controlled
pursuant to 12 U.S.C. 1843(k)(4)(H) and subpart J of the Board's
Regulation Y (12 CFR part 225); and
(2) Any company with respect to which the covered institution
acquired ownership or control in the ordinary course of collecting a
debt previously contracted in good faith.
(jj) Vesting of incentive-based compensation means the transfer of
ownership of the incentive-based compensation to the covered person to
whom the incentive-based compensation was awarded, such that the
covered person's right to the incentive-based compensation is no longer
contingent on the occurrence of any event.

Sec. 236.3 Applicability.

(a) When average total consolidated assets increase--(1) In
general. A regulated institution shall become a Level 1, Level 2, or
Level 3 covered institution when its average total consolidated assets
or the average total consolidated assets of any affiliate of the
regulated institution equals or exceeds $250 billion, $50 billion, or
$1 billion, respectively.
(2) Compliance date. A regulated institution that becomes a Level
1, Level 2, or Level 3 covered institution pursuant to paragraph (a)(1)
of this section shall comply with the requirements of this part for a
Level 1, Level 2, or Level 3 covered institution, respectively, not
later than the first day of the first calendar quarter that begins at
least 540 days after the date on which the regulated institution
becomes a Level 1, Level 2, or Level 3 covered institution,
respectively. Until that day, the Level 1, Level 2, or Level 3 covered
institution will remain subject to the requirements of this part, if
any, that applied to the regulated institution on the day before the
date on which it became a Level 1, Level 2, or Level 3 covered
institution.
(3) Grandfathered plans. A regulated institution that becomes a
Level 1, Level 2, or Level 3 covered institution under paragraph (a)(1)
of this section is not required to comply with requirements of this
part applicable to a Level 1, Level 2, or Level 3 covered institution,
respectively, with respect to any incentive-based compensation plan
with a performance period that begins before the date described in
paragraph (a)(2) of this section. Any such incentive-based compensation
plan shall remain subject to the requirements under this part, if any,
that applied to the regulated institution at the beginning of the
performance period.
(b) When total consolidated assets decrease. A Level 1, Level 2, or
Level 3 covered institution will remain subject to the requirements
applicable to such covered institution under this part unless and until
the total consolidated assets of such covered institution, or the total
consolidated assets of another Level 1, Level 2, or Level 3 covered
institution of which the first covered institution is a subsidiary, as
reported on the covered institution's regulatory reports, fall below
$250 billion, $50 billion, or $1 billion, respectively, for each of
four consecutive quarters. The calculation will be effective on the as-
of date of the fourth consecutive regulatory report.
(c) Compliance of covered institutions that are subsidiaries of
covered institutions. A covered institution that is a subsidiary of
another covered institution may meet any requirement of this part if
the parent covered institution complies with that requirement in such a
way that causes the relevant portion of the incentive-based
compensation program of the subsidiary covered institution to comply
with that requirement.

Sec. 236.4 Requirements and prohibitions applicable to all covered
institutions.

[[Page 37810]]

(e) Board of directors. A covered institution's board of directors,
or a committee thereof, must:
(1) Conduct oversight of the covered institution's incentive-based
compensation program;
(2) Approve incentive-based compensation arrangements for senior
executive officers, including the amounts of all awards and, at the
time of vesting, payouts under such arrangements; and
(3) Approve any material exceptions or adjustments to incentive-
based compensation policies or arrangements for senior executive
officers.
(f) Disclosure and recordkeeping requirements. A covered
institution must create annually and maintain for a period of at least
seven years records that document the structure of all its incentive-
based compensation arrangements and demonstrate compliance with this
part. A covered institution must disclose the records to the Board upon
request. At a minimum, the records must include copies of all
incentive-based compensation plans, a record of who is subject to each
plan, and a description of how the incentive-based compensation program
is compatible with effective risk management and controls.
(g) Rule of construction. A covered institution is not required to
report the actual amount of compensation, fees, or benefits of
individual covered persons as part of the disclosure and recordkeeping
requirements under this part.

Sec. 236.5 Additional disclosure and recordkeeping requirements for
Level 1 and Level 2 covered institutions.

(a) A Level 1 or Level 2 covered institution must create annually
and maintain for a period of at least seven years records that
document:
(1) The covered institution's senior executive officers and
significant risk-takers, listed by legal entity, job function,
organizational hierarchy, and line of business;
(2) The incentive-based compensation arrangements for senior
executive officers and significant risk-takers, including information
on percentage of incentive-based compensation deferred and form of
award;
(3) Any forfeiture and downward adjustment or clawback reviews and
decisions for senior executive officers and significant risk-takers;
and
(4) Any material changes to the covered institution's incentive-
based compensation arrangements and policies.
(b) A Level 1 or Level 2 covered institution must create and
maintain records in a manner that allows for an independent audit of
incentive-based compensation arrangements, policies, and procedures,
including, those required under Sec. 236.11.
(c) A Level 1 or Level 2 covered institution must provide the
records described in paragraph (a) of this section to the Board in such
form and with such frequency as requested by the Board.

Sec. 236.6 Reservation of authority for Level 3 covered institutions.

(a) In general. The Board may require a Level 3 covered institution
with average total consolidated assets greater than or equal to $10
billion and less than $50 billion to comply with some or all of the
provisions of Sec. Sec. 236.5 and 236.7 through 236.11 if the Board
determines that the Level 3 covered institution's complexity of
operations or compensation practices are consistent with those of a
Level 1 or Level 2 covered institution.
(b) Factors considered. Any exercise of authority under this
section will be in writing by the Board in accordance with procedures
established by the Board and will consider the activities, complexity
of operations, risk profile, and compensation practices of the Level 3
covered institution, in addition to any other relevant factors.

Sec. 236.7 Deferral, forfeiture and downward adjustment, and clawback
requirements for Level 1 and Level 2 covered institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will not be considered to appropriately balance
risk and reward, for purposes of Sec. 236.4(c)(1), unless the
following requirements are met.
(a) Deferral. (1) Qualifying incentive-based compensation must be
deferred as follows:
(i) Minimum required deferral amount. (A) A Level 1 covered
institution must defer at least 60 percent of a senior executive
officer's qualifying incentive-based compensation awarded for each
performance period.
(B) A Level 1 covered institution must defer at least 50 percent of
a significant risk-taker's qualifying incentive-based compensation
awarded for each performance period.
(C) A Level 2 covered institution must defer at least 50 percent of
a senior executive officer's qualifying incentive-based compensation
awarded for each performance period.
(D) A Level 2 covered institution must defer at least 40 percent of
a significant risk-taker's qualifying incentive-based compensation
awarded for each performance period.
(ii) Minimum required deferral period. (A) For a senior executive
officer or significant risk-taker of a Level 1 covered institution, the
deferral period for deferred qualifying incentive-based compensation
must be at least 4 years.
(B) For a senior executive officer or significant risk-taker of a
Level 2 covered institution, the deferral period for deferred
qualifying incentive-based compensation must be at least 3 years.
(iii) Vesting of amounts during deferral period--(A) Pro rata
vesting. During a deferral period, deferred qualifying incentive-based
compensation may not vest faster than on a pro rata annual basis
beginning no earlier than the first anniversary of the end of the
performance period for which the amounts were awarded.
(B) Acceleration of vesting. A Level 1 or Level 2 covered
institution must not accelerate the vesting of a covered person's
deferred qualifying incentive-based compensation that is required to be
deferred under this part, except in the case of death or disability of
such covered person.
(2) Incentive-based compensation awarded under a long-term
incentive plan must be deferred as follows:
(i) Minimum required deferral amount. (A) A Level 1 covered
institution must defer at least 60 percent of a senior executive
officer's incentive-based compensation awarded under a long-term
incentive plan for each performance period.
(B) A Level 1 covered institution must defer at least 50 percent of
a significant risk-taker's incentive-based compensation awarded under a
long-term incentive plan for each performance period.
(C) A Level 2 covered institution must defer at least 50 percent of
a senior executive officer's incentive-based compensation awarded under
a long-term incentive plan for each performance period.
(D) A Level 2 covered institution must defer at least 40 percent of
a significant risk-taker's incentive-based compensation awarded under a
long-term incentive plan for each performance period.
(ii) Minimum required deferral period. (A) For a senior executive
officer or significant risk-taker of a Level 1 covered institution, the
deferral period for deferred long-term incentive plan amounts must be
at least 2 years.
(B) For a senior executive officer or significant risk-taker of a
Level 2 covered institution, the deferral period for deferred long-term
incentive plan amounts must be at least 1 year.
(iii) Vesting of amounts during deferral period--(A) Pro rata
vesting.

[[Page 37811]]

During a deferral period, deferred long-term incentive plan amounts may
not vest faster than on a pro rata annual basis beginning no earlier
than the first anniversary of the end of the performance period for
which the amounts were awarded.
(B) Acceleration of vesting. A Level 1 or Level 2 covered
institution must not accelerate the vesting of a covered person's
deferred long-term incentive plan amounts that is required to be
deferred under this part, except in the case of death or disability of
such covered person.
(3) Adjustments of deferred qualifying incentive-based compensation
and deferred long-term incentive plan compensation amounts. A Level 1
or Level 2 covered institution may not increase deferred qualifying
incentive-based compensation or deferred long-term incentive plan
amounts for a senior executive officer or significant risk-taker during
the deferral period. For purposes of this paragraph, an increase in
value attributable solely to a change in share value, a change in
interest rates, or the payment of interest according to terms set out
at the time of the award is not considered an increase in incentive-
based compensation amounts.
(4) Composition of deferred qualifying incentive-based compensation
and deferred long-term incentive plan compensation for Level 1 and
Level 2 covered institutions--(i) Cash and equity-like instruments. For
a senior executive officer or significant risk-taker of a Level 1 or
Level 2 covered institution that issues equity or is an affiliate of a
covered institution that issues equity, any deferred qualifying
incentive-based compensation or deferred long-term incentive plan
amounts must include substantial portions of both deferred cash and
equity-like instruments throughout the deferral period.
(ii) Options. If a senior executive officer or significant risk-
taker of a Level 1 or Level 2 covered institution receives incentive-
based compensation for a performance period in the form of options, the
total amount of such options that may be used to meet the minimum
deferral amount requirements of paragraph (a)(1)(i) or (a)(2)(i) of
this section is limited to no more than 15 percent of the amount of
total incentive-based compensation awarded to the senior executive
officer or significant risk-taker for that performance period.
(b) Forfeiture and downward adjustment--(1) Compensation at risk.
(i) A Level 1 or Level 2 covered institution must place at risk of
forfeiture all unvested deferred incentive-based compensation of any
senior executive officer or significant risk-taker, including unvested
deferred amounts awarded under long-term incentive plans.
(ii) A Level 1 or Level 2 covered institution must place at risk of
downward adjustment all of a senior executive officer's or significant
risk-taker's incentive-based compensation amounts not yet awarded for
the current performance period, including amounts payable under long-
term incentive plans.
(2) Events triggering forfeiture and downward adjustment review. At
a minimum, a Level 1 or Level 2 covered institution must consider
forfeiture and downward adjustment of incentive-based compensation of
senior executive officers and significant risk-takers described in
paragraph (b)(3) of this section due to any of the following adverse
outcomes at the covered institution:
(i) Poor financial performance attributable to a significant
deviation from the risk parameters set forth in the covered
institution's policies and procedures;
(ii) Inappropriate risk taking, regardless of the impact on
financial performance;
(iii) Material risk management or control failures;
(iv) Non-compliance with statutory, regulatory, or supervisory
standards that results in:
(A) Enforcement or legal action against the covered institution
brought by a federal or state regulator or agency; or
(B) A requirement that the covered institution report a restatement
of a financial statement to correct a material error; and
(v) Other aspects of conduct or poor performance as defined by the
covered institution.
(3) Senior executive officers and significant risk-takers affected
by forfeiture and downward adjustment. A Level 1 or Level 2 covered
institution must consider forfeiture and downward adjustment for a
senior executive officer or significant risk-taker with direct
responsibility, or responsibility due to the senior executive officer's
or significant risk-taker's role or position in the covered
institution's organizational structure, for the events related to the
forfeiture and downward adjustment review set forth in paragraph (b)(2)
of this section.
(4) Determining forfeiture and downward adjustment amounts. A Level
1 or Level 2 covered institution must consider, at a minimum, the
following factors when determining the amount or portion of a senior
executive officer's or significant risk-taker's incentive-based
compensation that should be forfeited or adjusted downward:
(i) The intent of the senior executive officer or significant risk-
taker to operate outside the risk governance framework approved by the
covered institution's board of directors or to depart from the covered
institution's policies and procedures;
(ii) The senior executive officer's or significant risk-taker's
level of participation in, awareness of, and responsibility for, the
events triggering the forfeiture and downward adjustment review set
forth in paragraph (b)(2) of this section;
(iii) Any actions the senior executive officer or significant risk-
taker took or could have taken to prevent the events triggering the
forfeiture and downward adjustment review set forth in paragraph (b)(2)
of this section;
(iv) The financial and reputational impact of the events triggering
the forfeiture and downward adjustment review set forth in paragraph
(b)(2) of this section to the covered institution, the line or sub-line
of business, and individuals involved, as applicable, including the
magnitude of any financial loss and the cost of known or potential
subsequent fines, settlements, and litigation;
(v) The causes of the events triggering the forfeiture and downward
adjustment review set forth in paragraph (b)(2) of this section,
including any decision-making by other individuals; and
(vi) Any other relevant information, including past behavior and
past risk outcomes attributable to the senior executive officer or
significant risk-taker.
(c) Clawback. A Level 1 or Level 2 covered institution must include
clawback provisions in incentive-based compensation arrangements for
senior executive officers and significant risk-takers that, at a
minimum, allow the covered institution to recover incentive-based
compensation from a current or former senior executive officer or
significant risk-taker for seven years following the date on which such
compensation vests, if the covered institution determines that the
senior executive officer or significant risk-taker engaged in:
(1) Misconduct that resulted in significant financial or
reputational harm to the covered institution;
(2) Fraud; or
(3) Intentional misrepresentation of information used to determine
the senior executive officer or significant risk-taker's incentive-
based compensation.

[[Page 37812]]

Sec. 236.8 Additional prohibitions for Level 1 and Level 2 covered
institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will be considered to provide incentives that
appropriately balance risk and reward for purposes of Sec. 236.4(c)(1)
only if such institution complies with the following prohibitions.
(a) Hedging. A Level 1 or Level 2 covered institution must not
purchase a hedging instrument or similar instrument on behalf of a
covered person to hedge or offset any decrease in the value of the
covered person's incentive-based compensation.
(b) Maximum incentive-based compensation opportunity. A Level 1 or
Level 2 covered institution must not award incentive-based compensation
to:
(1) A senior executive officer in excess of 125 percent of the
target amount for that incentive-based compensation; or
(2) A significant risk-taker in excess of 150 percent of the target
amount for that incentive-based compensation.
(c) Relative performance measures. A Level 1 or Level 2 covered
institution must not use incentive-based compensation performance
measures that are based solely on industry peer performance
comparisons.
(d) Volume driven incentive-based compensation. A Level 1 or Level
2 covered institution must not provide incentive-based compensation to
a covered person that is based solely on transaction revenue or volume
without regard to transaction quality or compliance of the covered
person with sound risk management.

Sec. 236.9 Risk management and controls requirements for Level 1 and
Level 2 covered institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will be considered to be compatible with effective
risk management and controls for purposes of Sec. 236.4(c)(2) only if
such institution meets the following requirements.
(a) A Level 1 or Level 2 covered institution must have a risk
management framework for its incentive-based compensation program that:
(1) Is independent of any lines of business;
(2) Includes an independent compliance program that provides for
internal controls, testing, monitoring, and training with written
policies and procedures consistent with Sec. 236.11; and
(3) Is commensurate with the size and complexity of the covered
institution's operations.
(b) A Level 1 or Level 2 covered institution must:
(1) Provide individuals engaged in control functions with the
authority to influence the risk-taking of the business areas they
monitor; and
(2) Ensure that covered persons engaged in control functions are
compensated in accordance with the achievement of performance
objectives linked to their control functions and independent of the
performance of those business areas.
(c) A Level 1 or Level 2 covered institution must provide for the
independent monitoring of:
(1) All incentive-based compensation plans in order to identify
whether those plans provide incentives that appropriately balance risk
and reward;
(2) Events related to forfeiture and downward adjustment reviews
and decisions of forfeiture and downward adjustment reviews in order to
determine consistency with Sec. 236.7(b); and
(3) Compliance of the incentive-based compensation program with the
covered institution's policies and procedures.

Sec. 236.10 Governance requirements for Level 1 and Level 2 covered
institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will not be considered to be supported by effective
governance for purposes of Sec. 236.4(c)(3), unless:
(a) The covered institution establishes a compensation committee
composed solely of directors who are not senior executive officers to
assist the board of directors in carrying out its responsibilities
under Sec. 236.4(e); and
(b) The compensation committee established pursuant to paragraph
(a) of this section obtains:
(1) Input from the risk and audit committees of the covered
institution's board of directors, or groups performing similar
functions, and risk management function on the effectiveness of risk
measures and adjustments used to balance risk and reward in incentive-
based compensation arrangements;
(2) A written assessment of the effectiveness of the covered
institution's incentive-based compensation program and related
compliance and control processes in providing risk-taking incentives
that are consistent with the risk profile of the covered institution,
submitted on an annual or more frequent basis by the management of the
covered institution and developed with input from the risk and audit
committees of its board of directors, or groups performing similar
functions, and from the covered institution's risk management and audit
functions; and
(3) An independent written assessment of the effectiveness of the
covered institution's incentive-based compensation program and related
compliance and control processes in providing risk-taking incentives
that are consistent with the risk profile of the covered institution,
submitted on an annual or more frequent basis by the internal audit or
risk management function of the covered institution, developed
independently of the covered institution's management.

Sec. 236.11 Policies and procedures requirements for Level 1 and
Level 2 covered institutions.

A Level 1 or Level 2 covered institution must develop and implement
policies and procedures for its incentive-based compensation program
that, at a minimum:
(a) Are consistent with the prohibitions and requirements of this
part;
(b) Specify the substantive and procedural criteria for the
application of forfeiture and clawback, including the process for
determining the amount of incentive-based compensation to be clawed
back;
(c) Require that the covered institution maintain documentation of
final forfeiture, downward adjustment, and clawback decisions;
(d) Specify the substantive and procedural criteria for the
acceleration of payments of deferred incentive-based compensation to a
covered person, consistent with Sec. 236.7(a)(1)(iii)(B) and
(a)(2)(iii)(B));
(e) Identify and describe the role of any employees, committees, or
groups authorized to make incentive-based compensation decisions,
including when discretion is authorized;
(f) Describe how discretion is expected to be exercised to
appropriately balance risk and reward;
(g) Require that the covered institution maintain documentation of
the establishment, implementation, modification, and monitoring of
incentive-based compensation arrangements, sufficient to support the
covered institution's decisions;
(h) Describe how incentive-based compensation arrangements will be
monitored;
(i) Specify the substantive and procedural requirements of the
independent compliance program consistent with Sec. 236.9(a)(2); and
(j) Ensure appropriate roles for risk management, risk oversight,
and other control function personnel in the covered institution's
processes for:

[[Page 37813]]

(1) Designing incentive-based compensation arrangements and
determining awards, deferral amounts, deferral periods, forfeiture,
downward adjustment, clawback, and vesting; and
(2) Assessing the effectiveness of incentive-based compensation
arrangements in restraining inappropriate risk-taking.

Sec. 236.12 Indirect actions.

A covered institution must not indirectly, or through or by any
other person, do anything that would be unlawful for such covered
institution to do directly under this part.

Sec. 236.13 Enforcement.

Federal Deposit Insurance Corporation

12 CFR Chapter III

Authority and Issuance

For the reasons set forth in the joint preamble, the Federal
Deposit Insurance Corporation proposes to amend chapter III of title 12
of the Code of Federal Regulations as follows:
0
3. Add part 372 to read as follows:

PART 372--INCENTIVE-BASED COMPENSATION ARRANGEMENTS

Sec.
372.1 Authority, scope, and initial applicability.
372.2 Definitions.
372.3 Applicability.
372.4 Requirements and prohibitions applicable to all covered
institutions.
372.5 Additional disclosure and recordkeeping requirements for Level
1 and Level 2 covered institutions.
372.6 Reservation of authority for Level 3 covered institutions.
372.7 Deferral, forfeiture and downward adjustment, and clawback
requirements for Level 1 and Level 2 covered institutions.
372.8 Additional prohibitions for Level 1 and Level 2 covered
institutions.
372.9 Risk management and controls requirements for Level 1 and
Level 2 covered institutions.
372.10 Governance requirements for Level 1 and Level 2 covered
institutions.
372.11 Policies and procedures requirements for Level 1 and Level 2
covered institutions.
372.12 Indirect actions.
372.13 Enforcement.

Authority: 12 U.S.C. 5641, 12 U.S.C. 1818, 12 U.S.C. 1819 Tenth,
12 U.S.C. 1831p-1.

Sec. 372.1 Authority, scope, and initial applicability.

(a) Authority. This part is issued pursuant to section 956 of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (12 U.S.C.
5641), and sections 8 (12 U.S.C. 1818), 9 (12 U.S.C. 1819 Tenth), and
39 (12 U.S.C. 1831p-1) of the Federal Deposit Insurance Act.
(b) Scope. This part applies to a covered institution with average
total consolidated assets greater than or equal to $1 billion that
offers incentive-based compensation to covered persons.
(c) Initial applicability--(1) Compliance date. A covered
institution must meet the requirements of this part no later than [Date
of the beginning of the first calendar quarter that begins at least 540
days after a final rule is published in the Federal Register]. Whether
a covered institution is a Level 1, Level 2, or Level 3 covered
institution at that time will be determined based on average total
consolidated assets as of [Date of the beginning of the first calendar
quarter that begins after a final rule is published in the Federal
Register].
(2) Grandfathered plans. A covered institution is not required to
comply with the requirements of this part with respect to any
incentive-based compensation plan with a performance period that begins
before [Compliance Date as described in Sec. 372.1(c)(1)].
(d) Preservation of authority. Nothing in this part in any way
limits the authority of the Corporation under other provisions of
applicable law and regulations.

Sec. 372.2 Definitions.

[[Page 37814]]

measuring, monitoring, or controlling risk-taking.
(i) Covered institution means
(1) A state nonmember bank, state savings association, or a state
insured branch of a foreign bank, as such terms are defined in section
3 of the Federal Deposit Insurance Act, 12 U.S.C. 1813, with average
total consolidated assets greater than or equal to $1 billion; and
(2) A subsidiary of a state nonmember bank, state savings
association, or a state insured branch of a foreign bank, as such terms
are defined in section 3 of the Federal Deposit Insurance Act, 12
U.S.C. 1813, that:
(i) Is not a broker, dealer, person providing insurance, investment
company, or investment adviser; and
(ii) Has average total consolidated assets greater than or equal to
$1 billion.
(j) Covered person means any executive officer, employee, director,
or principal shareholder who receives incentive-based compensation at a
covered institution.
(k) Deferral means the delay of vesting of incentive-based
compensation beyond the date on which the incentive-based compensation
is awarded.
(l) Deferral period means the period of time between the date a
performance period ends and the last date on which the incentive-based
compensation awarded for such performance period vests.
(m) Depository institution holding company means a top-tier
depository institution holding company, where ``depository institution
holding company'' has the same meaning as in section 3 of the Federal
Deposit Insurance Act (12 U.S.C. 1813).
(n) Director of a covered institution means a member of the board
of directors.
(o) Downward adjustment means a reduction of the amount of a
covered person's incentive-based compensation not yet awarded for any
performance period that has already begun, including amounts payable
under long-term incentive plans, in accordance with a forfeiture and
downward adjustment review under Sec. 372.7(b).
(p) Equity-like instrument means:
(1) Equity in the covered institution or of any affiliate of the
covered institution; or
(2) A form of compensation:
(i) Payable at least in part based on the price of the shares or
other equity instruments of the covered institution or of any affiliate
of the covered institution; or
(ii) That requires, or may require, settlement in the shares of the
covered institution or of any affiliate of the covered institution.
(q) Forfeiture means a reduction of the amount of deferred
incentive-based compensation awarded to a covered person that has not
vested.
(r) Incentive-based compensation means any variable compensation,
fees, or benefits that serve as an incentive or reward for performance.
(s) Incentive-based compensation arrangement means an agreement
between a covered institution and a covered person, under which the
covered institution provides incentive-based compensation to the
covered person, including incentive-based compensation delivered
through one or more incentive-based compensation plans.
(t) Incentive-based compensation plan means a document setting
forth terms and conditions governing the opportunity for and the
payment of incentive-based compensation payments to one or more covered
persons.
(u) Incentive-based compensation program means a covered
institution's framework for incentive-based compensation that governs
incentive-based compensation practices and establishes related
controls.
(v) Level 1 covered institution means
(1) A covered institution that is a subsidiary of a depository
institution holding company with average total consolidated assets
greater than or equal to $250 billion;
(2) A covered institution with average total consolidated assets
greater than or equal to $250 billion that is not a subsidiary of a
covered institution or of a depository institution holding company; and
(3) A covered institution that is a subsidiary of a covered
institution with average total consolidated assets greater than or
equal to $250 billion.
(w) Level 2 covered institution means
(1) A covered institution that is a subsidiary of a depository
institution holding company with average total consolidated assets
greater than or equal to $50 billion but less than $250 billion;
(2) A covered institution with average total consolidated assets
greater than or equal to $50 billion but less than $250 billion that is
not a subsidiary of a covered institution or of a depository
institution holding company; and
(3) A covered institution that is a subsidiary of a covered
institution with average total consolidated assets greater than or
equal to $50 billion but less than $250 billion.
(x) Level 3 covered institution means
(1) A covered institution that is a subsidiary of a depository
institution holding company with average total consolidated assets
greater than or equal to $1 billion but less than $50 billion;
(2) A covered institution with average total consolidated assets
greater than or equal to $1 billion but less than $50 billion that is
not a subsidiary of a covered institution or of a depository
institution holding company; and
(3) A covered institution that is a subsidiary of a covered
institution with average total consolidated assets greater than or
equal to $1 billion but less than $50 billion.
(y) Long-term incentive plan means a plan to provide incentive-
based compensation that is based on a performance period of at least
three years.
(z) Option means an instrument through which a covered institution
provides a covered person the right, but not the obligation, to buy a
specified number of shares representing an ownership stake in a company
at a predetermined price within a set time period or on a date certain,
or any similar instrument, such as a stock appreciation right.
(aa) Performance period means the period during which the
performance of a covered person is assessed for purposes of determining
incentive-based compensation.
(bb) Principal shareholder means a natural person who, directly or
indirectly, or acting through or in concert with one or more persons,
owns, controls, or has the power to vote 10 percent or more of any
class of voting securities of a covered institution.
(cc) Qualifying incentive-based compensation means the amount of
incentive-based compensation awarded to a covered person for a
particular performance period, excluding amounts awarded to the covered
person for that particular performance period under a long-term
incentive plan.
(dd) [Reserved].
(ee) Regulatory report means
(1) For a state nonmember bank and state savings association,
Consolidated Reports of Condition and Income;
(2) For an state insured branch of a foreign bank, the Reports of
Assets and Liabilities of U.S. Branches and Agencies of Foreign Banks--
FFIEC 002; and
(3) For a depository institution holding company:
(i) The Consolidated Financial Statements for Bank Holding
Companies (``FR Y-9C'');
(ii) In the case of a savings and loan holding company that is not
required to file an FR Y-9C, the Quarterly Savings and Loan Holding
Company Report (``FR 2320''), if the savings and loan holding company
reports consolidated assets on the FR 2320, as applicable; and

[[Page 37815]]

(iii) In the case of a savings and loan holding company that does
not file an FRY-9C or report consolidated assets on the FR2320, a
report submitted to the Board of Governors of the Federal Reserve
System pursuant to 12 CFR 236.2(ee).
(ff) Section 956 affiliate means an affiliate that is an
institution described in Sec. 372.2(i), 12 CFR 42.2(i), 12 CFR
236.2(i), 12 CFR 741.2(i), 12 CFR 1232.2(i), or 17 CFR 303.2(i).
(gg) Senior executive officer means a covered person who holds the
title or, without regard to title, salary, or compensation, performs
the function of one or more of the following positions at a covered
institution for any period of time in the relevant performance period:
President, chief executive officer, executive chairman, chief operating
officer, chief financial officer, chief investment officer, chief legal
officer, chief lending officer, chief risk officer, chief compliance
officer, chief audit executive, chief credit officer, chief accounting
officer, or head of a major business line or control function.
(hh) Significant risk-taker means:
(1) Any covered person at a Level 1 or Level 2 covered institution,
other than a senior executive officer, who received annual base salary
and incentive-based compensation for the last calendar year that ended
at least 180 days before the beginning of the performance period of
which at least one-third is incentive-based compensation and is--
(i) A covered person of a Level 1 covered institution who received
annual base salary and incentive-based compensation for the last
calendar year that ended at least 180 days before the beginning of the
performance period that placed the covered person among the highest 5
percent in annual base salary and incentive-based compensation among
all covered persons (excluding senior executive officers) of the Level
1 covered institution together with all individuals who receive
incentive-based compensation at any section 956 affiliate of the Level
1 covered institution;
(ii) A covered person of a Level 2 covered institution who received
annual base salary and incentive-based compensation for the last
calendar year that ended at least 180 days before the beginning of the
performance period that placed the covered person among the highest 2
percent in annual base salary and incentive-based compensation among
all covered persons (excluding senior executive officers) of the Level
2 covered institution together with all individuals who receive
incentive-based compensation at any section 956 affiliate of the Level
2 covered institution; or
(iii) A covered person of a covered institution who may commit or
expose 0.5 percent or more of the common equity tier 1 capital, or in
the case of a registered securities broker or dealer, 0.5 percent or
more of the tentative net capital, of the covered institution or of any
section 956 affiliate of the covered institution, whether or not the
individual is a covered person of that specific legal entity; and
(2) Any covered person at a Level 1 or Level 2 covered institution,
other than a senior executive officer, who is designated as a
``significant risk-taker'' by the Corporation because of that person's
ability to expose a covered institution to risks that could lead to
material financial loss in relation to the covered institution's size,
capital, or overall risk tolerance, in accordance with procedures
established by the Corporation, or by the covered institution.
(3) For purposes of this part, an individual who is an employee,
director, senior executive officer, or principal shareholder of an
affiliate of a Level 1 or Level 2 covered institution, where such
affiliate has less than $1 billion in total consolidated assets, and
who otherwise would meet the requirements for being a significant risk-
taker under paragraph (hh)(1)(iii) of this section, shall be considered
to be a significant risk-taker with respect to the Level 1 or Level 2
covered institution for which the individual may commit or expose 0.5
percent or more of common equity tier 1 capital or tentative net
capital. The Level 1 or Level 2 covered institution for which the
individual commits or exposes 0.5 percent or more of common equity tier
1 capital or tentative net capital shall ensure that the individual's
incentive compensation arrangement complies with the requirements of
this part.
(4) If the Corporation determines, in accordance with procedures
established by the Corporation, that a Level 1 covered institution's
activities, complexity of operations, risk profile, and compensation
practices are similar to those of a Level 2 covered institution, the
Level 1 covered institution may apply paragraph (hh)(1)(i) of this
section to covered persons of the Level 1 covered institution by
substituting ``2 percent'' for ``5 percent''.
(ii) Subsidiary means any company that is owned or controlled
directly or indirectly by another company.
(jj) Vesting of incentive-based compensation means the transfer of
ownership of the incentive-based compensation to the covered person to
whom the incentive-based compensation was awarded, such that the
covered person's right to the incentive-based compensation is no longer
contingent on the occurrence of any event.

Sec. 372.3 Applicability.

(a) When average total consolidated assets increase--(1) In
general--(i) Covered institution subsidiaries of depository institution
holding companies. A state nonmember bank or state savings association
that is a subsidiary of a depository institution holding company shall
become a Level 1, Level 2, or Level 3 covered institution when the
depository institution holding company's average total consolidated
assets increase to an amount that equals or exceeds $250 billion, $50
billion, or $1 billion, respectively.
(ii) Covered institutions that are not subsidiaries of a depository
institution holding company. A state nonmember bank, state savings
association, or state insured branch of a foreign bank that is not a
subsidiary of a state nonmember bank, state savings association, or
state insured branch of a foreign bank, or depository institution
holding company shall become a Level 1, Level 2, or Level 3 covered
institution when such state nonmember bank, state savings association,
or state insured branch of a foreign bank's average total consolidated
assets increase to an amount that equals or exceeds $250 billion, $50
billion, or $1 billion, respectively.
(iii) Subsidiaries of covered institutions. A subsidiary of a state
nonmember bank, state savings association, or state insured branch of a
foreign bank, as described under Sec. 372.2(i)(2), shall become a
Level 1, Level 2, or Level 3 covered institution when the state
nonmember bank, state savings association, or state insured branch of a
foreign bank becomes a Level 1, Level 2, or Level 3 covered
institution, respectively, under paragraph (a)(1)(i) or (ii) of this
section.
(2) Compliance date. A state nonmember bank, state savings
association, state insured branch of a foreign bank, or subsidiary
thereof, that becomes a Level 1, Level 2, or Level 3 covered
institution pursuant to paragraph (a)(1) of this section shall comply
with the requirements of this part for a Level 1, Level 2, or Level 3
covered institution, respectively, not later than the first day of the
first calendar quarter that begins at least 540 days after the date on
which such state nonmember bank, state savings association, state
insured branch of a

[[Page 37816]]

foreign bank, or subsidiary thereof becomes a Level 1, Level 2, or
Level 3 covered institution, respectively. Until that day, the Level 1,
Level 2, or Level 3 covered institution will remain subject to the
requirements of this part, if any, that applied to the institution on
the day before the date on which it became a Level 1, Level 2, or Level
3 covered institution.
(3) Grandfathered plans. A state nonmember bank, state savings
association, state insured branch of a foreign bank, or subsidiary
thereof, that becomes a Level 1, Level 2, or Level 3 covered
institution under paragraph (a)(1) of this section is not required to
comply with requirements of this part applicable to a Level 1, Level 2,
or Level 3 covered institution, respectively, with respect to any
incentive-based compensation plan with a performance period that begins
before the date described in paragraph (a)(2) of this section. Any such
incentive-based compensation plan shall remain subject to the
requirements under this part, if any, that applied to such state
nonmember bank, state savings association, state insured branch of a
foreign bank, or subsidiary thereof at the beginning of the performance
period.
(b) When total consolidated assets decrease--(1) Covered
institutions that are subsidiaries of depository institution holding
companies. A Level 1, Level 2, or Level 3 covered institution that is a
subsidiary of a depository institution holding company will remain
subject to the requirements applicable to such covered institution at
that level under this part unless and until the total consolidated
assets of the depository institution holding company, as reported on
the depository institution holding company's regulatory reports, fall
below $250 billion, $50 billion, or $1 billion, respectively, for each
of four consecutive quarters.
(2) Covered institutions that are not subsidiaries of depository
institution holding companies. A Level 1, Level 2, or Level 3 covered
institution that is not a subsidiary of a depository institution
holding company will remain subject to the requirements applicable to
such covered institution at that level under this part unless and until
the total consolidated assets of the covered institution, as reported
on the covered institution's regulatory reports, fall below $250
billion, $50 billion, or $1 billion, respectively, for each of four
consecutive quarters.
(3) Subsidiaries of covered institutions. A Level 1, Level 2, or
Level 3 covered institution that is a subsidiary of a state nonmember
bank, state savings association, or state insured branch of a foreign
bank that is a covered institution will remain subject to the
requirements applicable to such state nonmember bank, state savings
association, or state insured branch of a foreign bank at that level
under this part unless and until the total consolidated assets of the
state nonmember bank, state savings association, state insured branch
of a foreign bank, or depository holding company of the state nonmember
bank or state savings association, as reported on its regulatory
reports, fall below $250 billion, $50 billion, or $1 billion,
respectively, for each of four consecutive quarters.
(4) The calculations under this paragraph (b) of this section will
be effective on the as-of date of the fourth consecutive regulatory
report.
(c) Compliance of covered institutions that are subsidiaries of
covered institutions. A covered institution that is a subsidiary of
another covered institution may meet any requirement of this part if
the parent covered institution complies with that requirement in a way
that causes the relevant portion of the incentive-based compensation
program of the subsidiary covered institution to comply with that
requirement.

Sec. 372.4 Requirements and prohibitions applicable to all covered
institutions.

[[Page 37817]]

must create annually and maintain for a period of at least seven years
records that document the structure of all its incentive-based
compensation arrangements and demonstrate compliance with this part. A
covered institution must disclose the records to the Corporation upon
request. At a minimum, the records must include copies of all
incentive-based compensation plans, a record of who is subject to each
plan, and a description of how the incentive-based compensation program
is compatible with effective risk management and controls.
(g) Rule of construction. A covered institution is not required to
report the actual amount of compensation, fees, or benefits of
individual covered persons as part of the disclosure and recordkeeping
requirements under this part.

Sec. 372.5 Additional disclosure and recordkeeping requirements for
Level 1 and Level 2 covered institutions.

(a) A Level 1 or Level 2 covered institution must create annually
and maintain for a period of at least seven years records that
document:
(1) The covered institution's senior executive officers and
significant risk-takers, listed by legal entity, job function,
organizational hierarchy, and line of business;
(2) The incentive-based compensation arrangements for senior
executive officers and significant risk-takers, including information
on percentage of incentive-based compensation deferred and form of
award;
(3) Any forfeiture and downward adjustment or clawback reviews and
decisions for senior executive officers and significant risk-takers;
and
(4) Any material changes to the covered institution's incentive-
based compensation arrangements and policies.
(b) A Level 1 or Level 2 covered institution must create and
maintain records in a manner that allows for an independent audit of
incentive-based compensation arrangements, policies, and procedures,
including, those required under Sec. 372.11.
(c) A Level 1 or Level 2 covered institution must provide the
records described in paragraph (a) of this section to the Corporation
in such form and with such frequency as requested by the Corporation.

Sec. 372.6 Reservation of authority for Level 3 covered institutions.

(a) In general. The Corporation may require a Level 3 covered
institution with average total consolidated assets greater than or
equal to $10 billion and less than $50 billion to comply with some or
all of the provisions of Sec. Sec. 372.5 and 372.7 through 372.11 if
the Corporation determines that the Level 3 covered institution's
complexity of operations or compensation practices are consistent with
those of a Level 1 or Level 2 covered institution.
(b) Factors considered. Any exercise of authority under this
section will be in writing by the Corporation in accordance with
procedures established by the Corporation and will consider the
activities, complexity of operations, risk profile, and compensation
practices of the Level 3 covered institution, in addition to any other
relevant factors.

Sec. 372.7 Deferral, forfeiture and downward adjustment, and clawback
requirements for Level 1 and Level 2 covered institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will not be considered to appropriately balance
risk and reward, for purposes of Sec. 372.4(c)(1), unless the
following requirements are met.
(a) Deferral. (1) Qualifying incentive-based compensation must be
deferred as follows:
(i) Minimum required deferral amount.
(A) A Level 1 covered institution must defer at least 60 percent of
a senior executive officer's qualifying incentive-based compensation
awarded for each performance period.
(B) A Level 1 covered institution must defer at least 50 percent of
a significant risk-taker's qualifying incentive-based compensation
awarded for each performance period.
(C) A Level 2 covered institution must defer at least 50 percent of
a senior executive officer's qualifying incentive-based compensation
awarded for each performance period.
(D) A Level 2 covered institution must defer at least 40 percent of
a significant risk-taker's qualifying incentive-based compensation
awarded for each performance period.
(ii) Minimum required deferral period. (A) For a senior executive
officer or significant risk-taker of a Level 1 covered institution, the
deferral period for deferred qualifying incentive-based compensation
must be at least 4 years.
(B) For a senior executive officer or significant risk-taker of a
Level 2 covered institution, the deferral period for deferred
qualifying incentive-based compensation must be at least 3 years.
(iii) Vesting of amounts during deferral period--(A) Pro rata
vesting. During a deferral period, deferred qualifying incentive-based
compensation may not vest faster than on a pro rata annual basis
beginning no earlier than the first anniversary of the end of the
performance period for which the amounts were awarded.
(B) Acceleration of vesting. A Level 1 or Level 2 covered
institution must not accelerate the vesting of a covered person's
deferred qualifying incentive-based compensation that is required to be
deferred under this part, except in the case of death or disability of
such covered person.
(2) Incentive-based compensation awarded under a long-term
incentive plan must be deferred as follows:
(i) Minimum required deferral amount. (A) A Level 1 covered
institution must defer at least 60 percent of a senior executive
officer's incentive-based compensation awarded under a long-term
incentive plan for each performance period.
(B) A Level 1 covered institution must defer at least 50 percent of
a significant risk-taker's incentive-based compensation awarded under a
long-term incentive plan for each performance period.
(C) A Level 2 covered institution must defer at least 50 percent of
a senior executive officer's incentive-based compensation awarded under
a long-term incentive plan for each performance period.
(D) A Level 2 covered institution must defer at least 40 percent of
a significant risk-taker's incentive-based compensation awarded under a
long-term incentive plan for each performance period.
(ii) Minimum required deferral period. (A) For a senior executive
officer or significant risk-taker of a Level 1 covered institution, the
deferral period for deferred long-term incentive plan amounts must be
at least 2 years.
(B) For a senior executive officer or significant risk-taker of a
Level 2 covered institution, the deferral period for deferred long-term
incentive plan amounts must be at least 1 year.
(iii) Vesting of amounts during deferral period--(A) Pro rata
vesting. During a deferral period, deferred long-term incentive plan
amounts may not vest faster than on a pro rata annual basis beginning
no earlier than the first anniversary of the end of the performance
period for which the amounts were awarded.
(B) Acceleration of vesting. A Level 1 or Level 2 covered
institution must not accelerate the vesting of a covered person's
deferred long-term incentive plan amounts that is required to be
deferred under this part, except in the case of death or disability of
such covered person.

[[Page 37818]]

(3) Adjustments of deferred qualifying incentive-based compensation
and deferred long-term incentive plan compensation amounts. A Level 1
or Level 2 covered institution may not increase deferred qualifying
incentive-based compensation or deferred long-term incentive plan
amounts for a senior executive officer or significant risk-taker during
the deferral period. For purposes of this paragraph, an increase in
value attributable solely to a change in share value, a change in
interest rates, or the payment of interest according to terms set out
at the time of the award is not considered an increase in incentive-
based compensation amounts.
(4) Composition of deferred qualifying incentive-based compensation
and deferred long-term incentive plan compensation for Level 1 and
Level 2 covered institutions--(i) Cash and equity-like instruments. For
a senior executive officer or significant risk-taker of a Level 1 or
Level 2 covered institution that issues equity or is an affiliate of a
covered institution that issues equity, any deferred qualifying
incentive-based compensation or deferred long-term incentive plan
amounts must include substantial portions of both deferred cash and
equity-like instruments throughout the deferral period.
(ii) Options. If a senior executive officer or significant risk-
taker of a Level 1 or Level 2 covered institution receives incentive-
based compensation for a performance period in the form of options, the
total amount of such options that may be used to meet the minimum
deferral amount requirements of paragraph (a)(1)(i) or (a)(2)(i) of
this section is limited to no more than 15 percent of the amount of
total incentive-based compensation awarded to the senior executive
officer or significant risk-taker for that performance period.
(b) Forfeiture and downward adjustment--(1) Compensation at risk.
(i) A Level 1 or Level 2 covered institution must place at risk of
forfeiture all unvested deferred incentive-based compensation of any
senior executive officer or significant risk-taker, including unvested
deferred amounts awarded under long-term incentive plans.
(ii) A Level 1 or Level 2 covered institution must place at risk of
downward adjustment all of a senior executive officer's or significant
risk-taker's incentive-based compensation amounts not yet awarded for
the current performance period, including amounts payable under long-
term incentive plans.
(2) Events triggering forfeiture and downward adjustment review. At
a minimum, a Level 1 or Level 2 covered institution must consider
forfeiture and downward adjustment of incentive-based compensation of
senior executive officers and significant risk-takers described in
paragraph (b)(3) of this section due to any of the following adverse
outcomes at the covered institution:
(i) Poor financial performance attributable to a significant
deviation from the risk parameters set forth in the covered
institution's policies and procedures;
(ii) Inappropriate risk taking, regardless of the impact on
financial performance;
(iii) Material risk management or control failures;
(iv) Non-compliance with statutory, regulatory, or supervisory
standards that results in:
(A) Enforcement or legal action against the covered institution
brought by a federal or state regulator or agency; or
(B) A requirement that the covered institution report a restatement
of a financial statement to correct a material error; and
(v) Other aspects of conduct or poor performance as defined by the
covered institution.
(3) Senior executive officers and significant risk-takers affected
by forfeiture and downward adjustment. A Level 1 or Level 2 covered
institution must consider forfeiture and downward adjustment for a
senior executive officer or significant risk-taker with direct
responsibility, or responsibility due to the senior executive officer's
or significant risk-taker's role or position in the covered
institution's organizational structure, for the events related to the
forfeiture and downward adjustment review set forth in paragraph (b)(2)
of this section.
(4) Determining forfeiture and downward adjustment amounts. A Level
1 or Level 2 covered institution must consider, at a minimum, the
following factors when determining the amount or portion of a senior
executive officer's or significant risk-taker's incentive-based
compensation that should be forfeited or adjusted downward:
(i) The intent of the senior executive officer or significant risk-
taker to operate outside the risk governance framework approved by the
covered institution's board of directors or to depart from the covered
institution's policies and procedures;
(ii) The senior executive officer's or significant risk-taker's
level of participation in, awareness of, and responsibility for, the
events triggering the forfeiture and downward adjustment review set
forth in paragraph (b)(2) of this section;
(iii) Any actions the senior executive officer or significant risk-
taker took or could have taken to prevent the events triggering the
forfeiture and downward adjustment review set forth in paragraph (b)(2)
of this section;
(iv) The financial and reputational impact of the events triggering
the forfeiture and downward adjustment review set forth in paragraph
(b)(2) of this section to the covered institution, the line or sub-line
of business, and individuals involved, as applicable, including the
magnitude of any financial loss and the cost of known or potential
subsequent fines, settlements, and litigation;
(v) The causes of the events triggering the forfeiture and downward
adjustment review set forth in paragraph (b)(2) of this section,
including any decision-making by other individuals; and
(vi) Any other relevant information, including past behavior and
past risk outcomes attributable to the senior executive officer or
significant risk-taker.
(c) Clawback. A Level 1 or Level 2 covered institution must include
clawback provisions in incentive-based compensation arrangements for
senior executive officers and significant risk-takers that, at a
minimum, allow the covered institution to recover incentive-based
compensation from a current or former senior executive officer or
significant risk-taker for seven years following the date on which such
compensation vests, if the covered institution determines that the
senior executive officer or significant risk-taker engaged in:
(1) Misconduct that resulted in significant financial or
reputational harm to the covered institution;
(2) Fraud; or
(3) Intentional misrepresentation of information used to determine
the senior executive officer or significant risk-taker's incentive-
based compensation.

Sec. 372.8 Additional prohibitions for Level 1 and Level 2 covered
institutions.

[[Page 37819]]

in the value of the covered person's incentive-based compensation.
(b) Maximum incentive-based compensation opportunity. A Level 1 or
Level 2 covered institution must not award incentive-based compensation
to:
(1) A senior executive officer in excess of 125 percent of the
target amount for that incentive-based compensation; or
(2) A significant risk-taker in excess of 150 percent of the target
amount for that incentive-based compensation.
(c) Relative performance measures. A Level 1 or Level 2 covered
institution must not use incentive-based compensation performance
measures that are based solely on industry peer performance
comparisons.
(d) Volume driven incentive-based compensation. A Level 1 or Level
2 covered institution must not provide incentive-based compensation to
a covered person that is based solely on transaction revenue or volume
without regard to transaction quality or compliance of the covered
person with sound risk management.

Sec. 372.9 Risk management and controls requirements for Level 1 and
Level 2 covered institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will be considered to be compatible with effective
risk management and controls for purposes of Sec. 372.4(c)(2) only if
such institution meets the following requirements.
(a) A Level 1 or Level 2 covered institution must have a risk
management framework for its incentive-based compensation program that:
(1) Is independent of any lines of business;
(2) Includes an independent compliance program that provides for
internal controls, testing, monitoring, and training with written
policies and procedures consistent with Sec. 372.11; and
(3) Is commensurate with the size and complexity of the covered
institution's operations.
(b) A Level 1 or Level 2 covered institution must:
(1) Provide individuals engaged in control functions with the
authority to influence the risk-taking of the business areas they
monitor; and
(2) Ensure that covered persons engaged in control functions are
compensated in accordance with the achievement of performance
objectives linked to their control functions and independent of the
performance of those business areas.
(c) A Level 1 or Level 2 covered institution must provide for the
independent monitoring of:
(1) All incentive-based compensation plans in order to identify
whether those plans provide incentives that appropriately balance risk
and reward;
(2) Events related to forfeiture and downward adjustment reviews
and decisions of forfeiture and downward adjustment reviews in order to
determine consistency with Sec. 372.7(b); and
(3) Compliance of the incentive-based compensation program with the
covered institution's policies and procedures.

Sec. 372.10 Governance requirements for Level 1 and Level 2 covered
institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will not be considered to be supported by effective
governance for purposes of Sec. 372.4(c)(3), unless:
(a) The covered institution establishes a compensation committee
composed solely of directors who are not senior executive officers to
assist the board of directors in carrying out its responsibilities
under Sec. 372.4(e); and
(b) The compensation committee established pursuant to paragraph
(a) of this section obtains:
(1) Input from the risk and audit committees of the covered
institution's board of directors, or groups performing similar
functions, and risk management function on the effectiveness of risk
measures and adjustments used to balance risk and reward in incentive-
based compensation arrangements;
(2) A written assessment of the effectiveness of the covered
institution's incentive-based compensation program and related
compliance and control processes in providing risk-taking incentives
that are consistent with the risk profile of the covered institution,
submitted on an annual or more frequent basis by the management of the
covered institution and developed with input from the risk and audit
committees of its board of directors, or groups performing similar
functions, and from the covered institution's risk management and audit
functions; and
(3) An independent written assessment of the effectiveness of the
covered institution's incentive-based compensation program and related
compliance and control processes in providing risk-taking incentives
that are consistent with the risk profile of the covered institution,
submitted on an annual or more frequent basis by the internal audit or
risk management function of the covered institution, developed
independently of the covered institution's management.

Sec. 372.11 Policies and procedures requirements for Level 1 and
Level 2 covered institutions.

A Level 1 or Level 2 covered institution must develop and implement
policies and procedures for its incentive-based compensation program
that, at a minimum:
(a) Are consistent with the prohibitions and requirements of this
part;
(b) Specify the substantive and procedural criteria for the
application of forfeiture and clawback, including the process for
determining the amount of incentive-based compensation to be clawed
back;
(c) Require that the covered institution maintain documentation of
final forfeiture, downward adjustment, and clawback decisions;
(d) Specify the substantive and procedural criteria for the
acceleration of payments of deferred incentive-based compensation to a
covered person, consistent with Sec. 372.7(a)(1)(iii)(B) and
(a)(2)(iii)(B));
(e) Identify and describe the role of any employees, committees, or
groups authorized to make incentive-based compensation decisions,
including when discretion is authorized;
(f) Describe how discretion is expected to be exercised to
appropriately balance risk and reward;
(g) Require that the covered institution maintain documentation of
the establishment, implementation, modification, and monitoring of
incentive-based compensation arrangements, sufficient to support the
covered institution's decisions;
(h) Describe how incentive-based compensation arrangements will be
monitored;
(i) Specify the substantive and procedural requirements of the
independent compliance program consistent with Sec. 372.9(a)(2); and
(j) Ensure appropriate roles for risk management, risk oversight,
and other control function personnel in the covered institution's
processes for:
(1) Designing incentive-based compensation arrangements and
determining awards, deferral amounts, deferral periods, forfeiture,
downward adjustment, clawback, and vesting; and
(2) Assessing the effectiveness of incentive-based compensation
arrangements in restraining inappropriate risk-taking.

Sec. 372.12 Indirect actions.

A covered institution must not indirectly, or through or by any
other

[[Page 37820]]

person, do anything that would be unlawful for such covered institution
to do directly under this part.

Sec. 372.13 Enforcement.

National Credit Union Administration

12 CFR Chapter VII

Authority and Issuance

For the reasons stated in the joint preamble, the National Credit
Union Administration proposes to amend chapter VII of title 12 of the
Code of Federal Regulations as follows:

PART 741--REQUIREMENTS FOR INSURANCE

0
4. The authority citation for part 741 continues to read as follows:

Authority: 12 U.S.C. 1757, 1766, 1781-1790, and 1790d; 31
U.S.C. 3717.

0
5. Add Sec. 741.226 to read as follows:

Sec. 741.226 Incentive-based compensation arrangements.

Any credit union which is insured pursuant to Title II of the Act
must adhere to the requirements stated in part 751 of this chapter.
0
6. Add part 751 to subchapter A to read as follows.

PART 751--INCENTIVE-BASED COMPENSATION ARRANGEMENTS

Sec.
751.1 Authority, scope, and initial applicability.
751.2 Definitions.
751.3 Applicability.
751.4 Requirements and prohibitions applicable to all credit unions
subject to this part.
751.5 Additional disclosure and recordkeeping requirements for Level
1 and Level 2 credit unions.
751.6 Reservation of authority for Level 3 credit unions.
751.7 Deferral, forfeiture and downward adjustment, and clawback
requirements for Level 1 and Level 2 credit unions.
751.8 Additional prohibitions for Level 1 and Level 2 credit unions.
751.9 Risk management and controls requirements for Level 1 and
Level 2 credit unions.
751.10 Governance requirements for Level 1 and Level 2 credit
unions.
751.11 Policies and procedures requirements for Level 1 and Level 2
credit unions.
751.12 Indirect actions.
751.13 Enforcement.
751.14 Credit unions in conservatorship or liquidation.

Authority: 12 U.S.C. 1751 et seq. and 5641.

Sec. 751.1 Authority, scope, and initial applicability.

(a) Authority. This part is issued pursuant to section 956 of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (12 U.S.C.
5641) and the Federal Credit Union Act (12 U.S.C. 1751 et seq.)
(b) Scope. This part applies to any federally insured credit union,
or any credit union eligible to make application to become an insured
credit union under 12 U.S.C. 1781, with average total consolidated
assets greater than or equal to $1 billion that offers incentive-based
compensation to covered persons.
(c) Initial applicability--(1) Compliance date. A credit union must
meet the requirements of this part no later than [Date of the beginning
of the first calendar quarter that begins at least 540 days after a
final rule is published in the Federal Register]. Whether a credit
union is a Level 1, Level 2, or Level 3 credit union at that time will
be determined based on average total consolidated assets as of [Date of
the beginning of the first calendar quarter that begins after a final
rule is published in the Federal Register].
(2) Grandfathered plans. A credit union is not required to comply
with the requirements of this part with respect to any incentive-based
compensation plan with a performance period that begins before
[Compliance Date as described in paragraph (c)(1) of this section].
(d) Preservation of authority. Nothing in this part in any way
limits the authority of NCUA under other provisions of applicable law
and regulations.

Sec. 751.2 Definitions.

For purposes of this part only, the following definitions apply
unless otherwise specified:
(a) [Reserved].
(b) Average total consolidated assets means the average of a credit
union's total consolidated assets, as reported on the credit union's
regulatory reports, for the four most recent consecutive quarters. If a
credit union has not filed a regulatory report for each of the four
most recent consecutive quarters, the credit union's average total
consolidated assets means the average of its total consolidated assets,
as reported on its regulatory reports, for the most recent quarter or
consecutive quarters, as applicable. Average total consolidated assets
are measured on the as-of date of the most recent regulatory report
used in the calculation of the average.
(c) To award incentive-based compensation means to make a final
determination, conveyed to a covered person, of the amount of
incentive-based compensation payable to the covered person for
performance over a performance period.
(d) Board of directors means the governing body of a credit union
that oversees the activities of the credit union.
(e) Clawback means a mechanism by which a credit union can recover
vested incentive-based compensation from a covered person.
(f) Compensation, fees, or benefits means all direct and indirect
payments, both cash and non-cash, awarded to, granted to, or earned by
or for the benefit of, any covered person in exchange for services
rendered to a credit union.
(g) [Reserved].
(h) Control function means a compliance, risk management, internal
audit, legal, human resources, accounting, financial reporting, or
finance role responsible for identifying, measuring, monitoring, or
controlling risk-taking.
(i) [Reserved].
(j) Covered person means any executive officer, employee, or
director who receives incentive-based compensation at a credit union.
(k) Deferral means the delay of vesting of incentive-based
compensation beyond the date on which the incentive-based compensation
is awarded.
(l) Deferral period means the period of time between the date a
performance period ends and the last date on which the incentive-based
compensation awarded for such performance period vests.
(m) [Reserved].
(n) Director of a credit union means a member of the board of
directors.
(o) Downward adjustment means a reduction of the amount of a
covered person's incentive-based compensation not yet awarded for any
performance period that has already begun, including amounts payable
under long-term incentive plans, in accordance with a forfeiture and
downward adjustment review under Sec. 751.7(b).
(p) [Reserved].
(q) Forfeiture means a reduction of the amount of deferred
incentive-based compensation awarded to a covered person that has not
vested.
(r) Incentive-based compensation means any variable compensation,
fees, or benefits that serve as an incentive or reward for performance.
(s) Incentive-based compensation arrangement means an agreement
between a credit union and a covered

[[Page 37821]]

person, under which the credit union provides incentive-based
compensation to the covered person, including incentive-based
compensation delivered through one or more incentive-based compensation
plans.
(t) Incentive-based compensation plan means a document setting
forth terms and conditions governing the opportunity for and the
payment of incentive-based compensation payments to one or more covered
persons.
(u) Incentive-based compensation program means a credit union's
framework for incentive-based compensation that governs incentive-based
compensation practices and establishes related controls.
(v) Level 1 credit union means a credit union with average total
consolidated assets greater than or equal to $250 billion.
(w) Level 2 credit union means a credit union with average total
consolidated assets greater than or equal to $50 billion that is not a
Level 1 credit union.
(x) Level 3 credit union means a credit union with average total
consolidated assets greater than or equal to $1 billion that is not a
Level 1 credit union or Level 2 credit union.
(y) Long-term incentive plan means a plan to provide incentive-
based compensation that is based on a performance period of at least
three years.
(z) [Reserved].
(aa) Performance period means the period during which the
performance of a covered person is assessed for purposes of determining
incentive-based compensation.
(bb) [Reserved].
(cc) Qualifying incentive-based compensation means the amount of
incentive-based compensation awarded to a covered person for a
particular performance period, excluding amounts awarded to the covered
person for that particular performance period under a long-term
incentive plan.
(dd) [Reserved].
(ee) Regulatory report means NCUA form 5300 or 5310 call report.
(ff) [Reserved].
(gg) Senior executive officer means a covered person who holds the
title or, without regard to title, salary, or compensation, performs
the function of one or more of the following positions at a credit
union for any period of time in the relevant performance period:
President, chief executive officer, executive chairman, chief operating
officer, chief financial officer, chief investment officer, chief legal
officer, chief lending officer, chief risk officer, chief compliance
officer, chief audit executive, chief credit officer, chief accounting
officer, or head of a major business line or control function.
(hh) Significant risk-taker means:
(1) Any covered person at a Level 1 or Level 2 credit union, other
than a senior executive officer, who received annual base salary and
incentive-based compensation for the last calendar year that ended at
least 180 days before the beginning of the performance period of which
at least one-third is incentive-based compensation and is--
(i) A covered person of a Level 1 credit union who received annual
base salary and incentive-based compensation for the last calendar year
that ended at least 180 days before the beginning of the performance
period that placed the covered person among the highest 5 percent in
annual base salary and incentive-based compensation among all covered
persons (excluding senior executive officers) of the Level 1 credit
union;
(ii) A covered person of a Level 2 credit union who received annual
base salary and incentive-based compensation for the last calendar year
that ended at least 180 days before the beginning of the performance
period that placed the covered person among the highest 2 percent in
annual base salary and incentive-based compensation among all covered
persons (excluding senior executive officers) of the Level 2 credit
union; or
(iii) A covered person of a credit union who may commit or expose
0.5 percent or more of the net worth or total capital of the credit
union; and
(2) Any covered person at a Level 1 or Level 2 credit union, other
than a senior executive officer, who is designated as a ``significant
risk-taker'' by NCUA because of that person's ability to expose a
credit union to risks that could lead to material financial loss in
relation to the credit union's size, capital, or overall risk
tolerance, in accordance with procedures established by NCUA, or by the
credit union.
(3) [Reserved]
(4) If NCUA determines, in accordance with procedures established
by NCUA, that a Level 1 credit union's activities, complexity of
operations, risk profile, and compensation practices are similar to
those of a Level 2 credit union, the Level 1 credit union may apply
paragraph (hh)(1)(i) of this section to covered persons of the Level 1
credit union by substituting ``2 percent'' for ``5 percent''.
(ii) [Reserved]
(jj) Vesting of incentive-based compensation means the transfer of
ownership of the incentive-based compensation to the covered person to
whom the incentive-based compensation was awarded, such that the
covered person's right to the incentive-based compensation is no longer
contingent on the occurrence of any event.

751.3 Applicability.

(a) When average total consolidated assets increase--(1) In
general. A credit union shall become a Level 1, Level 2, or Level 3
credit union when its average total consolidated assets increase to an
amount that equals or exceeds $250 billion, $50 billion, or $1 billion,
respectively.
(2) Compliance date. A credit union that becomes a Level 1, Level
2, or Level 3 credit union pursuant to paragraph (a)(1) of this section
shall comply with the requirements of this part for a Level 1, Level 2,
or Level 3 credit union, respectively, not later than the first day of
the first calendar quarter that begins at least 540 days after the date
on which the credit union becomes a Level 1, Level 2, or Level 3 credit
union, respectively. Until that day, the Level 1, Level 2, or Level 3
credit union will remain subject to the requirements of this part, if
any, that applied to the credit union on the day before the date on
which it became a Level 1, Level 2, or Level 3 credit union.
(3) Grandfathered plans. A credit union that becomes a Level 1,
Level 2, or Level 3 credit union under paragraph (a)(1) of this section
is not required to comply with requirements of this part applicable to
a Level 1, Level 2, or Level 3 credit union, respectively, with respect
to any incentive-based compensation plan with a performance period that
begins before the date described in paragraph (a)(2) of this section.
(b) When total consolidated assets decrease. A Level 1, Level 2, or
Level 3 credit union will remain subject to the requirements applicable
to such credit union under this part unless and until the total
consolidated assets of the credit union, as reported on the credit
union's regulatory reports, fall below $250 billion, $50 billion, or $1
billion, respectively, for each of four consecutive quarters. The
calculation will be effective on the as-of date of the fourth
consecutive regulatory report.

751.4 Requirements and prohibitions applicable to all credit unions
subject to this part.

(a) In general. A credit union must not establish or maintain any
type of incentive-based compensation arrangement, or any feature of any
such arrangement, that encourages inappropriate risks by the credit
union:

[[Page 37822]]

(1) By providing a covered person with excessive compensation,
fees, or benefits; or
(2) That could lead to material financial loss to the credit union.
(b) Excessive compensation. Compensation, fees, and benefits are
considered excessive for purposes of paragraph (a)(1) of this section
when amounts paid are unreasonable or disproportionate to the value of
the services performed by a covered person, taking into consideration
all relevant factors, including, but not limited to:
(1) The combined value of all compensation, fees, or benefits
provided to the covered person;
(2) The compensation history of the covered person and other
individuals with comparable expertise at the credit union;
(3) The financial condition of the credit union;
(4) Compensation practices at comparable credit unions, based upon
such factors as asset size, geographic location, and the complexity of
the credit union's operations and assets;
(5) For post-employment benefits, the projected total cost and
benefit to the credit union; and
(6) Any connection between the covered person and any fraudulent
act or omission, breach of trust or fiduciary duty, or insider abuse
with regard to the credit union.
(c) Material financial loss. An incentive-based compensation
arrangement at a credit union encourages inappropriate risks that could
lead to material financial loss to the credit union, unless the
arrangement:
(1) Appropriately balances risk and reward;
(2) Is compatible with effective risk management and controls; and
(3) Is supported by effective governance.
(d) Performance measures. An incentive-based compensation
arrangement will not be considered to appropriately balance risk and
reward for purposes of paragraph (c)(1) of this section unless:
(1) The arrangement includes financial and non-financial measures
of performance, including considerations of risk-taking, that are
relevant to a covered person's role within a credit union and to the
type of business in which the covered person is engaged and that are
appropriately weighted to reflect risk-taking;
(2) The arrangement is designed to allow non-financial measures of
performance to override financial measures of performance when
appropriate in determining incentive-based compensation; and
(3) Any amounts to be awarded under the arrangement are subject to
adjustment to reflect actual losses, inappropriate risks taken,
compliance deficiencies, or other measures or aspects of financial and
non-financial performance.
(e) Board of directors. A credit union's board of directors, or a
committee thereof, must:
(1) Conduct oversight of the credit union's incentive-based
compensation program;
(2) Approve incentive-based compensation arrangements for senior
executive officers, including the amounts of all awards and, at the
time of vesting, payouts under such arrangements; and
(3) Approve any material exceptions or adjustments to incentive-
based compensation policies or arrangements for senior executive
officers.
(f) Disclosure and recordkeeping requirements. A credit union must
create annually and maintain for a period of at least seven years
records that document the structure of all its incentive-based
compensation arrangements and demonstrate compliance with this part. A
credit union must disclose the records to NCUA upon request. At a
minimum, the records must include copies of all incentive-based
compensation plans, a record of who is subject to each plan, and a
description of how the incentive-based compensation program is
compatible with effective risk management and controls.
(g) Rule of construction. A credit union is not required to report
the actual amount of compensation, fees, or benefits of individual
covered persons as part of the disclosure and recordkeeping
requirements under this part.

Sec. 751.5 Additional disclosure and recordkeeping requirements for
Level 1 and Level 2 credit unions.

(a) A Level 1 or Level 2 credit union must create annually and
maintain for a period of at least seven years records that document:
(1) The credit union's senior executive officers and significant
risk-takers, listed by legal entity, job function, organizational
hierarchy, and line of business;
(2) The incentive-based compensation arrangements for senior
executive officers and significant risk-takers, including information
on percentage of incentive-based compensation deferred and form of
award;
(3) Any forfeiture and downward adjustment or clawback reviews and
decisions for senior executive officers and significant risk-takers;
and
(4) Any material changes to the credit union's incentive-based
compensation arrangements and policies.
(b) A Level 1 or Level 2 credit union must create and maintain
records in a manner that allows for an independent audit of incentive-
based compensation arrangements, policies, and procedures, including,
those required under Sec. 751.11.
(c) A Level 1 or Level 2 credit union must provide the records
described in paragraph (a) of this section to NCUA in such form and
with such frequency as requested by NCUA.

Sec. 751.6 Reservation of authority for Level 3 credit unions.

(a) In general. NCUA may require a Level 3 credit union with
average total consolidated assets greater than or equal to $10 billion
and less than $50 billion to comply with some or all of the provisions
of Sec. Sec. 751.5 and 751.7 through 751.11 if NCUA determines that
the Level 3 credit union's complexity of operations or compensation
practices are consistent with those of a Level 1 or Level 2 credit
union.
(b) Factors considered. Any exercise of authority under this
section will be in writing by the NCUA Board in accordance with
procedures established by the NCUA Board and will consider the
activities, complexity of operations, risk profile, and compensation
practices of the Level 3 credit union, in addition to any other
relevant factors.

Sec. 751.7 Deferral, forfeiture and downward adjustment, and clawback
requirements for Level 1 and Level 2 credit unions.

An incentive-based compensation arrangement at a Level 1 or Level 2
credit union will not be considered to appropriately balance risk and
reward, for purposes of Sec. 751.4(c)(1), unless the following
requirements are met.
(a) Deferral. (1) Qualifying incentive-based compensation must be
deferred as follows:
(i) Minimum required deferral amount. (A) A Level 1 credit union
must defer at least 60 percent of a senior executive officer's
qualifying incentive-based compensation awarded for each performance
period.
(B) A Level 1 credit union must defer at least 50 percent of a
significant risk-taker's qualifying incentive-based compensation
awarded for each performance period.
(C) A Level 2 credit union must defer at least 50 percent of a
senior executive officer's qualifying incentive-based compensation
awarded for each performance period.

[[Page 37823]]

(D) A Level 2 credit union must defer at least 40 percent of a
significant risk-taker's qualifying incentive-based compensation
awarded for each performance period.
(ii) Minimum required deferral period. (A) For a senior executive
officer or significant risk-taker of a Level 1 credit union, the
deferral period for deferred qualifying incentive-based compensation
must be at least 4 years.
(B) For a senior executive officer or significant risk-taker of a
Level 2 credit union, the deferral period for deferred qualifying
incentive-based compensation must be at least 3 years.
(iii) Vesting of amounts during deferral period--(A) Pro rata
vesting. During a deferral period, deferred qualifying incentive-based
compensation may not vest faster than on a pro rata annual basis
beginning no earlier than the first anniversary of the end of the
performance period for which the amounts were awarded.
(B) Acceleration of vesting. A Level 1 or Level 2 credit union must
not accelerate the vesting of a covered person's deferred qualifying
incentive-based compensation that is required to be deferred under this
part, except in the case of:
(1) Death or disability of such covered person; or
(2) The payment of income taxes that become due on deferred amounts
before the covered person is vested in the deferred amount. For
purposes of this paragraph, any accelerated vesting must be deducted
from the scheduled deferred amounts proportionally to the deferral
schedule.
(2) Incentive-based compensation awarded under a long-term
incentive plan must be deferred as follows:
(i) Minimum required deferral amount. (A) A Level 1 credit union
must defer at least 60 percent of a senior executive officer's
incentive-based compensation awarded under a long-term incentive plan
for each performance period.
(B) A Level 1 credit union must defer at least 50 percent of a
significant risk-taker's incentive-based compensation awarded under a
long-term incentive plan for each performance period.
(C) A Level 2 credit union must defer at least 50 percent of a
senior executive officer's incentive-based compensation awarded under a
long-term incentive plan for each performance period.
(D) A Level 2 credit union must defer at least 40 percent of a
significant risk-taker's incentive-based compensation awarded under a
long-term incentive plan for each performance period.
(ii) Minimum required deferral period. (A) For a senior executive
officer or significant risk-taker of a Level 1 credit union, the
deferral period for deferred long-term incentive plan amounts must be
at least 2 years.
(B) For a senior executive officer or significant risk-taker of a
Level 2 credit union, the deferral period for deferred long-term
incentive plan amounts must be at least 1 year.
(iii) Vesting of amounts during deferral period--(A) Pro rata
vesting. During a deferral period, deferred long-term incentive plan
amounts may not vest faster than on a pro rata annual basis beginning
no earlier than the first anniversary of the end of the performance
period for which the amounts were awarded.
(B) Acceleration of vesting. A Level 1 or Level 2 credit union must
not accelerate the vesting of a covered person's deferred long-term
incentive plan amounts that is required to be deferred under this part,
except in the case of:
(1) Death or disability of such covered person; or
(2) The payment of income taxes that become due on deferred amounts
before the covered person is vested in the deferred amount. For
purposes of this paragraph, any accelerated vesting must be deducted
from the scheduled deferred amounts proportionally to the deferral
schedule.
(3) Adjustments of deferred qualifying incentive-based compensation
and deferred long-term incentive plan compensation amounts. A Level 1
or Level 2 credit union may not increase deferred qualifying incentive-
based compensation or deferred long-term incentive plan amounts for a
senior executive officer or significant risk-taker during the deferral
period. For purposes of this paragraph, an increase in value
attributable solely to a change in share value, a change in interest
rates, or the payment of interest according to terms set out at the
time of the award is not considered an increase in incentive-based
compensation amounts.
(4) [Reserved].
(b) Forfeiture and downward adjustment--(1) Compensation at risk.
(i) A Level 1 or Level 2 credit union must place at risk of forfeiture
all unvested deferred incentive-based compensation of any senior
executive officer or significant risk-taker, including unvested
deferred amounts awarded under long-term incentive plans.
(ii) A Level 1 or Level 2 credit union must place at risk of
downward adjustment all of a senior executive officer's or significant
risk-taker's incentive-based compensation amounts not yet awarded for
the current performance period, including amounts payable under long-
term incentive plans.
(2) Events triggering forfeiture and downward adjustment review. At
a minimum, a Level 1 or Level 2 credit union must consider forfeiture
and downward adjustment of incentive-based compensation of senior
executive officers and significant risk-takers described in paragraph
(b)(3) of this section due to any of the following adverse outcomes at
the credit union:
(i) Poor financial performance attributable to a significant
deviation from the risk parameters set forth in the credit union's
policies and procedures;
(ii) Inappropriate risk taking, regardless of the impact on
financial performance;
(iii) Material risk management or control failures;
(iv) Non-compliance with statutory, regulatory, or supervisory
standards that results in:
(A) Enforcement or legal action against the credit union brought by
a federal or state regulator or agency; or
(B) A requirement that the credit union report a restatement of a
financial statement to correct a material error; and
(v) Other aspects of conduct or poor performance as defined by the
credit union.
(3) Senior executive officers and significant risk-takers affected
by forfeiture and downward adjustment. A Level 1 or Level 2 credit
union must consider forfeiture and downward adjustment for a senior
executive officer or significant risk-taker with direct responsibility,
or responsibility due to the senior executive officer's or significant
risk-taker's role or position in the credit union's organizational
structure, for the events related to the forfeiture and downward
adjustment review set forth in paragraph (b)(2) of this section.
(4) Determining forfeiture and downward adjustment amounts. A Level
1 or Level 2 credit union must consider, at a minimum, the following
factors when determining the amount or portion of a senior executive
officer's or significant risk-taker's incentive-based compensation that
should be forfeited or adjusted downward:
(i) The intent of the senior executive officer or significant risk-
taker to operate outside the risk governance framework approved by the
credit union's board of directors or to depart from the credit union's
policies and procedures;
(ii) The senior executive officer's or significant risk-taker's
level of participation in, awareness of, and responsibility for, the
events triggering

[[Page 37824]]

the forfeiture and downward adjustment review set forth in paragraph
(b)(2) of this section;
(iii) Any actions the senior executive officer or significant risk-
taker took or could have taken to prevent the events triggering the
forfeiture and downward adjustment review set forth in paragraph (b)(2)
of this section;
(iv) The financial and reputational impact of the events triggering
the forfeiture and downward adjustment review set forth in paragraph
(b)(2) of this section to the credit union, the line or sub-line of
business, and individuals involved, as applicable, including the
magnitude of any financial loss and the cost of known or potential
subsequent fines, settlements, and litigation;
(v) The causes of the events triggering the forfeiture and downward
adjustment review set forth in paragraph (b)(2) of this section,
including any decision-making by other individuals; and
(vi) Any other relevant information, including past behavior and
past risk outcomes attributable to the senior executive officer or
significant risk-taker.
(c) Clawback. A Level 1 or Level 2 credit union must include
clawback provisions in incentive-based compensation arrangements for
senior executive officers and significant risk-takers that, at a
minimum, allow the credit union to recover incentive-based compensation
from a current or former senior executive officer or significant risk-
taker for seven years following the date on which such compensation
vests, if the credit union determines that the senior executive officer
or significant risk-taker engaged in:
(1) Misconduct that resulted in significant financial or
reputational harm to the credit union;
(2) Fraud; or
(3) Intentional misrepresentation of information used to determine
the senior executive officer or significant risk-taker's incentive-
based compensation.

Sec. 751.8 Additional prohibitions for Level 1 and Level 2 credit
unions.

An incentive-based compensation arrangement at a Level 1 or Level 2
credit union will be considered to provide incentives that
appropriately balance risk and reward for purposes of Sec. 751.4(c)(1)
only if such credit union complies with the following prohibitions.
(a) Hedging. A Level 1 or Level 2 credit union must not purchase a
hedging instrument or similar instrument on behalf of a covered person
to hedge or offset any decrease in the value of the covered person's
incentive-based compensation.
(b) Maximum incentive-based compensation opportunity. A Level 1 or
Level 2 credit union must not award incentive-based compensation to:
(1) A senior executive officer in excess of 125 percent of the
target amount for that incentive-based compensation; or
(2) A significant risk-taker in excess of 150 percent of the target
amount for that incentive-based compensation.
(c) Relative performance measures. A Level 1 or Level 2 credit
union must not use incentive-based compensation performance measures
that are based solely on industry peer performance comparisons.
(d) Volume driven incentive-based compensation. A Level 1 or Level
2 credit union must not provide incentive-based compensation to a
covered person that is based solely on transaction revenue or volume
without regard to transaction quality or compliance of the covered
person with sound risk management.

Sec. 751.9 Risk management and controls requirements for Level 1 and
Level 2 credit unions.

An incentive-based compensation arrangement at a Level 1 or Level 2
credit union will be considered to be compatible with effective risk
management and controls for purposes of Sec. 751.4(c)(2) only if such
credit union meets the following requirements.
(a) A Level 1 or Level 2 credit union must have a risk management
framework for its incentive-based compensation program that:
(1) Is independent of any lines of business;
(2) Includes an independent compliance program that provides for
internal controls, testing, monitoring, and training with written
policies and procedures consistent with Sec. 751.11; and
(3) Is commensurate with the size and complexity of the credit
union's operations.
(b) A Level 1 or Level 2 credit union must:
(1) Provide individuals engaged in control functions with the
authority to influence the risk-taking of the business areas they
monitor; and
(2) Ensure that covered persons engaged in control functions are
compensated in accordance with the achievement of performance
objectives linked to their control functions and independent of the
performance of those business areas.
(c) A Level 1 or Level 2 credit union must provide for the
independent monitoring of:
(1) All incentive-based compensation plans in order to identify
whether those plans provide incentives that appropriately balance risk
and reward;
(2) Events related to forfeiture and downward adjustment reviews
and decisions of forfeiture and downward adjustment reviews in order to
determine consistency with Sec. 751.7(b); and
(3) Compliance of the incentive-based compensation program with the
credit union's policies and procedures.

Sec. 751.10 Governance requirements for Level 1 and Level 2 credit
unions.

An incentive-based compensation arrangement at a Level 1 or Level 2
credit union will not be considered to be supported by effective
governance for purposes of Sec. 751.4(c)(3), unless:
(a) The credit union establishes a compensation committee composed
solely of directors who are not senior executive officers to assist the
board of directors in carrying out its responsibilities under Sec.
751.4(e); and
(b) The compensation committee established pursuant to paragraph
(a) of this section obtains:
(1) Input from the risk and audit committees of the credit union's
board of directors, or groups performing similar functions, and risk
management function on the effectiveness of risk measures and
adjustments used to balance risk and reward in incentive-based
compensation arrangements;
(2) A written assessment of the effectiveness of the credit union's
incentive-based compensation program and related compliance and control
processes in providing risk-taking incentives that are consistent with
the risk profile of the credit union, submitted on an annual or more
frequent basis by the management of the credit union and developed with
input from the risk and audit committees of its board of directors, or
groups performing similar functions, and from the credit union's risk
management and audit functions; and
(3) An independent written assessment of the effectiveness of the
credit union's incentive-based compensation program and related
compliance and control processes in providing risk-taking incentives
that are consistent with the risk profile of the credit union,
submitted on an annual or more frequent basis by the internal audit or
risk management function of the credit union, developed independently
of the credit union's management.

[[Page 37825]]

Sec. 751.11 Policies and procedures requirements for Level 1 and
Level 2 credit unions.

A Level 1 or Level 2 credit union must develop and implement
policies and procedures for its incentive-based compensation program
that, at a minimum:
(a) Are consistent with the prohibitions and requirements of this
part;
(b) Specify the substantive and procedural criteria for the
application of forfeiture and clawback, including the process for
determining the amount of incentive-based compensation to be clawed
back;
(c) Require that the credit union maintain documentation of final
forfeiture, downward adjustment, and clawback decisions;
(d) Specify the substantive and procedural criteria for the
acceleration of payments of deferred incentive-based compensation to a
covered person, consistent with Sec. 751.7(a)(1)(iii)(B) and
(a)(2)(iii)(B));
(e) Identify and describe the role of any employees, committees, or
groups authorized to make incentive-based compensation decisions,
including when discretion is authorized;
(f) Describe how discretion is expected to be exercised to
appropriately balance risk and reward;
(g) Require that the credit union maintain documentation of the
establishment, implementation, modification, and monitoring of
incentive-based compensation arrangements, sufficient to support the
credit union's decisions;
(h) Describe how incentive-based compensation arrangements will be
monitored;
(i) Specify the substantive and procedural requirements of the
independent compliance program consistent with Sec. 751.9(a)(2); and
(j) Ensure appropriate roles for risk management, risk oversight,
and other control function personnel in the credit union's processes
for:
(1) Designing incentive-based compensation arrangements and
determining awards, deferral amounts, deferral periods, forfeiture,
downward adjustment, clawback, and vesting; and
(2) Assessing the effectiveness of incentive-based compensation
arrangements in restraining inappropriate risk-taking.

Sec. 751.12 Indirect actions.

A credit union must not indirectly, or through or by any other
person, do anything that would be unlawful for such credit union to do
directly under this part. The term ``any other person'' includes a
credit union service organization described in 12 U.S.C. 1757(7)(I) or
established under similar state law.

Sec. 751.13 Enforcement.

Sec. 751.14 Credit unions in conservatorship or liquidation.

(a) Scope. This section applies to federally insured credit unions
for which any one or more of the following parties are acting as
conservator or liquidating agent:
(1) The National Credit Union Administration Board;
(2) The appropriate state supervisory authority; or
(3) Any party designated by the National Credit Union
Administration Board or by the appropriate state supervisory authority.
(b) Compensation requirements. For a credit union subject to this
section, the requirements of this part do not apply. Instead, the
conservator or liquidating agent, in its discretion and according to
the circumstances deemed relevant in the judgment of the conservator or
liquidating agent, will determine the requirements that best fulfill
the requirements and purposes of 12 U.S.C. 5641. The conservator or
liquidating agent may determine appropriate transition terms and
provisions in the event that the credit union ceases to be within the
scope of this section.

Federal Housing Finance Agency

Authority and Issuance

Accordingly, for the reasons stated in the joint preamble, under
the authority of 12 U.S.C. 4526 and 5641, FHFA proposes to amend
chapter XII of title 12 of the Code of Federal Regulation as follows:
0
7. Add part 1232 to subchapter B to read as follows:

PART 1232--INCENTIVE-BASED COMPENSATION ARRANGEMENTS

Sec.
1232.1 Authority, scope, and initial applicability.
1232.2 Definitions.
1232.3 Applicability.
1232.4 Requirements and prohibitions applicable to all covered
institutions.
1232.5 Additional disclosure and recordkeeping requirements for
Level 1 and Level 2 covered institutions.
1232.6 Reservation of authority for Level 3 covered institutions.
1232.7 Deferral, forfeiture and downward adjustment, and clawback
requirements for Level 1 and Level 2 covered institutions.
1232.8 Additional prohibitions for Level 1 and Level 2 covered
institutions.
1232.9 Risk management and controls requirements for Level 1 and
Level 2 covered institutions.
1232.10 Governance requirements for Level 1 and Level 2 covered
institutions.
1232.11 Policies and procedures requirements for Level 1 and Level 2
covered institutions.
1232.12 Indirect actions.
1232.13 Enforcement.
1232.14 Covered institutions in conservatorship or receivership.

Authority: 12 U.S.C. 4511(b), 4513, 4514, 4518, 4526, ch. 46
subch. III, and 5641.

Sec. 1232.1 Authority, scope, and initial applicability.

(a) Authority. This part is issued pursuant to section 956 of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (12 U.S.C.
5641) and sections 1311, 1313, 1314, 1318, and 1319G and Subtitle C of
the Safety and Soundness Act (12 U.S.C. 4511(b), 4513, 4514, 4518,
4526, and ch. 46 subch. III).
(b) Scope. This part applies to a covered institution with average
total consolidated assets greater than or equal to $1 billion that
offers incentive-based compensation to covered persons.
(c) Initial applicability--(1) Compliance date. A covered
institution must meet the requirements of this part no later than [Date
of the beginning of the first calendar quarter that begins at least 540
days after a final rule is published in the Federal Register]. Whether
a covered institution other than a Federal Home Loan Bank is a Level 1,
Level 2, or Level 3 covered institution at that time will be determined
based on average total consolidated assets as of [Date of the beginning
of the first calendar quarter that begins after a final rule is
published in the Federal Register].
(2) Grandfathered plans. A covered institution is not required to
comply with the requirements of this part with respect to any
incentive-based compensation plan with a performance period that begins
before [Compliance Date as described in paragraph (c)(1) of this
section].
(d) Preservation of authority. Nothing in this part in any way
limits the authority of the Federal Housing Finance Agency under other
provisions of applicable law and regulations.

Sec. 1232.2 Definitions.

For purposes of this part only, the following definitions apply
unless otherwise specified:
(a) [Reserved].

[[Page 37826]]

(b) Average total consolidated assets means the average of a
regulated institution's total consolidated assets, as reported on the
regulated institution's regulatory reports, for the four most recent
consecutive quarters. If a regulated institution has not filed a
regulatory report for each of the four most recent consecutive
quarters, the regulated institution's average total consolidated assets
means the average of its total consolidated assets, as reported on its
regulatory reports, for the most recent quarter or consecutive
quarters, as applicable. Average total consolidated assets are measured
on the as-of date of the most recent regulatory report used in the
calculation of the average.
(c) To award incentive-based compensation means to make a final
determination, conveyed to a covered person, of the amount of
incentive-based compensation payable to the covered person for
performance over a performance period.
(d) Board of directors means the governing body of a covered
institution that oversees the activities of the covered institution,
often referred to as the board of directors or board of managers.
(e) Clawback means a mechanism by which a covered institution can
recover vested incentive-based compensation from a covered person.
(f) Compensation, fees, or benefits means all direct and indirect
payments, both cash and non-cash, awarded to, granted to, or earned by
or for the benefit of, any covered person in exchange for services
rendered to a covered institution.
(g) [Reserved].
(h) Control function means a compliance, risk management, internal
audit, legal, human resources, accounting, financial reporting, or
finance role responsible for identifying, measuring, monitoring, or
controlling risk-taking.
(i) Covered institution means a regulated institution with average
total consolidated assets greater than or equal to $1 billion.
(j) Covered person means any executive officer, employee, director,
or principal shareholder who receives incentive-based compensation at a
covered institution.
(k) Deferral means the delay of vesting of incentive-based
compensation beyond the date on which the incentive-based compensation
is awarded.
(l) Deferral period means the period of time between the date a
performance period ends and the last date on which the incentive-based
compensation awarded for such performance period vests.
(m) [Reserved].
(n) Director of a covered institution means a member of the board
of directors.
(o) Downward adjustment means a reduction of the amount of a
covered person's incentive-based compensation not yet awarded for any
performance period that has already begun, including amounts payable
under long-term incentive plans, in accordance with a forfeiture and
downward adjustment review under Sec. 1232.7(b).
(p) Equity-like instrument means:
(1) Equity in the covered institution or of any affiliate of the
covered institution; or
(2) A form of compensation:
(i) Payable at least in part based on the price of the shares or
other equity instruments of the covered institution or of any affiliate
of the covered institution; or
(ii) That requires, or may require, settlement in the shares of the
covered institution or of any affiliate of the covered institution.
(q) Forfeiture means a reduction of the amount of deferred
incentive-based compensation awarded to a covered person that has not
vested.
(r) Incentive-based compensation means any variable compensation,
fees, or benefits that serve as an incentive or reward for performance.
(s) Incentive-based compensation arrangement means an agreement
between a covered institution and a covered person, under which the
covered institution provides incentive-based compensation to the
covered person, including incentive-based compensation delivered
through one or more incentive-based compensation plans.
(t) Incentive-based compensation plan means a document setting
forth terms and conditions governing the opportunity for and the
payment of incentive-based compensation payments to one or more covered
persons.
(u) Incentive-based compensation program means a covered
institution's framework for incentive-based compensation that governs
incentive-based compensation practices and establishes related
controls.
(v) Level 1 covered institution means a covered institution with
average total consolidated assets greater than or equal to $250 billion
that is not a Federal Home Loan Bank.
(w) Level 2 covered institution means a covered institution with
average total consolidated assets greater than or equal to $50 billion
that is not a Level 1 covered institution and any Federal Home Loan
Bank that is a covered institution.
(x) Level 3 covered institution means a covered institution with
average total consolidated assets greater than or equal to $1 billion
that is not a Level 1 covered institution or Level 2 covered
institution.
(y) Long-term incentive plan means a plan to provide incentive-
based compensation that is based on a performance period of at least
three years.
(z) Option means an instrument through which a covered institution
provides a covered person the right, but not the obligation, to buy a
specified number of shares representing an ownership stake in a company
at a predetermined price within a set time period or on a date certain,
or any similar instrument, such as a stock appreciation right.
(aa) Performance period means the period during which the
performance of a covered person is assessed for purposes of determining
incentive-based compensation.
(bb) Principal shareholder means a natural person who, directly or
indirectly, or acting through or in concert with one or more persons,
owns, controls, or has the power to vote 10 percent or more of any
class of voting securities of a covered institution.
(cc) Qualifying incentive-based compensation means the amount of
incentive-based compensation awarded to a covered person for a
particular performance period, excluding amounts awarded to the covered
person for that particular performance period under a long-term
incentive plan.
(dd) Regulated institution means an Enterprise, as defined in 12
U.S.C. 4502(10), and a Federal Home Loan Bank.
(ee) Regulatory report means the Call Report Statement of
Condition.
(ff) [Reserved].
(gg) Senior executive officer means a covered person who holds the
title or, without regard to title, salary, or compensation, performs
the function of one or more of the following positions at a covered
institution for any period of time in the relevant performance period:
President, chief executive officer, executive chairman, chief operating
officer, chief financial officer, chief investment officer, chief legal
officer, chief lending officer, chief risk officer, chief compliance
officer, chief audit executive, chief credit officer, chief accounting
officer, or head of a major business line or control function.
(hh) Significant risk-taker means:
(1) Any covered person at a Level 1 or Level 2 covered institution,
other

[[Page 37827]]

than a senior executive officer, who received annual base salary and
incentive-based compensation for the last calendar year that ended at
least 180 days before the beginning of the performance period of which
at least one-third is incentive-based compensation and is--
(i) A covered person of a Level 1 covered institution who received
annual base salary and incentive-based compensation for the last
calendar year that ended at least 180 days before the beginning of the
performance period that placed the covered person among the highest 5
percent in annual base salary and incentive-based compensation among
all covered persons (excluding senior executive officers) of the Level
1 covered institution;
(ii) A covered person of a Level 2 covered institution who received
annual base salary and incentive-based compensation for the last
calendar year that ended at least 180 days before the beginning of the
performance period that placed the covered person among the highest 2
percent in annual base salary and incentive-based compensation among
all covered persons (excluding senior executive officers) of the Level
2 covered institution; or
(iii) A covered person of a covered institution who may commit or
expose 0.5 percent or more of the regulatory capital, in the case of a
Federal Home Loan Bank, or the minimum capital, in the case of an
Enterprise, of the covered institution; and
(2) Any covered person at a Level 1 or Level 2 covered institution,
other than a senior executive officer, who is designated as a
``significant risk-taker'' by the Federal Housing Finance Agency
because of that person's ability to expose a covered institution to
risks that could lead to material financial loss in relation to the
covered institution's size, capital, or overall risk tolerance, in
accordance with procedures established by the Federal Housing Finance
Agency, or by the covered institution.
(3) [Reserved].
(4) If the Federal Housing Finance Agency determines, in accordance
with procedures established by the Federal Housing Finance Agency, that
a Level 1 covered institution's activities, complexity of operations,
risk profile, and compensation practices are similar to those of a
Level 2 covered institution, the Level 1 covered institution may apply
paragraph (hh)(1)(i) of this section to covered persons of the Level 1
covered institution by substituting ``2 percent'' for ``5 percent''.
(ii) [Reserved].
(jj) Vesting of incentive-based compensation means the transfer of
ownership of the incentive-based compensation to the covered person to
whom the incentive-based compensation was awarded, such that the
covered person's right to the incentive-based compensation is no longer
contingent on the occurrence of any event.

Sec. 1232.3 Applicability.

(a) When average total consolidated assets increase--(1) In
general. A regulated institution other than a Federal Home Loan Bank
shall become a Level 1, Level 2, or Level 3 covered institution when
its average total consolidated assets increase to an amount that equals
or exceeds $250 billion, $50 billion, or $1 billion, respectively.
(2) Compliance date. A regulated institution that becomes a Level
1, Level 2, or Level 3 covered institution pursuant to paragraph (a)(1)
of this section shall comply with the requirements of this part for a
Level 1, Level 2, or Level 3 covered institution, respectively, not
later than the first day of the first calendar quarter that begins at
least 540 days after the date on which the regulated institution
becomes a Level 1, Level 2, or Level 3 covered institution,
respectively. Until that day, the Level 1, Level 2, or Level 3 covered
institution will remain subject to the requirements of this part, if
any, that applied to the regulated institution on the day before the
date on which it became a Level 1, Level 2, or Level 3 covered
institution.
(3) Grandfathered plans. A regulated institution that becomes a
Level 1, Level 2, or Level 3 covered institution under paragraph (a)(1)
of this section is not required to comply with requirements of this
part applicable to a Level 1, Level 2, or Level 3 covered institution,
respectively, with respect to any incentive-based compensation plan
with a performance period that begins before the date described in
paragraph (a)(2) of this section. Any such incentive-based compensation
plan shall remain subject to the requirements under this part, if any,
that applied to the regulated institution at the beginning of the
performance period.
(b) When total consolidated assets decrease. A Level 1, Level 2, or
Level 3 covered institution other than a Federal Home Loan Bank will
remain subject to the requirements applicable to such covered
institution under this part unless and until the total consolidated
assets of the covered institution, as reported on the covered
institution's regulatory reports, fall below $250 billion, $50 billion,
or $1 billion, respectively, for each of four consecutive quarters. A
Federal Home Loan Bank will remain subject to the requirements of a
Level 2 covered institution under this part unless and until the total
consolidated assets of the Federal Home Loan Bank, as reported on the
Federal Home Loan Bank's regulatory reports, fall below $1 billion for
each of four consecutive quarters. The calculation will be effective on
the as-of date of the fourth consecutive regulatory report.

Sec. 1232.4 Requirements and prohibitions applicable to all covered
institutions.

[[Page 37828]]

(2) Is compatible with effective risk management and controls; and
(3) Is supported by effective governance.
(d) Performance measures. An incentive-based compensation
arrangement will not be considered to appropriately balance risk and
reward for purposes of paragraph (c)(1) of this section unless:
(1) The arrangement includes financial and non-financial measures
of performance, including considerations of risk-taking, that are
relevant to a covered person's role within a covered institution and to
the type of business in which the covered person is engaged and that
are appropriately weighted to reflect risk-taking;
(2) The arrangement is designed to allow non-financial measures of
performance to override financial measures of performance when
appropriate in determining incentive-based compensation; and
(3) Any amounts to be awarded under the arrangement are subject to
adjustment to reflect actual losses, inappropriate risks taken,
compliance deficiencies, or other measures or aspects of financial and
non-financial performance.
(e) Board of directors. A covered institution's board of directors,
or a committee thereof, must:
(1) Conduct oversight of the covered institution's incentive-based
compensation program;
(2) Approve incentive-based compensation arrangements for senior
executive officers, including the amounts of all awards and, at the
time of vesting, payouts under such arrangements; and
(3) Approve any material exceptions or adjustments to incentive-
based compensation policies or arrangements for senior executive
officers.
(f) Disclosure and recordkeeping requirements. A covered
institution must create annually and maintain for a period of at least
seven years records that document the structure of all its incentive-
based compensation arrangements and demonstrate compliance with this
part. A covered institution must disclose the records to the Federal
Housing Finance Agency upon request. At a minimum, the records must
include copies of all incentive-based compensation plans, a record of
who is subject to each plan, and a description of how the incentive-
based compensation program is compatible with effective risk management
and controls.
(g) Rule of construction. A covered institution is not required to
report the actual amount of compensation, fees, or benefits of
individual covered persons as part of the disclosure and recordkeeping
requirements under this part, though it may be required to do so under
other applicable regulations of the Federal Housing Finance Agency.

Sec. 1232.5 Additional disclosure and recordkeeping requirements for
Level 1 and Level 2 covered institutions.

(a) A Level 1 or Level 2 covered institution must create annually
and maintain for a period of at least seven years records that
document:
(1) The covered institution's senior executive officers and
significant risk-takers, listed by legal entity, job function,
organizational hierarchy, and line of business;
(2) The incentive-based compensation arrangements for senior
executive officers and significant risk-takers, including information
on percentage of incentive-based compensation deferred and form of
award;
(3) Any forfeiture and downward adjustment or clawback reviews and
decisions for senior executive officers and significant risk-takers;
and
(4) Any material changes to the covered institution's incentive-
based compensation arrangements and policies.
(b) A Level 1 or Level 2 covered institution must create and
maintain records in a manner that allows for an independent audit of
incentive-based compensation arrangements, policies, and procedures,
including those required under Sec. 1232.11.
(c) A Level 1 or Level 2 covered institution must provide the
records described in paragraph (a) of this section to the Federal
Housing Finance Agency in such form and with such frequency as
requested by the Federal Housing Finance Agency.

Sec. 1232.6 Reservation of authority for Level 3 covered
institutions.

(a) In general. The Federal Housing Finance Agency may require a
Level 3 covered institution with average total consolidated assets
greater than or equal to $10 billion and less than $50 billion to
comply with some or all of the provisions of Sec. Sec. 1232.5 and
1232.7 through 1232.11 if the Federal Housing Finance Agency determines
that the Level 3 covered institution's complexity of operations or
compensation practices are consistent with those of a Level 1 or Level
2 covered institution.
(b) Factors considered. Any exercise of authority under this
section will be in writing by the Federal Housing Finance Agency in
accordance with procedures established by the Federal Housing Finance
Agency and will consider the activities, complexity of operations, risk
profile, and compensation practices of the Level 3 covered institution,
in addition to any other relevant factors.

Sec. 1232.7 Deferral, forfeiture and downward adjustment, and
clawback requirements for Level 1 and Level 2 covered institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will not be considered to appropriately balance
risk and reward, for purposes of Sec. 1232.4(c)(1), unless the
following requirements are met.
(a) Deferral. (1) Qualifying incentive-based compensation must be
deferred as follows:
(i) Minimum required deferral amount. (A) A Level 1 covered
institution must defer at least 60 percent of a senior executive
officer's qualifying incentive-based compensation awarded for each
performance period.
(B) A Level 1 covered institution must defer at least 50 percent of
a significant risk-taker's qualifying incentive-based compensation
awarded for each performance period.
(C) A Level 2 covered institution must defer at least 50 percent of
a senior executive officer's qualifying incentive-based compensation
awarded for each performance period.
(D) A Level 2 covered institution must defer at least 40 percent of
a significant risk-taker's qualifying incentive-based compensation
awarded for each performance period.
(ii) Minimum required deferral period. (A) For a senior executive
officer or significant risk-taker of a Level 1 covered institution, the
deferral period for deferred qualifying incentive-based compensation
must be at least 4 years.
(B) For a senior executive officer or significant risk-taker of a
Level 2 covered institution, the deferral period for deferred
qualifying incentive-based compensation must be at least 3 years.
(iii) Vesting of amounts during deferral period--(A) Pro rata
vesting. During a deferral period, deferred qualifying incentive-based
compensation may not vest faster than on a pro rata annual basis
beginning no earlier than the first anniversary of the end of the
performance period for which the amounts were awarded.
(B) Acceleration of vesting. A Level 1 or Level 2 covered
institution must not accelerate the vesting of a covered person's
deferred qualifying incentive-based compensation that is required to be
deferred under this part, except in the case of death or disability of
such covered person.

[[Page 37829]]

(2) Incentive-based compensation awarded under a long-term
incentive plan must be deferred as follows:
(i) Minimum required deferral amount.
(A) A Level 1 covered institution must defer at least 60 percent of
a senior executive officer's incentive-based compensation awarded under
a long-term incentive plan for each performance period.
(B) A Level 1 covered institution must defer at least 50 percent of
a significant risk-taker's incentive-based compensation awarded under a
long-term incentive plan for each performance period.
(C) A Level 2 covered institution must defer at least 50 percent of
a senior executive officer's incentive-based compensation awarded under
a long-term incentive plan for each performance period.
(D) A Level 2 covered institution must defer at least 40 percent of
a significant risk-taker's incentive-based compensation awarded under a
long-term incentive plan for each performance period.
(ii) Minimum required deferral period. (A) For a senior executive
officer or significant risk-taker of a Level 1 covered institution, the
deferral period for deferred long-term incentive plan amounts must be
at least 2 years.
(B) For a senior executive officer or significant risk-taker of a
Level 2 covered institution, the deferral period for deferred long-term
incentive plan amounts must be at least 1 year.
(iii) Vesting of amounts during deferral period--(A) Pro rata
vesting. During a deferral period, deferred long-term incentive plan
amounts may not vest faster than on a pro rata annual basis beginning
no earlier than the first anniversary of the end of the performance
period for which the amounts were awarded.
(B) Acceleration of vesting. A Level 1 or Level 2 covered
institution must not accelerate the vesting of a covered person's
deferred long-term incentive plan amounts that is required to be
deferred under this part, except in the case of death or disability of
such covered person.
(3) Adjustments of deferred qualifying incentive-based compensation
and deferred long-term incentive plan compensation amounts. A Level 1
or Level 2 covered institution may not increase deferred qualifying
incentive-based compensation or deferred long-term incentive plan
amounts for a senior executive officer or significant risk-taker during
the deferral period. For purposes of this paragraph, an increase in
value attributable solely to a change in share value, a change in
interest rates, or the payment of interest according to terms set out
at the time of the award is not considered an increase in incentive-
based compensation amounts.
(4) Composition of deferred qualifying incentive-based compensation
and deferred long-term incentive plan compensation for Level 1 and
Level 2 covered institutions--(i) Cash and equity-like instruments. For
a senior executive officer or significant risk-taker of a Level 1 or
Level 2 covered institution, any deferred qualifying incentive-based
compensation or deferred long-term incentive plan amounts must include
substantial portions of both deferred cash and, in the case of a
covered institution that issues equity instruments and is permitted by
the Federal Housing Finance Agency to use equity-like instruments as
compensation for senior executive officers and significant risk-takers,
equity-like instruments throughout the deferral period.
(ii) Options. If a senior executive officer or significant risk-
taker of a Level 1 or Level 2 covered institution receives incentive-
based compensation for a performance period in the form of options, the
total amount of such options that may be used to meet the minimum
deferral amount requirements of paragraph (a)(1)(i) or (a)(2)(i) of
this section is limited to no more than 15 percent of the amount of
total incentive-based compensation awarded to the senior executive
officer or significant risk-taker for that performance period.
(b) Forfeiture and downward adjustment--(1) Compensation at risk.
(i) A Level 1 or Level 2 covered institution must place at risk of
forfeiture all unvested deferred incentive-based compensation of any
senior executive officer or significant risk-taker, including unvested
deferred amounts awarded under long-term incentive plans.
(ii) A Level 1 or Level 2 covered institution must place at risk of
downward adjustment all of a senior executive officer's or significant
risk-taker's incentive-based compensation amounts not yet awarded for
the current performance period, including amounts payable under long-
term incentive plans.
(2) Events triggering forfeiture and downward adjustment review. At
a minimum, a Level 1 or Level 2 covered institution must consider
forfeiture and downward adjustment of incentive-based compensation of
senior executive officers and significant risk-takers described in
paragraph (b)(3) of this section due to any of the following adverse
outcomes at the covered institution:
(i) Poor financial performance attributable to a significant
deviation from the risk parameters set forth in the covered
institution's policies and procedures;
(ii) Inappropriate risk taking, regardless of the impact on
financial performance;
(iii) Material risk management or control failures;
(iv) Non-compliance with statutory, regulatory, or supervisory
standards that results in:
(A) Enforcement or legal action against the covered institution
brought by a federal or state regulator or agency; or
(B) A requirement that the covered institution report a restatement
of a financial statement to correct a material error; and
(v) Other aspects of conduct or poor performance as defined by the
covered institution.
(3) Senior executive officers and significant risk-takers affected
by forfeiture and downward adjustment. A Level 1 or Level 2 covered
institution must consider forfeiture and downward adjustment for a
senior executive officer or significant risk-taker with direct
responsibility, or responsibility due to the senior executive officer's
or significant risk-taker's role or position in the covered
institution's organizational structure, for the events related to the
forfeiture and downward adjustment review set forth in paragraph (b)(2)
of this section.
(4) Determining forfeiture and downward adjustment amounts. A Level
1 or Level 2 covered institution must consider, at a minimum, the
following factors when determining the amount or portion of a senior
executive officer's or significant risk-taker's incentive-based
compensation that should be forfeited or adjusted downward:
(i) The intent of the senior executive officer or significant risk-
taker to operate outside the risk governance framework approved by the
covered institution's board of directors or to depart from the covered
institution's policies and procedures;
(ii) The senior executive officer's or significant risk-taker's
level of participation in, awareness of, and responsibility for, the
events triggering the forfeiture and downward adjustment review set
forth in paragraph (b)(2) of this section;
(iii) Any actions the senior executive officer or significant risk-
taker took or could have taken to prevent the events triggering the
forfeiture and downward

[[Page 37830]]

adjustment review set forth in paragraph (b)(2) of this section;
(iv) The financial and reputational impact of the events triggering
the forfeiture and downward adjustment review set forth in paragraph
(b)(2) of this section to the covered institution, the line or sub-line
of business, and individuals involved, as applicable, including the
magnitude of any financial loss and the cost of known or potential
subsequent fines, settlements, and litigation;
(v) The causes of the events triggering the forfeiture and downward
adjustment review set forth in paragraph (b)(2) of this section,
including any decision-making by other individuals; and
(vi) Any other relevant information, including past behavior and
past risk outcomes attributable to the senior executive officer or
significant risk-taker.
(c) Clawback. A Level 1 or Level 2 covered institution must include
clawback provisions in incentive-based compensation arrangements for
senior executive officers and significant risk-takers that, at a
minimum, allow the covered institution to recover incentive-based
compensation from a current or former senior executive officer or
significant risk-taker for seven years following the date on which such
compensation vests, if the covered institution determines that the
senior executive officer or significant risk-taker engaged in:
(1) Misconduct that resulted in significant financial or
reputational harm to the covered institution;
(2) Fraud; or
(3) Intentional misrepresentation of information used to determine
the senior executive officer or significant risk-taker's incentive-
based compensation.

Sec. 1232.8 Additional prohibitions for Level 1 and Level 2 covered
institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will be considered to provide incentives that
appropriately balance risk and reward for purposes of Sec.
1232.4(c)(1) only if such institution complies with the following
prohibitions.
(a) Hedging. A Level 1 or Level 2 covered institution must not
purchase a hedging instrument or similar instrument on behalf of a
covered person to hedge or offset any decrease in the value of the
covered person's incentive-based compensation.
(b) Maximum incentive-based compensation opportunity. A Level 1 or
Level 2 covered institution must not award incentive-based compensation
to:
(1) A senior executive officer in excess of 125 percent of the
target amount for that incentive-based compensation; or
(2) A significant risk-taker in excess of 150 percent of the target
amount for that incentive-based compensation.
(c) Relative performance measures. A Level 1 or Level 2 covered
institution must not use incentive-based compensation performance
measures that are based solely on industry peer performance
comparisons.
(d) Volume driven incentive-based compensation. A Level 1 or Level
2 covered institution must not provide incentive-based compensation to
a covered person that is based solely on transaction revenue or volume
without regard to transaction quality or compliance of the covered
person with sound risk management.

Sec. 1232.9 Risk management and controls requirements for Level 1 and
Level 2 covered institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will be considered to be compatible with effective
risk management and controls for purposes of Sec. 1232.4(c)(2) only if
such institution meets the following requirements.
(a) A Level 1 or Level 2 covered institution must have a risk
management framework for its incentive-based compensation program that:
(1) Is independent of any lines of business;
(2) Includes an independent compliance program that provides for
internal controls, testing, monitoring, and training with written
policies and procedures consistent with Sec. 1232.11; and
(3) Is commensurate with the size and complexity of the covered
institution's operations.
(b) A Level 1 or Level 2 covered institution must:
(1) Provide individuals engaged in control functions with the
authority to influence the risk-taking of the business areas they
monitor; and
(2) Ensure that covered persons engaged in control functions are
compensated in accordance with the achievement of performance
objectives linked to their control functions and independent of the
performance of those business areas.
(c) A Level 1 or Level 2 covered institution must provide for the
independent monitoring of:
(1) All incentive-based compensation plans in order to identify
whether those plans provide incentives that appropriately balance risk
and reward;
(2) Events related to forfeiture and downward adjustment reviews
and decisions of forfeiture and downward adjustment reviews in order to
determine consistency with Sec. 1232.7(b); and
(3) Compliance of the incentive-based compensation program with the
covered institution's policies and procedures.

Sec. 1232.10 Governance requirements for Level 1 and Level 2 covered
institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will not be considered to be supported by effective
governance for purposes of Sec. 1232.4(c)(3), unless:
(a) The covered institution establishes a compensation committee
composed solely of directors who are not senior executive officers to
assist the board of directors in carrying out its responsibilities
under Sec. 1232.4(e); and
(b) The compensation committee established pursuant to paragraph
(a) of this section obtains:
(1) Input from the risk and audit committees of the covered
institution's board of directors, or groups performing similar
functions, and risk management function on the effectiveness of risk
measures and adjustments used to balance risk and reward in incentive-
based compensation arrangements;
(2) A written assessment of the effectiveness of the covered
institution's incentive-based compensation program and related
compliance and control processes in providing risk-taking incentives
that are consistent with the risk profile of the covered institution,
submitted on an annual or more frequent basis by the management of the
covered institution and developed with input from the risk and audit
committees of its board of directors, or groups performing similar
functions, and from the covered institution's risk management and audit
functions; and
(3) An independent written assessment of the effectiveness of the
covered institution's incentive-based compensation program and related
compliance and control processes in providing risk-taking incentives
that are consistent with the risk profile of the covered institution,
submitted on an annual or more frequent basis by the internal audit or
risk management function of the covered institution, developed
independently of the covered institution's management.

Sec. 1232.11 Policies and procedures requirements for Level 1 and
Level 2 covered institutions.

A Level 1 or Level 2 covered institution must develop and implement

[[Page 37831]]

policies and procedures for its incentive-based compensation program
that, at a minimum:
(a) Are consistent with the prohibitions and requirements of this
part;
(b) Specify the substantive and procedural criteria for the
application of forfeiture and clawback, including the process for
determining the amount of incentive-based compensation to be clawed
back;
(c) Require that the covered institution maintain documentation of
final forfeiture, downward adjustment, and clawback decisions;
(d) Specify the substantive and procedural criteria for the
acceleration of payments of deferred incentive-based compensation to a
covered person, consistent with Sec. 1232.7(a)(1)(iii)(B) and
(a)(2)(iii)(B));
(e) Identify and describe the role of any employees, committees, or
groups authorized to make incentive-based compensation decisions,
including when discretion is authorized;
(f) Describe how discretion is expected to be exercised to
appropriately balance risk and reward;
(g) Require that the covered institution maintain documentation of
the establishment, implementation, modification, and monitoring of
incentive-based compensation arrangements, sufficient to support the
covered institution's decisions;
(h) Describe how incentive-based compensation arrangements will be
monitored;
(i) Specify the substantive and procedural requirements of the
independent compliance program consistent with Sec. 1232.9(a)(2); and
(j) Ensure appropriate roles for risk management, risk oversight,
and other control function personnel in the covered institution's
processes for:
(1) Designing incentive-based compensation arrangements and
determining awards, deferral amounts, deferral periods, forfeiture,
downward adjustment, clawback, and vesting; and
(2) Assessing the effectiveness of incentive-based compensation
arrangements in restraining inappropriate risk-taking.

Sec. 1232.12 Indirect actions.

A covered institution must not indirectly, or through or by any
other person, do anything that would be unlawful for such covered
institution to do directly under this part.

Sec. 1232.13 Enforcement.

The provisions of this part shall be enforced under subtitle C of
the Safety and Soundness Act (12 U.S.C. ch. 46 subch. III).

Sec. 1232.14 Covered institutions in conservatorship or receivership.

(a) Scope. This section applies to covered institutions that are in
conservatorship or receivership, or are limited-life regulated
entities, under the Safety and Soundness Act.
(b) Compensation requirements. For a covered institution subject to
this section, the requirements that would otherwise apply under this
part shall be those that are determined by the Agency to best fulfill
the requirements and purposes of 12 U.S.C. 5641, taking into
consideration the possible duration of the covered institution's
conservatorship or receivership, the nature of the institution's
governance while under conservatorship or receivership, the need to
attract and retain management and other talent to such an institution,
the limitations on such an institution's ability to employ equity-like
instruments as incentive-based compensation, and any other
circumstances deemed relevant in the judgment of the Agency. The Agency
may determine appropriate transition terms and provisions in the event
that the covered institution ceases to be within the scope of this
section.

Securities and Exchange Commission

Authority and Issuance

For the reasons set forth in the joint preamble, the SEC proposes
to amend title 17, chapter II of the Code of Federal Regulations as
follows:

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934

0
8. The authority citation for part 240 continues to read in part as
follows:

Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f,
78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4,
78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78dd, 78ll, 78mm,
80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, 7201 et seq.,
and 8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C. 1350;
and Pub. L. 111-203, 939A, 124 Stat. 1376 (2010), unless otherwise
noted.
* * * * *
Section 240.17a-4 also issued under secs. 2, 17, 23(a), 48 Stat.
897, as amended; 15 U.S.C. 78a, 78d-1, 78d-2; sec. 14, Pub. L. 94-
29, 89 Stat. 137 (15 U.S.C. 78a); sec. 18, Pub. L. 94-29, 89 Stat.
155 (15 U.S.C. 78w);
* * * * *
0
9. Section 240.17a-4 is amended by adding paragraph (e)(10). The
addition reads as follows:

Sec. 240.17a-4 Records to be preserved by certain exchange members,
brokers and dealers.

* * * * *
(e) * * *
(10) The records required pursuant to Sec. Sec. 303.4(f), 303.5,
and 303.11 of this chapter.
* * * * *

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

0
10. The authority citation continues to read in part as follows:

Authority: 15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(11)(H), 80b-
2(a)(17), 80b-3, 80b-4, 80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless
otherwise noted.
* * * * *
Section 275.204-2 is also issued under 15 U.S.C. 80b-6.
* * * * *
0
11. Section 275.204-2 is amended by adding paragraph (a)(19) and by
revising paragraph (e)(1). The additions and revisions read as follows:

Sec. 275.204-2 Books and records to be maintained by investment
advisers.

(a) * * *
(19) The records required pursuant to, and for the periods
specified in, Sec. Sec. 303.4(f), 303.5, and 303.11 of this chapter.
* * * * *
(e)(1) All books and records required to be made under the
provisions of paragraphs (a) to (c)(1)(i), inclusive, and (c)(2) of
this section (except for books and records required to be made under
the provisions of paragraphs (a)(11), (a)(12)(i), (a)(12)(iii),
(a)(13)(ii), (a)(13)(iii), (a)(16), (a)(17)(i), and (a)(19) of this
section), shall be maintained and preserved in an easily accessible
place for a period of not less than five years from the end of the
fiscal year during which the last entry was made on such record, the
first two years in an appropriate office of the investment adviser.
* * * * *
0
12. Add part 303 to read as follows:

PART 303--INCENTIVE-BASED COMPENSATION ARRANGEMENTS

Sec.
303.1 Authority, scope, and initial applicability.
303.2 Definitions.
303.3 Applicability.
303.4 Requirements and prohibitions applicable to all covered
institutions.
303.5 Additional disclosure and recordkeeping requirements for Level
1 and Level 2 covered institutions.
303.6 Reservation of authority for Level 3 covered institutions.

[[Page 37832]]

303.7 Deferral, forfeiture and downward adjustment, and clawback
requirements for Level 1 and Level 2 covered institutions.
303.8 Additional prohibitions for Level 1 and Level 2 covered
institutions.
303.9 Risk management and controls requirements for Level 1 and
Level 2 covered institutions.
303.10 Governance requirements for Level 1 and Level 2 covered
institutions.
303.11 Policies and procedures requirements for Level 1 and Level 2
covered institutions.
303.12 Indirect actions.
303.13 Enforcement.

Authority: 15 U.S.C. 78q, 78w, 80b-4, and 80b-11 and 12 U.S.C.
5641.

Sec. 303.1 Authority, scope, and initial applicability.

(a) Authority. This part is issued pursuant to section 956 of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (12 U.S.C.
5641), 15 U.S.C. 78q, 78w, 80b-4, and 80b-11.
(b) Scope. This part applies to a covered institution with average
total consolidated assets greater than or equal to $1 billion that
offers incentive-based compensation to covered persons.
(c) Initial applicability--(1) Compliance date. A covered
institution must meet the requirements of this part no later than [Date
of the beginning of the first calendar quarter that begins at least 540
days after a final rule is published in the Federal Register]. Whether
a covered institution is a Level 1, Level 2, or Level 3 covered
institution at that time will be determined based on average total
consolidated assets as of [Date of the beginning of the first calendar
quarter that begins after a final rule is published in the Federal
Register].
(2) Grandfathered plans. A covered institution is not required to
comply with the requirements of this part with respect to any
incentive-based compensation plan with a performance period that begins
before [Compliance Date as described in paragraph (c)(1) of this
section].
(d) Preservation of authority. Nothing in this part in any way
limits the authority of the Commission under other provisions of
applicable law and regulations.

Sec. 303.2 Definitions.

For purposes of this part only, the following definitions apply
unless otherwise specified:
(a) Affiliate means any company that controls, is controlled by, or
is under common control with another company.
(b) Average total consolidated assets means the average of a
regulated institution's total consolidated assets, as reported on the
regulated institution's regulatory reports, for the four most recent
consecutive quarters. If a regulated institution has not filed a
regulatory report for each of the four most recent consecutive
quarters, the regulated institution's average total consolidated assets
means the average of its total consolidated assets, as reported on its
regulatory reports, for the most recent quarter or consecutive
quarters, as applicable. Average total consolidated assets are measured
on the as-of date of the most recent regulatory report used in the
calculation of the average. Average total consolidated assets for a
regulated institution that is an investment adviser means the regulated
institution's total assets (exclusive of non-proprietary assets) shown
on the balance sheet for the regulated institution for the most recent
fiscal year end.
(c) To award incentive-based compensation means to make a final
determination, conveyed to a covered person, of the amount of
incentive-based compensation payable to the covered person for
performance over a performance period.
(d) Board of directors means the governing body of a covered
institution that oversees the activities of the covered institution,
often referred to as the board of directors or board of managers.
(e) Clawback means a mechanism by which a covered institution can
recover vested incentive-based compensation from a covered person.
(f) Compensation, fees, or benefits means all direct and indirect
payments, both cash and non-cash, awarded to, granted to, or earned by
or for the benefit of, any covered person in exchange for services
rendered to a covered institution.
(g) Control means that any company has control over any company
if--
(1) The company directly or indirectly or acting through one or
more other persons owns, controls, or has power to vote 25 percent or
more of any class of voting securities of the company;
(2) The company controls in any manner the election of a majority
of the directors or trustees of the company; or
(3) The Commission determines, after notice and opportunity for
hearing, that the company directly or indirectly exercises a
controlling influence over the management or policies of the company.
(h) Control function means a compliance, risk management, internal
audit, legal, human resources, accounting, financial reporting, or
finance role responsible for identifying, measuring, monitoring, or
controlling risk-taking.
(i) Covered institution means a regulated institution with average
total consolidated assets greater than or equal to $1 billion.
(j) Covered person means any executive officer, employee, director,
or principal shareholder who receives incentive-based compensation at a
covered institution.
(k) Deferral means the delay of vesting of incentive-based
compensation beyond the date on which the incentive-based compensation
is awarded.
(l) Deferral period means the period of time between the date a
performance period ends and the last date on which the incentive-based
compensation awarded for such performance period vests.
(m) Depository institution holding company means a top-tier
depository institution holding company, where ``depository institution
holding company'' has the same meaning as in section 3 of the Federal
Deposit Insurance Act (12 U.S.C. 1813).
(n) Director of a covered institution means a member of the board
of directors.
(o) Downward adjustment means a reduction of the amount of a
covered person's incentive-based compensation not yet awarded for any
performance period that has already begun, including amounts payable
under long-term incentive plans, in accordance with a forfeiture and
downward adjustment review under Sec. 303.7(b).
(p) Equity-like instrument means:
(1) Equity in the covered institution or any affiliate of the
covered institution; or
(2) A form of compensation:
(i) Payable at least in part based on the price of the shares or
other equity instruments of the covered institution or of any affiliate
of the covered institution; or
(ii) That requires, or may require, settlement in the shares of the
covered institution or of any affiliate of the covered institution.
(q) Forfeiture means a reduction of the amount of deferred
incentive-based compensation awarded to a covered person that has not
vested.
(r) Incentive-based compensation means any variable compensation,
fees, or benefits that serve as an incentive or reward for performance.
(s) Incentive-based compensation arrangement means an agreement
between a covered institution and a covered person, under which the
covered institution provides incentive-based compensation to the
covered person, including incentive-based compensation delivered
through one or

[[Page 37833]]

more incentive-based compensation plans.
(t) Incentive-based compensation plan means a document setting
forth terms and conditions governing the opportunity for and the
payment of incentive-based compensation payments to one or more covered
persons.
(u) Incentive-based compensation program means a covered
institution's framework for incentive-based compensation that governs
incentive-based compensation practices and establishes related
controls.
(v) Level 1 covered institution means a:
(i) Covered institution with average total consolidated assets
greater than or equal to $250 billion; or
(ii) Covered institution that is a subsidiary of a depository
institution holding company that is a Level 1 covered institution
pursuant to 12 CFR 236.2.
(w) Level 2 covered institution means a:
(i) Covered institution with average total consolidated assets
greater than or equal to $50 billion that is not a Level 1 covered
institution; or
(ii) Covered institution that is a subsidiary of a depository
institution holding company that is a Level 2 covered institution
pursuant to 12 CFR 236.2.
(x) Level 3 covered institution means a covered institution with
average total consolidated assets greater than or equal to $1 billion
that is not a Level 1 covered institution or Level 2 covered
institution.
(y) Long-term incentive plan means a plan to provide incentive-
based compensation that is based on a performance period of at least
three years.
(z) Option means an instrument through which a covered institution
provides a covered person the right, but not the obligation, to buy a
specified number of shares representing an ownership stake in a company
at a predetermined price within a set time period or on a date certain,
or any similar instrument, such as a stock appreciation right.
(aa) Performance period means the period during which the
performance of a covered person is assessed for purposes of determining
incentive-based compensation.
(bb) Principal shareholder means a natural person who, directly or
indirectly, or acting through or in concert with one or more persons,
owns, controls, or has the power to vote 10 percent or more of any
class of voting securities of a covered institution.
(cc) Qualifying incentive-based compensation means the amount of
incentive-based compensation awarded to a covered person for a
particular performance period, excluding amounts awarded to the covered
person for that particular performance period under a long-term
incentive plan.
(dd) Regulated institution means a broker or dealer registered
under section 15 of the Securities Exchange Act of 1934 (15 U.S.C. 78o)
and an investment adviser as such term is defined in section 202(a)(11)
of the Investment Advisers Act of 1940 (15 U.S.C. 80b-2(a)(11)).
(ee) Regulatory report means, for a broker-dealer registered under
section 15 of the Securities Exchange Act of 1934 (15 U.S.C. 78o), the
Financial and Operational Combined Uniform Single Report, Form X-17A-5,
17 CFR 249.617, or any successors thereto.
(ff) Section 956 affiliate means an affiliate that is an
institution described in Sec. 303.2(i), 12 CFR 42.2(i), 12 CFR
236.2(i), 12 CFR 372.2(i), 12 CFR 741.2(i), or 12 CFR 1232.2(i).
(gg) Senior executive officer means a covered person who holds the
title or, without regard to title, salary, or compensation, performs
the function of one or more of the following positions at a covered
institution for any period of time in the relevant performance period:
President, chief executive officer, executive chairman, chief operating
officer, chief financial officer, chief investment officer, chief legal
officer, chief lending officer, chief risk officer, chief compliance
officer, chief audit executive, chief credit officer, chief accounting
officer, or head of a major business line or control function.
(hh) Significant risk-taker means:
(1) Any covered person at a Level 1 or Level 2 covered institution,
other than a senior executive officer, who received annual base salary
and incentive-based compensation for the last calendar year that ended
at least 180 days before the beginning of the performance period of
which at least one-third is incentive-based compensation and is--
(i) A covered person of a Level 1 covered institution who received
annual base salary and incentive-based compensation for the last
calendar year that ended at least 180 days before the beginning of the
performance period that placed the covered person among the highest 5
percent in annual base salary and incentive-based compensation among
all covered persons (excluding senior executive officers) of the Level
1 covered institution together with all individuals who receive
incentive-based compensation at any section 956 affiliate of the Level
1 covered institution;
(ii) A covered person of a Level 2 covered institution who received
annual base salary and incentive-based compensation for the last
calendar year that ended at least 180 days before the beginning of the
performance period that placed the covered person among the highest 2
percent in annual base salary and incentive-based compensation among
all covered persons (excluding senior executive officers) of the Level
2 covered institution together with all individuals who receive
incentive-based compensation at any section 956 affiliate of the Level
2 covered institution; or
(iii) A covered person of a covered institution who may commit or
expose 0.5 percent or more of the common equity tier 1 capital, or in
the case of a registered securities broker or dealer, 0.5 percent or
more of the tentative net capital, of the covered institution or of any
section 956 affiliate of the covered institution, whether or not the
individual is a covered person of that specific legal entity; and
(2) Any covered person at a Level 1 or Level 2 covered institution,
other than a senior executive officer, who is designated as a
``significant risk-taker'' by the Commission because of that person's
ability to expose a covered institution to risks that could lead to
material financial loss in relation to the covered institution's size,
capital, or overall risk tolerance, in accordance with procedures
established by the Commission, or by the covered institution.
(3) For purposes of this part, an individual who is an employee,
director, senior executive officer, or principal shareholder of an
affiliate of a Level 1 or Level 2 covered institution, where such
affiliate has less than $1 billion in total consolidated assets, and
who otherwise would meet the requirements for being a significant risk-
taker under paragraph (hh)(1)(iii) of this section, shall be considered
to be a significant risk-taker with respect to the Level 1 or Level 2
covered institution for which the individual may commit or expose 0.5
percent or more of common equity tier 1 capital or tentative net
capital. The Level 1 or Level 2 covered institution for which the
individual commits or exposes 0.5 percent or more of common equity tier
1 capital or tentative net capital shall ensure that the individual's
incentive compensation arrangement complies with the requirements of
this part.

[[Page 37834]]

(4) If the Commission determines, in accordance with procedures
established by the Commission, that a Level 1 covered institution's
activities, complexity of operations, risk profile, and compensation
practices are similar to those of a Level 2 covered institution, the
Level 1 covered institution may apply paragraph (hh)(1)(i) of this
section to covered persons of the Level 1 covered institution by
substituting ``2 percent'' for ``5 percent.''
(ii) Subsidiary means any company that is owned or controlled
directly or indirectly by another company.
(jj) Vesting of incentive-based compensation means the transfer of
ownership of the incentive-based compensation to the covered person to
whom the incentive-based compensation was awarded, such that the
covered person's right to the incentive-based compensation is no longer
contingent on the occurrence of any event.

Sec. 303.3 Applicability.

(a) When average total consolidated assets increase--(1) In
general. (i) A regulated institution shall become a Level 1, Level 2,
or Level 3 covered institution when its average total consolidated
assets increase to an amount that equals or exceeds $250 billion, $50
billion, or $1 billion, respectively.
(ii) A covered institution regardless of its average total
consolidated assets (provided that, for the avoidance of doubt, such
covered institution has average total consolidated assets greater than
or equal to $1 billion) that is a subsidiary of a depository
institution holding company shall become a Level 1 or Level 2 covered
institution when such depository institution holding company becomes a
Level 1 or Level 2 covered institution, respectively, pursuant to 12
CFR 236.3.
(2) Compliance date. (i) A regulated institution that becomes a
Level 1, Level 2, or Level 3 covered institution pursuant to paragraph
(a)(1)(i) of this section shall comply with the requirements of this
part for a Level 1, Level 2, or Level 3 covered institution,
respectively, not later than the first day of the first calendar
quarter that begins at least 540 days after the date on which the
regulated institution becomes a Level 1, Level 2, or Level 3 covered
institution, respectively. Until that day, the Level 1, Level 2, or
Level 3 covered institution will remain subject to the requirements of
this part, if any, that applied to the regulated institution on the day
before the date on which it became a Level 1, Level 2, or Level 3
covered institution.
(b) A covered institution that becomes a Level 1 or Level 2 covered
institution pursuant to paragraph (a)(1)(ii) of this section shall
comply with the requirements of this part for a Level 1 or Level 2
covered institution, respectively, not later than the first day of the
first calendar quarter that begins at least 540 days after the date on
which the regulated institution becomes a Level 1 or Level 2 covered
institution, respectively. Until that day, the Level 1 or Level 2
covered institution will remain subject to the requirements of this
part, if any, that applied to the covered institution on the day before
the date on which it became a Level 1 or Level 2 covered institution.
(3) Grandfathered plans. (i) A regulated institution that becomes a
Level 1, Level 2, or Level 3 covered institution under paragraph
(a)(1)(i) of this section is not required to comply with requirements
of this part applicable to a Level 1, Level 2, or Level 3 covered
institution, respectively, with respect to any incentive-based
compensation plan with a performance period that begins before the date
described in paragraph (a)(2)(i) of this section. Any such incentive-
based compensation plan shall remain subject to the requirements under
this part, if any, that applied to the regulated institution at the
beginning of the performance period.
(b) A covered institution that becomes a Level 1 or Level 2 covered
institution under paragraph (a)(1)(ii) of this section is not required
to comply with requirements of this part applicable to a Level 1 or
Level 2 covered institution, respectively, with respect to any
incentive-based compensation plan with a performance period that begins
before the date described in paragraph (a)(2)(ii) of this section. Any
such incentive-based compensation plan shall remain subject to the
requirements under this part, if any, that applied to the covered
institution at the beginning of the performance period.
(b) When total consolidated assets decrease. (1) A Level 1, Level
2, or Level 3 covered institution will remain subject to the
requirements applicable to such covered institution under this part
unless and until the total consolidated assets of such covered
institution, as reported on the covered institution's regulatory
reports, fall below $250 billion, $50 billion, or $1 billion,
respectively, for each of four consecutive quarters. The calculation
will be effective on the as-of date of the fourth consecutive
regulatory report.
(2) A Level 1, Level 2, or Level 3 covered institution that is an
investment adviser will remain subject to the requirements applicable
to such covered institution under this part unless and until the
average total consolidated assets of the covered institution fall below
$250 billion, $50 billion, or $1 billion, respectively as of the most
recent fiscal year end.
(3) A covered institution that is a Level 1 or Level 2 covered
institution solely by virtue of its being a subsidiary of a depository
institution holding company will remain subject to the requirements
applicable to such covered institution under this part unless and until
such depository institution holding company ceases to be subject to the
requirements applicable to it in accordance with 12 CFR 236.3.

Sec. 303.4 Requirements and prohibitions applicable to all covered
institutions.

[[Page 37835]]

could lead to material financial loss to the covered institution,
unless the arrangement:
(1) Appropriately balances risk and reward;
(2) Is compatible with effective risk management and controls; and
(3) Is supported by effective governance.
(d) Performance measures. An incentive-based compensation
arrangement will not be considered to appropriately balance risk and
reward for purposes of paragraph (c)(1) of this section, unless:
(1) The arrangement includes financial and non-financial measures
of performance, including considerations of risk-taking, that are
relevant to a covered person's role within a covered institution and to
the type of business in which the covered person is engaged and that
are appropriately weighted to reflect risk-taking;
(2) The arrangement is designed to allow non-financial measures of
performance to override financial measures of performance when
appropriate in determining incentive-based compensation; and
(3) Any amounts to be awarded under the arrangement are subject to
adjustment to reflect actual losses, inappropriate risks taken,
compliance deficiencies, or other measures or aspects of financial and
non-financial performance.
(e) Board of directors. A covered institution's board of directors,
or a committee thereof, must:
(1) Conduct oversight of the covered institution's incentive-based
compensation program;
(2) Approve incentive-based compensation arrangements for senior
executive officers, including the amounts of all awards and, at the
time of vesting, payouts under such arrangements; and
(3) Approve any material exceptions or adjustments to incentive-
based compensation policies or arrangements for senior executive
officers.
(f) Disclosure and recordkeeping requirements. A covered
institution must create annually and maintain for a period of at least
seven years records that document the structure of all its incentive-
based compensation arrangements and demonstrate compliance with this
part. A covered institution must disclose the records to the Commission
upon request. At a minimum, the records must include copies of all
incentive-based compensation plans, a record of who is subject to each
plan, and a description of how the incentive-based compensation program
is compatible with effective risk management and controls.
(g) Rule of construction. A covered institution is not required to
report the actual amount of compensation, fees, or benefits of
individual covered persons as part of the disclosure and recordkeeping
requirements under this part.

Sec. 303.5 Additional disclosure and recordkeeping requirements for
Level 1 and Level 2 covered institutions.

(a) A Level 1 or Level 2 covered institution must create annually
and maintain for a period of at least seven years records that
document:
(1) The covered institution's senior executive officers and
significant risk-takers, listed by legal entity, job function,
organizational hierarchy, and line of business;
(2) The incentive-based compensation arrangements for senior
executive officers and significant risk-takers, including information
on percentage of incentive-based compensation deferred and form of
award;
(3) Any forfeiture and downward adjustment or clawback reviews and
decisions for senior executive officers and significant risk-takers;
and
(4) Any material changes to the covered institution's incentive-
based compensation arrangements and policies.
(b) A Level 1 or Level 2 covered institution must create and
maintain records in a manner that allows for an independent audit of
incentive-based compensation arrangements, policies, and procedures,
including those required under Sec. 303.11.
(c) A Level 1 or Level 2 covered institution must provide the
records described in paragraph (a) of this section to the Commission in
such form and with such frequency as requested by the Commission.

Sec. 303.6 Reservation of authority for Level 3 covered institutions.

(a) In general. The Commission may require a Level 3 covered
institution with average total consolidated assets greater than or
equal to $10 billion and less than $50 billion to comply with some or
all of the provisions of Sec. Sec. 303.5 and 303.7 through 303.11 if
the Commission determines that the Level 3 covered institution's
complexity of operations or compensation practices are consistent with
those of a Level 1 or Level 2 covered institution.
(b) Factors considered. Any exercise of authority under this
section will be in writing by the Commission in accordance with
procedures established by the Commission and will consider the
activities, complexity of operations, risk profile, and compensation
practices of the Level 3 covered institution, in addition to any other
relevant factors.

Sec. 303.7 Deferral, forfeiture and downward adjustment, and clawback
requirements for Level 1 and Level 2 covered institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will not be considered to appropriately balance
risk and reward, for purposes of Sec. 303.4(c)(1), unless the
following requirements are met.
(a) Deferral. (1) Qualifying incentive-based compensation must be
deferred as follows:
(i) Minimum required deferral amount. (A) A Level 1 covered
institution must defer at least 60 percent of a senior executive
officer's qualifying incentive-based compensation awarded for each
performance period.
(B) A Level 1 covered institution must defer at least 50 percent of
a significant risk-taker's qualifying incentive-based compensation
awarded for each performance period.
(C) A Level 2 covered institution must defer at least 50 percent of
a senior executive officer's qualifying incentive-based compensation
awarded for each performance period.
(D) A Level 2 covered institution must defer at least 40 percent of
a significant risk-taker's qualifying incentive-based compensation
awarded for each performance period.
(ii) Minimum required deferral period. (A) For a senior executive
officer or significant risk-taker of a Level 1 covered institution, the
deferral period for deferred qualifying incentive-based compensation
must be at least 4 years.
(B) For a senior executive officer or significant risk-taker of a
Level 2 covered institution, the deferral period for deferred
qualifying incentive-based compensation must be at least 3 years.
(iii) Vesting of amounts during deferral period. (A) Pro rata
vesting. During a deferral period, deferred qualifying incentive-based
compensation may not vest faster than on a pro rata annual basis
beginning no earlier than the first anniversary of the end of the
performance period for which the amounts were awarded.
(B) Acceleration of vesting. A Level 1 or Level 2 covered
institution must not accelerate the vesting of a covered person's
deferred qualifying incentive-based compensation that is required to be
deferred under this part, except in the case of death or disability of
such covered person.
(2) Incentive-based compensation awarded under a long-term
incentive plan must be deferred as follows:

[[Page 37836]]

(i) Minimum required deferral amount. (A) A Level 1 covered
institution must defer at least 60 percent of a senior executive
officer's incentive-based compensation awarded under a long-term
incentive plan for each performance period.
(B) A Level 1 covered institution must defer at least 50 percent of
a significant risk-taker's incentive-based compensation awarded under a
long-term incentive plan for each performance period.
(C) A Level 2 covered institution must defer at least 50 percent of
a senior executive officer's incentive-based compensation awarded under
a long-term incentive plan for each performance period.
(D) A Level 2 covered institution must defer at least 40 percent of
a significant risk-taker's incentive-based compensation awarded under a
long-term incentive plan for each performance period.
(ii) Minimum required deferral period. (A) For a senior executive
officer or significant risk-taker of a Level 1 covered institution, the
deferral period for deferred long-term incentive plan amounts must be
at least 2 years.
(B) For a senior executive officer or significant risk-taker of a
Level 2 covered institution, the deferral period for deferred long-term
incentive plan amounts must be at least 1 year.
(iii) Vesting of amounts during deferral period--(A) Pro rata
vesting. During a deferral period, deferred long-term incentive plan
amounts may not vest faster than on a pro rata annual basis beginning
no earlier than the first anniversary of the end of the performance
period for which amounts were awarded.
(B) Acceleration of vesting. A Level 1 or Level 2 covered
institution must not accelerate the vesting of a covered person's
deferred long-term incentive plan amounts that is required to be
deferred under this part, except in the case of death or disability of
such covered person.
(3) Adjustments of deferred qualifying incentive-based compensation
and deferred long-term incentive plan compensation amounts. A Level 1
or Level 2 covered institution may not increase deferred qualifying
incentive-based compensation or deferred long-term incentive plan
amounts for a senior executive officer or significant risk-taker during
the deferral period. For purposes of this paragraph, an increase in
value attributable solely to a change in share value, a change in
interest rates, or the payment of interest according to terms set out
at the time of the award is not considered an increase in incentive-
based compensation amounts.
(4) Composition of deferred qualifying incentive-based compensation
and deferred long-term incentive plan compensation for Level 1 and
Level 2 covered institutions--(i) Cash and equity-like instruments. For
a senior executive officer or significant risk-taker of a Level 1 or
Level 2 covered institution that issues equity or is an affiliate of a
covered institution that issues equity, any deferred qualifying
incentive-based compensation or deferred long-term incentive plan
amounts must include substantial portions of both deferred cash and
equity-like instruments throughout the deferral period.
(ii) Options. If a senior executive officer or significant risk-
taker of a Level 1 or Level 2 covered institution receives incentive-
based compensation for a performance period in the form of options, the
total amount of such options that may be used to meet the minimum
deferral amount requirements of paragraph (a)(1)(i) or (a)(2)(i) of
this section is limited to no more than 15 percent of the amount of
total incentive-based compensation awarded to the senior executive
officer or significant risk-taker for that performance period.
(b) Forfeiture and downward adjustment--(1) Compensation at risk.
(i) A Level 1 or Level 2 covered institution must place at risk of
forfeiture all unvested deferred incentive-based compensation of any
senior executive officer or significant risk-taker, including unvested
deferred amounts awarded under long-term incentive plans.
(ii) A Level 1 or Level 2 covered institution must place at risk of
downward adjustment all of a senior executive officer's or significant
risk-taker's incentive-based compensation amounts not yet awarded for
the current performance period, including amounts payable under long-
term incentive plans.
(2) Events triggering forfeiture and downward adjustment review. At
a minimum, a Level 1 or Level 2 covered institution must consider
forfeiture and downward adjustment of incentive-based compensation of
senior executive officers and significant risk-takers described in
paragraph (b)(3) of this section due to any of the following adverse
outcomes at the covered institution:
(i) Poor financial performance attributable to a significant
deviation from the risk parameters set forth in the covered
institution's policies and procedures;
(ii) Inappropriate risk taking, regardless of the impact on
financial performance;
(iii) Material risk management or control failures;
(iv) Non-compliance with statutory, regulatory, or supervisory
standards that results in:
(A) Enforcement or legal action against the covered institution
brought by a federal or state regulator or agency; or
(B) A requirement that the covered institution report a restatement
of a financial statement to correct a material error; and
(v) Other aspects of conduct or poor performance as defined by the
covered institution.
(3) Senior executive officers and significant risk-takers affected
by forfeiture and downward adjustment. A Level 1 or Level 2 covered
institution must consider forfeiture and downward adjustment for a
senior executive officer or significant risk-taker with direct
responsibility, or responsibility due to the senior executive officer's
or significant risk-taker's role or position in the covered
institution's organizational structure, for the events related to the
forfeiture and downward adjustment review set forth in paragraph (b)(2)
of this section.
(4) Determining forfeiture and downward adjustment amounts. A Level
1 or Level 2 covered institution must consider, at a minimum, the
following factors when determining the amount or portion of a senior
executive officer's or significant risk-taker's incentive-based
compensation that should be forfeited or adjusted downward:
(i) The intent of the senior executive officer or significant risk-
taker to operate outside the risk governance framework approved by the
covered institution's board of directors or to depart from the covered
institution's policies and procedures;
(ii) The senior executive officer's or significant risk-taker's
level of participation in, awareness of, and responsibility for, the
events triggering the forfeiture and downward adjustment review set
forth in paragraph (b)(2) of this section;
(iii) Any actions the senior executive officer or significant risk-
taker took or could have taken to prevent the events triggering the
forfeiture and downward adjustment review set forth in paragraph (b)(2)
of this section;
(iv) The financial and reputational impact of the events triggering
the forfeiture and downward adjustment review set forth in paragraph
(b)(2) of this section to the covered institution, the line or sub-line
of business, and

[[Page 37837]]

individuals involved, as applicable, including the magnitude of any
financial loss and the cost of known or potential subsequent fines,
settlements, and litigation;
(v) The causes of the events triggering the forfeiture and downward
adjustment review set forth in paragraph (b)(2) of this section,
including any decision-making by other individuals; and
(vi) Any other relevant information, including past behavior and
past risk outcomes attributable to the senior executive officer or
significant risk-taker.
(c) Clawback. A Level 1 or Level 2 covered institution must include
clawback provisions in incentive-based compensation arrangements for
senior executive officers and significant risk-takers that, at a
minimum, allow the covered institution to recover incentive-based
compensation from a current or former senior executive officer or
significant risk-taker for seven years following the date on which such
compensation vests, if the covered institution determines that the
senior executive officer or significant risk-taker engaged in:
(1) Misconduct that resulted in significant financial or
reputational harm to the covered institution;
(2) Fraud; or
(3) Intentional misrepresentation of information used to determine
the senior executive officer or significant risk-taker's incentive-
based compensation.

Sec. 303.8 Additional prohibitions for Level 1 and Level 2 covered
institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will be considered to provide incentives that
appropriately balance risk and reward for purposes of Sec. 303.4(c)(1)
only if such institution complies with the following prohibitions.
(a) Hedging. A Level 1 or Level 2 covered institution must not
purchase a hedging instrument or similar instrument on behalf of a
covered person to hedge or offset any decrease in the value of the
covered person's incentive-based compensation.
(b) Maximum incentive-based compensation opportunity. A Level 1 or
Level 2 covered institution must not award incentive-based compensation
to:
(1) A senior executive officer in excess of 125 percent of the
target amount for that incentive-based compensation; or
(2) A significant risk-taker in excess of 150 percent of the target
amount for that incentive-based compensation.
(c) Relative performance measures. A Level 1 or Level 2 covered
institution must not use incentive-based compensation performance
measures that are based solely on industry peer performance
comparisons.
(d) Volume driven incentive-based compensation. A Level 1 or Level
2 covered institution must not provide incentive-based compensation to
a covered person that is based solely on transaction revenue or volume
without regard to transaction quality or compliance of the covered
person with sound risk management.

Sec. 303.9 Risk management and controls requirements for Level 1 and
Level 2 covered institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will be considered to be compatible with effective
risk management and controls for purposes of Sec. 303.4(c)(2) only if
such institution meets the following requirements.
(a) A Level 1 or Level 2 covered institution must have a risk
management framework for its incentive-based compensation program that:
(1) Is independent of any lines of business;
(2) Includes an independent compliance program that provides for
internal controls, testing, monitoring, and training with written
policies and procedures consistent with Sec. 303.11; and
(3) Is commensurate with the size and complexity of the covered
institution's operations.
(b) A Level 1 or Level 2 covered institution must:
(1) Provide individuals engaged in control functions with the
authority to influence the risk-taking of the business areas they
monitor; and
(2) Ensure that covered persons engaged in control functions are
compensated in accordance with the achievement of performance
objectives linked to their control functions and independent of the
performance of those business areas.
(c) A Level 1 or Level 2 covered institution must provide for the
independent monitoring of:
(1) All incentive-based compensation plans in order to identify
whether those plans provide incentives that appropriately balance risk
and reward;
(2) Events related to forfeiture and downward adjustment reviews
and decisions of forfeiture and downward adjustment reviews in order to
determine consistency with Sec. 303.7(b); and
(3) Compliance of the incentive-based compensation program with the
covered institution's policies and procedures.

Sec. 303.10 Governance requirements for Level 1 and Level 2 covered
institutions.

An incentive-based compensation arrangement at a Level 1 or Level 2
covered institution will not be considered to be supported by effective
governance for purposes of Sec. 303.4(c)(3), unless:
(a) The covered institution establishes a compensation committee
composed solely of directors who are not senior executive officers to
assist the board of directors in carrying out its responsibilities
under Sec. 303.4(e); and
(b) The compensation committee established pursuant to paragraph
(a) of this section obtains:
(1) Input from the risk and audit committees of the covered
institution's board of directors, or groups performing similar
functions, and risk management function on the effectiveness of risk
measures and adjustments used to balance risk and reward in incentive-
based compensation arrangements;
(2) A written assessment of the effectiveness of the covered
institution's incentive-based compensation program and related
compliance and control processes in providing risk-taking incentives
that are consistent with the risk profile of the covered institution,
submitted on an annual or more frequent basis by the management of the
covered institution and developed with input from the risk and audit
committees of its board of directors, or groups performing similar
functions, and from the covered institution's risk management and audit
functions; and
(3) An independent written assessment of the effectiveness of the
covered institution's incentive-based compensation program and related
compliance and control processes in providing risk-taking incentives
that are consistent with the risk profile of the covered institution,
submitted on an annual or more frequent basis by the internal audit or
risk management function of the covered institution, developed
independently of the covered institution's management.

Sec. 303.11 Policies and procedures requirements for Level 1 and
Level 2 covered institutions.

[[Page 37838]]

incentive-based compensation to be clawed back;
(c) Require that the covered institution maintain documentation of
final forfeiture, downward adjustment, and clawback decisions;
(d) Specify the substantive and procedural criteria for the
acceleration of payments of deferred incentive-based compensation to a
covered person, consistent with Sec. 303.7(a)(1)(iii)(B) and
(a)(2)(iii)(B);
(e) Identify and describe the role of any employees, committees, or
groups authorized to make incentive-based compensation decisions,
including when discretion is authorized;
(f) Describe how discretion is expected to be exercised to
appropriately balance risk and reward;
(g) Require that the covered institution maintain documentation of
the establishment, implementation, modification, and monitoring of
incentive-based compensation arrangements, sufficient to support the
covered institution's decisions;
(h) Describe how incentive-based compensation arrangements will be
monitored;
(i) Specify the substantive and procedural requirements of the
independent compliance program consistent with Sec. 303.9(a)(2); and
(j) Ensure appropriate roles for risk management, risk oversight,
and other control function personnel in the covered institution's
processes for:
(1) Designing incentive-based compensation arrangements, and
determining awards, deferral amounts, deferral periods, forfeiture,
downward adjustment, clawback, and vesting; and
(2) Assessing the effectiveness of incentive-based compensation
arrangements in restraining inappropriate risk-taking.

Sec. 303.12 Indirect actions.

A covered institution must not, indirectly or through or by any
other person, do anything that would be unlawful for such covered
institution to do directly under this part.

Sec. 303.13 Enforcement.

Dated: April 26, 2016.
Thomas J. Curry,
Comptroller of the Currency.
By order of the Board of Governors of the Federal Reserve
System, May 2, 2016.
Margaret McCloskey Shanks,
Deputy Secretary of the Board.
Dated at Washington, DC this 26th day of April, 2016.

By order of the Board of Directors.

Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary.
Dated: April 21, 2016.

By the Federal Housing Finance Agency.

Melvin L. Watt,
Director.

By the National Credit Union Administration Board on April 21,
2016.
Gerard Poliquin,
Secretary of the Board.
Dated: May 6, 2016.

By the Securities and Exchange Commission.
Robert W. Errett,
Deputy Secretary.
[FR Doc. 2016-11788 Filed 6-9-16; 8:45 am]
BILLING CODE 8011-01-P

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