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Proposed Rule issued for Incentive-Based Compensation

The federal banking regulators have issued a proposed rule (the “Proposed Rule”) to implement Section 959 of the Dodd-Frank Act, governing incentive-based compensation for executive officers, employees, directors, and principal shareholders (“covered persons”).  Incentive-based compensation is defined broadly to include any direct or indirect payment or other benefit intended as an incentive for performance.  The Proposed Rule will apply to financial institutions (including banks, bank holding companies, and subsidiaries) with consolidated assets of one billion dollars or more.  The rule, however, may eventually become a “best practice” for smaller banks. 

The Proposed Rule essentially supplements existing rules and guidance on compensation, which apply to all banking institutions, including 12 CFR Parts 208 and 364, and the Guidance on Sound Incentive Policies issued in June of 2010.  Covered institutions are prohibited from providing excessive incentive-based compensation to a covered person that would encourage that person to expose the institution to inappropriate risks.  The determination of whether incentive-based compensation is excessive will be based on the following factors, found in the standards for safety and soundness with respect to compensation in 12 CFR Parts 208 and 364:

  1. The combined value of all cash and non-cash benefits to the covered person;
  2. The compensation history of the covered person and other individuals with comparable experience at the institution;
  3. The financial condition of the institution;
  4. Compensation practices at comparable institutions;
  5. The projected costs and benefits of any post-employment compensation;
  6. Any connection between the covered person and instance of fraud, breaches of trust or fiduciary duty, or insider abuse at the institution; and
  7. Any other factors the applicable federal regulator deems relevant.

The Proposed Rule also prohibits an institution from using incentive-based compensation practices that could lead to a material financial loss by the institution.  A determination of this requirement is based on the three principles for incentive-based compensation found in the Guidance on Sound Incentive Policies.  Under these principles, incentive-based compensation should be the following:

  1. Appropriately balanced in terms of risk and financial reward (such as by deferring payments and adjusting them for risk, extending the performance period for rewards, and reducing reward sensitivity to short-term performance);
  2. Compatible with effective controls and risk-management processes; and
  3. Subject to strong corporate governance and oversight.

Covered institutions (institutions larger than one billion dollars) are required to file annual reports regarding their incentive-based compensation practices and adopt written policies and procedures.  Covered institutions with assets greater than fifty billion dollars are subject to further requirements applicable to the institution’s executive management and board of directors (including a required deferral of at least three years for a minimum of 50% of incentive-based payments for certain executives).  Comments on the proposed rule will be accepted for 45 days after publication in the Federal Register. 

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