The Dodd-Frank Act: An Overview of the 2016 Incentive-Based Compensation Proposal

Summary

Incentive compensation or incentive-based compensation refers to the portion of an employee’s pay that is not fixed in contrast to an annual or monthly salary. Incentive compensation takes the form of variable contingent compensation, particularly cash bonuses, that are based on the attainment of certain firm or employee performance metrics. Such pay has been a significant component of compensation for executives and other key personnel at many firms in the financial sector. Many argue that such compensation contributed to the 2007-2009 financial crisis by incentivizing pivotal financial firm personnel to take excessive, and in retrospect dangerous risks that were financially problematic for their firms.

In July 2010, in response to the financial crisis of 2007 to 2009, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act, P.L. 111-203). Section 956 of the law directed financial regulators to adopt new rules that jointly prescribe regulations or guidelines aimed at prohibiting incentive compensation arrangements that might encourage inappropriate risks at financial institutions. These regulators, the Agencies, are the National Credit Union Association, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission.

In April 2016, after releasing an ultimately unimplemented proposal in 2011, the Agencies proposed new rules to implement Section 956. The centerpiece of the proposal is a three-tiered protocol in which the stringency of incentive compensation limits grow as an entity’s consolidated asset total increases: Level 1, $250 billion and up; Level 2, $50 billion to $250 billion; and Level 3, $1 billion to $50 billion. Thousands of finance professionals and senior executives at various financial entities overseen by the Agencies would be potentially affected by the proposal, including those employed by commercial and investment banks, brokerage firms, hedge funds, and private equity funds. The Agencies will receive public comments on the proposal through July 22, 2016. The proposal will then require the approval of each agency in order to be finalized and adopted.

Level 1 and Level 2 institutions must comply with enhanced requirements as to the structure of their incentive compensation for senior executive officers (i.e., various top corporate leaders, including the president, the chief executive officer, and the chief operating officer) and significant risk-takers (i.e., top paid non-senior employees). For example, a Level 1 institution would be required to defer at least 60% of a senior executive officer’s qualifying incentive-based compensation and 50% of a significant risk-takers qualifying incentive-based compensation for up to four years. Senior executive officers and significant risk-takers incentive-based compensation awarded under the long-term incentive plan would be deferred by 60% and 50%, respectively, for at least two years. A Level 2 institution would be required to defer at least 50% of a senior executive officer’s qualifying incentive-based compensation and 40% of a significant risk-taker’s qualifying incentive-based compensation for at least three years.

Senior executives and significant risk-takers at Level 1 and 2 institutions would also be subject to reductions in previously earned incentive compensation (i.e., forfeiture and downward adjustment) in the event of certain behaviors, including when (1) deviation from risk parameters causes a firm’s poor financial performance, or (2) inappropriate risk-taking occurs regardless of the impact on the firm’s financial performance. Those employees could also have their vested incentive compensation clawed back by their employer under conditions determined by the employer, including (1) the existence of significant financial or reputational harm caused by the employee’s actions; (2) fraudulent conduct by the employee; or (3) intentional misrepresentations on the part of the employee.