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Will incentive compensation rules spread?

Federal regulators have again turned their attention to the incentive compensation practices at banks, bank holding companies, broker-dealers, investment advisers and certain other financial institutions for their executive officers, employees and directors. While regulatory action would apply only to financial institutions, all public companies should take note, as some requirements over time could start to apply to other companies as a matter of best practices and good corporate governance.

In response to the financial crisis, Congress adopted the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. Section 956 directs a group of federal agencies including the Securities and Exchange Commission and the Federal Reserve to jointly prescribe rules prohibiting financial institutions with consolidated assets of $1 billion or more from providing excessive incentive compensation to their executive officers, employees and directors that encourages inappropriate risk-taking or could lead to a material financial loss to the financial institution.

The federal agencies jointly issued proposed rules in 2011; however, no further action has been taken on them for almost five years.

In the last few weeks, the agencies have each released new proposed rules, and asked for comments by July 22. While the 2016 proposed rules are similar to those issued in 2011, they extend the more restrictive requirements to a broader group of institutions, as well as to a defined group of “significant risk-takers”—employees who are not senior executive officers, but whose relative compensation is high or who are in a position to expose the institution to significant risk.

The 2016 proposed rules classify covered financial institutions into three groups, with more restrictive rules applying to institutions with higher total assets: Level 1, consisting of covered institutions with consolidated assets of $250 billion or more; Level 2, for consolidated assets of $50 billion or more, but less than $250 billion; and Level 3, for consolidated assets of $1 billion or more, but less than $50 billion.

Some requirements apply to institutions at all three levels. Among other measures, these institutions are required to take into consideration an individual’s total compensation, the financial condition of the institution and the compensation at comparable institutions; balance risk and reward through risk-management controls and effective governance; include non-financial performance measures that can override financial performance in the event of inappropriate risks, compliance deficiencies and losses; and have board or committee oversight.

The 2016 proposed rules also contain a set of more restrictive requirements that apply only to senior executive officers and significant risk-takers at Level 1 and Level 2 institutions. These more restrictive requirements include a maximum incentive compensation limit of 125 to 150 percent of target; a mandatory deferral of 40 to 60 percent of short-term incentive compensation for two to four years and 40 to 50 percent of long-term incentive compensation for one to three years; and a requirement that incentive compensation be subject to forfeiture and downward adjustment before payment, and to a clawback for seven years after payment if the individual engaged in misconduct that caused significant financial or reputational harm to the institution.

Level 1 and Level 2 institutions also will be subject to enhanced recordkeeping, policy and procedure, and specified governance requirements for the incentive compensation of SEOs and SRTs, as well as a prohibition against hedging.

Commentators have speculated that these proposed rules will result in talented executives moving to unregulated businesses, where their incentive compensation would not be subject to the new strict limitations. Others believe that the proposed rules will cause decreases in the value of financial institutions and the return to their shareholders, as executives favor less-than-optimal risk taking by the institution, so as to minimize the possible reduction of their incentive compensation.

Looking at the effect of prior government attempts to limit executive compensation, the proposed rules could result in higher amounts of compensation to affected executives at financial institutions to compensate them for the mandatory deferral and the additional risk of forfeiture and clawback.

While the new proposed rules will apply only to financial institutions, we may see similar restrictions used more frequently by other companies. Some public companies already have started to incorporate potential risk in structuring their incentive compensation arrangements, delaying payment of a portion of incentive compensation and subjecting incentive compensation to clawback. Stay tuned.

Christopher Potash is a partner at Harter Secrest & Emery LLP and the head of its executive compensation practice.

5/20/2016 (c) 2016 Rochester Business Journal. To obtain permission to reprint this article, call 585-546-8303 or email rbj@rbj.net.

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