COMMENT CALL: The NCUA and other federal financial regulators have jointly issued proposed rules on incentive-based compensation arrangements. They would apply only to federally insured credit unions with at least $1 billion in assets. Based on the most recent call report data, that means 14 Wisconsin-based credit unions would be subject to the rules, but all others would be exempt.
The rules are being proposed under section 956 of the Dodd-Frank Act, which requires the agencies to issue regulations or guidelines that:
- Prohibit incentive-based compensation arrangements at covered financial institutions that encourage inappropriate risks by providing excessive compensation or that could lead to material financial loss; and
- Require those covered financial institutions to disclose information concerning incentive-based compensation arrangements to the appropriate federal regulator.
The proposed rules are intended to make incentive-based compensation arrangements more sensitive to risk. These include a prohibition on incentive-based compensation arrangements that do not include risk adjustment of awards, deferral of payments, and forfeiture and “clawback” provisions. The rules would also emphasize the important role of sound governance and risk management controls, helping safeguard covered institutions from incentive-based compensation arrangements that encourage inappropriate risks. The recordkeeping and disclosure requirements in the proposal would help regulators monitor and identify areas of potential concern.
A new version of older proposals
The rules are a re-proposal of incentive-based compensation rules that the federal regulators jointly proposed in 2011 and again in 2016.
The League wrote a letter to the NCUA Board in July of 2016, opposing those rules. Our letter summed up our position this way:
We appreciate that Congress and the regulators are taking steps to control the imprudent incentives paid by some big banks and mortgage companies. Americans rightly consider such programs a moral hazard, encouraging excessive risks for short-term gains at the expense of long-term institutional stability. However, credit unions are not the problem. The NCUA is not required to participate (nor should it) in this ambiguous and intrusive joint proposal. For credit unions, these rules are not needed. NCUA guidance could better serve our industry by establishing best practices in a format that allows the NCUA to expand on and fully explain its expectations.
The new proposal repeats the text proposed in 2016, but also seeks public comment on certain alternatives and questions, based on the agencies’ supervisory experiences over the past eight years.
Key features of the new proposal
This section of the Comment Call summarizes the proposal’s key provisions.
“Covered institutions”
The proposal would create a tiered system by dividing credit unions into three categories, each with separate requirements:
- Level 1: institutions with assets of $250 billion and above;
- Level 2: institutions with assets of at least $50 billion and below $250 billion; and
- Level 3: institutions with assets of at least $1 billion and below $50 billion.
As of the end of the first quarter of 2024, no federally insured credit unions were in Level 1, two credit unions were in Level 2, and 441 credit unions were in Level 3.
Most federally insured credit unions would be exempt from this rule.
“Covered persons”
The proposal would apply to “covered persons,” which would include executive officers, employees, directors, or principal shareholders receiving incentive-based compensation at a covered institution.
“Senior executive officers” would mean a covered person who holds the title or performs the function of one or more of the following positions 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.
“Significant risk-takers” would be defined under one of two potential tests:
- As covered persons who are among the top 5% (for Level 1 covered institutions), or top 2% (for Level 2 covered institutions), of highest compensated covered persons (excluding senior executive officers) in the entire consolidated organization, including affiliated covered institutions (the “relative compensation test”).
- As a covered person who has the authority to commit or expose 0.5% or more of the capital of the covered institution or an affiliate that is itself a covered institution (the “exposure test”).
Prohibition on arrangement that encourage risk
The proposal would prohibit incentive-based compensation arrangements at covered institutions that could encourage “inappropriate risks” by providing “excessive compensation” relative to the value of the services performed by executives or other employees.
Incentive-based compensation arrangements would have to appropriately balance risk and financial rewards by:
- Including financial and non-financial measures of performance.
- Allowing non-financial measures of performance to override financial measures of performance, when appropriate.
- Being subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance.
Deferral of payments
The proposal would require incentive-based compensation arrangements at Level 1 or 2 institutions to be subject to temporary deferral of a portion (40% to 60%, depending on institution size) of compensation. Deferral periods could range from one to four years, depending on the type of incentive-based compensation arrangement, the size of the covered institution, and whether the covered person is a senior executive officer or a significant risk-taker.
Forfeiture and downward adjustments
The proposal would require Level 1 and 2 institutions to consideration of forfeiture or downward adjustment of incentive-based compensation for senior executive officers and significant risk-takers if any of the following adverse outcomes occur:
- Poor financial performance due to deviation from risk guidelines;
- Inappropriate risk taking;
- Material risk management or control failures;
- Statutory, regulatory, or supervisory non-compliance that resulted in enforcement or legal action by agencies or financial restatement; or
- Other poor performance or misconduct.
Clawbacks
The proposal would require incentive-based compensation arrangements for senior executive officers and significant risk-takers at Level 1 and 2 institutions to include clawback provisions, allowing the institution to recover incentive-based compensation for a minimum of seven years.
If an institution determines that a current or former senior executive officer or significant risk-taker engaged in any of the following, it would be required to consider clawing back compensation:
- Misconduct that resulted in significant financial or reputational harm to the institution;
- Fraud; or
- Intentional misrepresentation of information used to determine the incentive-based compensation.
Other prohibitions
These other prohibitions would apply only to Level 1 and 2 institutions:
- If incentive-based compensation is in the form of options, the amount of options used to meet the minimum required deferred compensation could not exceed 15% of the total incentive-based compensation awarded for the performance period.
- The rules would prohibit purchasing hedging instruments for covered persons that offset any decrease in the value of incentive-based compensation arrangements.
- The rules would prohibit awarding incentive-based compensation to a senior executive officer in excess of 125% of the target amount for that incentive-based compensation. For a significant risk-taker, the limit would be 150%.
- The rules would prohibit use of performance measures based solely on industry peer performance comparisons.
- The rules would prohibit providing incentive-based compensation to a covered person based solely on transaction revenue or volume without regard to transaction quality or compliance with sound risk management.
Sound governance & risk management controls
The proposal would require Level 1 and 2 institutions to establish:
- Risk management frameworks for incentive-based compensation programs that are independent of any lines of business, include an independent compliance program, and are commensurate with the size and complexity of operations.
- A compensation committee (composed solely of directors who are not senior executive officers) that would obtain input (and independent written assessments) from the institution’s risk and audit committees, and risk management function, on the effectiveness of risk measures and adjustments around incentive-based compensation arrangements.
Recordkeeping & disclosures
The proposal would require all covered institutions (i.e., credit unions with more than $1 billion in assets) to create and maintain records for seven years documenting the structure of incentive-based compensation arrangements and compliance with the rules. Similarly, the rules would require disclosure of these records to the supervising agency upon request.
Alternative provisions
Based on the regulators’ supervisory experiences, changes in industry practices, and other developments, the agencies are considering a number of alternative regulatory provisions, including these:
- Compliance date. Reducing the timeline for complying with the rule from 540 days to 365 days after a final rule is published.
- Two-tiered asset thresholds. Establishing a two-level structure rather than a three-level structure, where the general prohibitions and requirements would apply to all covered institutions, and the proposed additional prohibitions and requirements would apply to covered institutions with average consolidated assets of $50 billion or more.
- “Significant risk-taker” definition. Replacing the two tests (i.e., relative compensation test and exposure test), with requiring covered institutions to identify significant risk-takers and submit a notice of its identification methodology to its federal regulator.
- Performance measures and targets. Requiring performance measures and targets to be established before the beginning of the performance period.
- Options. Modifying the proposed limit on options from 15% to no more than 10% of the amount of total incentive-based compensation awarded for that performance period.
- Forfeiture and downward adjustment. Limiting the discretion of Level 1 or 2 institutions to seek to recover incentive-based compensation by requiring (rather than requiring consideration of) forfeiture and downward adjustment of incentive-based compensation for the adverse outcomes.
- Clawbacks. Requiring Level 1 or 2 institutions to claw back (rather than “consider” clawing back) any vested (i.e. paid) incentive-based compensation. This alternative would provide an exception to recovery if the institution can document that clawback is impracticable or an equivalent amount of incentive-based compensation has been impacted through forfeiture or downward adjustment.
- Hedging. Prohibiting Level 1 and 2 institutions from designing incentive-based compensation arrangements that allow a covered person to purchase a hedging instrument or similar instrument to offset any decrease in the value of the covered person’s incentive-based compensation. This would include requiring covered institutions to have contracts with employees that ban personal hedging.
- Volume-driven incentive-based compensation. Expanding the prohibition to cover all incentive-based compensation based on transaction revenue or volume, rather than limiting the provision to incentive-based compensation based solely on transaction revenue or volume.
- Risk management and controls requirements. Adding a requirement for a Level 1 or 2 covered institution to include, as part of their risk management framework, a requirement that a risk management and controls assessment from the independent risk and control functions be considered when setting incentive-based compensation for senior executive officers and significant risk-takers.
Make your voice heard
The League would like to comment on this proposal, but to do so effectively, we need input from covered credit unions. Are you willing to share your reactions to the rules? Do they go too far? What provisions should be changed to improve the proposal? Please reach out to The League’s SVP & General Counsel, Paul Guttormsson, by Sept. 9, so that our letter (which must be submitted to the NCUA by Sept. 16, 2024) can reflect your views.