U.S. Regulators Propose Rules on Incentive-Based
Compensation Arrangements at Large Financial
Institutions
February 24, 2011
In the latest round of rulemaking under the Dodd-Frank Wall Street Reform and Consumer
Protection Act (the “Dodd-Frank Act”), the Federal Deposit Insurance Corporation recently
issued proposed rules governing incentive-based compensation arrangements at major financial
institutions, including new reporting requirements and prohibitions on compensation
arrangements that are excessive in nature or that could expose such institutions to material
financial loss. In the case of financial institutions that have $50 billion or more in consolidated
assets, at least 50% of incentive-based compensation payable to the executive officers of suchinstitutions must be deferred for a period of no less than three years, with the deferred amountsubject to a look-back review based on actual losses or other performance measures that become
better known during the deferral period. The same rules are soon expected to be issued by theother major banking and financial regulators, including the Federal Reserve, the Office of theComptroller of the Currency, the Office of Thrift Supervision, and the Securities and Exchange
Commission.
Section 956 of the Dodd-Frank Act requires that the major banking and financial regulators tojointly issue regulations or guidelines that prohibit incentive-based payment arrangements, or
any feature of such arrangements, that encourage inappropriate risks by a financial institution
by providing excessive compensation or that could lead to a material financial loss to theinstitution. The proposed rules are intended to satisfy that requirement.
Following a 45-day public comment period, the proposed rules are expected to become effective
six months after their final adoption and publication in the Federal Register by the various
regulators. This memorandum reviews some of the key features of the proposed rules, which
are intended to supplement, rather than replace, existing rules and guidance adopted by theseregulators regarding compensation practices.1
A.

The Broad Scope of the Proposed Rules

The proposed rules apply to “covered financial institutions”—that is, generally, any of thefollowing types of institutions that have, on a consolidated basis, assets of $1 billion or more:
1

These rules and guidance include the Guidance on Sound Incentive Compensation Policies (75 Fed.
Reg. 36935 (June 25, 2010)), which was adopted by the federal banking regulators last year; theStandards for Safety and Soundness (60 Fed. Reg. 35678 (July 10, 1995), as amended at 61 Fed. Reg.
43950 (Aug. 27, 1996)); and the compensation-related disclosure requirements adopted by the SEC for
public companies (see, e.g., Item 402(s) of Regulation S-K, 17 C.F.R. § 229.402(s), adopted in Securities
Act Release No. 9080, 74 Fed. Reg. 68334 (Dec. 23, 2009)).

Memorandum – February 24, 2011

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depository institutions (including the uninsured U.S. branches and agencies offoreign banks),
depository institution holding companies (including foreign banks that are treated asbank holding companies under the International Banking Act),
registered broker-dealers under the Exchange Act,
investment advisers under the Investment Advisers Act, andany other financial institution that the federal banking and financial regulators
jointly determine should be treated as covered by the rules.

Only incentive-based compensation paid by covered financial institutions to “covered persons”
would be subject to the requirements of the proposed rules. The term “covered person”
includes any executive officer, employee, director, or principal shareholder (i.e., any individualthat directly or indirectly, or acting in concert through one or more persons, owns or controls
10% or more of any class of voting securities) of a covered financial institution. An “executive
officer” is defined broadly to include any person who holds the title of (or, without such title,
performs the function of) one the following positions: president, chief executive officer,
executive chairman, chief operating officer, chief financial officer, chief investment officer, chief
lending officer, chief legal officer, chief risk officer, or the head of a major business line.
“Incentive-based compensation” means “any variable compensation that serves as an incentive
for performance.” The definition of “compensation” covers all direct and indirect payments,
fees or benefits, both cash and non-cash (including equity), awarded or granted to, or earned byor for the benefit of, any covered person in exchange for services rendered to the covered
financial institution. Examples of compensation included in the definition are payments or
benefits pursuant to an employment contract, compensation or benefit arrangement, feearrangement, perquisites, stock option plan, post-employment benefit, or “other compensatory
arrangement.”
Compensation that is specifically excluded from these rules is, generally: compensation
awarded solely for, and the payment of which is solely tied to, continued employment (e.g.,salary); compensation that provides rewards solely for activities or behaviors that do not
involve risk-taking (e.g., payments for achieving or maintaining professional certification); andcompensation based solely on the employee’s level of fixed compensation that does not vary
based on performance metrics (e.g., employer contributions to a 401(k) plan based on a fixed
percentage of the employee’s salary).
B.

Prohibition on “Excessive” Compensation Arrangements and Those Arrangements
That May Lead to “Material Financial Loss”

The proposed rules prohibit a covered financial institution from establishing or maintaining
incentive-based compensation arrangements that encourage inappropriate risk-taking by
providing excessive compensation or that could otherwise lead to a material financial loss to thecovered financial institution.

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Memorandum – February 24, 2011

1.

“Excessive” Compensation

Under the proposed rules, a covered financial institution is prohibited from establishing ormaintaining incentive-based compensation arrangements, or any individual feature of sucharrangements, that encourage a covered person to expose a covered financial institution to
inappropriate risks by providing that person with excessive compensation.
Compensation will be considered “excessive” when amounts paid are unreasonable ordisproportionate to, among other things, the amount, nature, quality, and scope of services
performed by the covered person. The relevant regulators are to assess whether compensation
is excessive using the following standards, which are part of the “safety and soundness”
compensation standards contained in Section 39 of the Federal Deposit Insurance Act:
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the combined value of all cash and non-cash benefits provided to the covered
person;the compensation history of the covered person and other individuals withcomparable expertise at the covered financial institution;
the financial condition of the institution;comparable compensation practices at peer institutions, based upon such factors asasset size, geographic location, and the complexity of the institution’s operations andassets;the projected total costs and benefit to the covered financial institution, with regard
to post-employment benefits;
any connection between the individual and any fraudulent acts or omissions,fiduciary duty or trust breaches, or insider abuse with regard to the covered financial
institution; andany other factors that the applicable regulator considers to be important.
Incentive-Based Compensation Arrangements and the Prospect for “Material
Financial Loss” at the Covered Financial Institution

The proposed rules also ban incentive-based compensation arrangements for individual
covered persons, or groups of covered persons, whose particular activities may expose thecovered financial institution to “inappropriate risks that could lead to a material financial loss.”
The types of covered persons contemplated by this portion of the rules are: (i) executive officers
and other persons who are responsible for oversight of firm-wide activities or material businesslines; (ii) other individual covered persons, including non-executive employees, based on thenature of their activities (such as traders with large position limits relative to the institution’s
overall risk tolerance); and (iii) groups of covered persons who are subject to the same or similar
incentive-based compensation arrangements and who, in the aggregate, could expose theinstitution to a material financial loss, even if no individual covered person in the group could
expose the institution to such loss (such as loan officers who, as group, originate loans that
account for a material amount of the institution’s credit risk).
An incentive-based compensation arrangement will not be compliant with the rules unless it (i)balances risk and financial rewards, (ii) is compatible with effective controls and risk
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Memorandum – February 24, 2011

management, and (iii) is supported by strong corporate governance. Covered financial
institutions will be required to establish and maintain policies and procedures related to thesestandards, as described in more detail below.
(i)Balance of Risks and Rewards

A central theme underlying the proposed rules is that of balance.
Incentive-based
compensation arrangements must balance risk and financial rewards in such a way that covered
persons lack incentives to take excessive risks that could lead to a material financial loss at thecovered financial institution. The proposed rules state specifically that an incentive-based
compensation arrangement will be deemed “balanced” when the amounts paid to a covered
person appropriately take into account the risks, as well as the financial benefits, from thecovered person’s activities and the impact of those activities on the institution. In this regard,
regulators will consider a full range of risks associated with a covered person’s activities(including credit, market, liquidity, operational, legal, compliance and reputational risks), as
well as the time horizon over which those risks may be realized.
The proposed rules cite four methods that covered financial institutions may use to ensurecompensation is more sensitive to risk: (i) deferring payment of the compensation beyond theend of a performance period and adjusting the amount payable based on actual losses or otherperformance criteria; (ii) adjusting awards on account of risk, based on quantitative or othermeasures that take into account the risk the covered person’s activities pose to the institution;(iii) extending performance periods, so that some or all risk outcomes associated with thecovered person’s activities are realized or better known at the time of payment; and (iv)reducing the rate at which awards increase as a covered person achieves higher levels of therelevant performance measure or measures used in the person’s incentive-based compensation
arrangement.
(ii)

Compatibility with Effective Controls and Risk Management

A covered financial institution’s risk management processes and internal controls must buttressthe development and maintenance of balanced incentive-based compensation arrangements.
Among other things, regulators will look to whether risk-management personnel are engaged
in the institution’s design of incentive-based compensation arrangements, as well as in themonitoring and assessment of such arrangements to ensure they are balanced with the overallrisks of an institution. The proposed rules also require a covered financial institution’s policies
to provide for the monitoring described above to be done by a group or person that is“independent” of the covered person. To be considered independent, the group or person musthave a separate reporting line to senior management from the covered person who is creating
the risks.

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Memorandum – February 24, 2011

(iii)

Strong Corporate GovernanceA covered financial institution’s board of directors (or committee thereof) must actively oversee
the development and operation of incentive-based compensation arrangements and related
control processes. This would include the review and approval by the institution’s board of
directors (or committee thereof) of the overall goals of any incentive-based compensation
program to ensure they are consistent with the institution’s risk tolerance, as well as the receipt
and analysis of data to test whether the overall design is consistent with the goals and purposesof Section 956 of the Dodd-Frank Act.
C.

Special Considerations for Executive Officers and Certain Designated Employees ofVery Large Covered Financial Institutions

Not all covered financial institutions are treated alike under the proposed rules. Covered
financial institutions with consolidated assets of $50 billion or more2 will have to comply withthe following additional requirements with respect to their executive officers and certain of
their employees designated as having the individual ability to expose such institutions tosubstantial loss.
(i)

Holdback of Incentive-Based Pay for Executive Officers

These covered financial institutions will be required to defer at least 50% of incentive–based
compensation otherwise payable to their executive officers over at least a three-year period.
The purpose of such deferral is to allow for risks not previously discernable or quantifiable tomaterialize by the end of the deferral period, in recognition of the fact that executive officers,
unlike other employees, make strategic and high-level decisions, the risks of which may not
become apparent for many years. Importantly, these amounts must be adjusted for actual
losses incurred by the institution or based on other measures or aspects of performance that
become known during the relevant deferral period. Covered financial institutions will be able
to release (or allow vesting of) these deferred amounts in a lump-sum at the conclusion of thedeferral period or, alternatively, in equal increments, pro rata, for each year of the deferral
period. For example, an institution required to apply a three-year deferral to a $150,000
incentive-based compensation amount could release a maximum of $50,000 each year, or it
could withhold the entire amount for the entire deferral period and release it as a lump-sum atthe conclusion of the three-year period. The institution could also employ a less rapid
distribution schedule by, for instance, releasing no amount after the first year, and thenreleasing a maximum of $100,000 the second year, and then $50,000 for the third year.

2

As of December 31, 2010, there were 35 bank holding companies that had at least $50 billion in
total consolidated assets. See National Information Center Website, available at
http://www.ffiec.gov/nicpubweb/nicweb/Top50Form.aspx.
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Memorandum – February 24, 2011

(ii)

Identification of Individual Employees Capable of Exposing an Institution to
Substantial Losses

The proposed rules would also require these covered financial institutions to identify individual
non-executive officer employees who have the ability to inflict substantial losses on theinstitution, based on its size, capital, or overall risk tolerance. The rules specifically identify
traders with large position limits relative to an institution’s overall risk tolerance, and otherindividuals who have the authority to place a substantial part of an institution’s capital at risk,
as examples of such employees.
The institution’s board of directors (or committee thereof) is charged with the responsibility of
indentifying those employees, other than executive officers, who individually may present a
substantial risk to the institution. In addition, the board of directors (or committee thereof) will
be required to approve the incentive-based compensation arrangements applicable to suchindividuals, and such approval may not be given unless the board (or committee) determinesthat the arrangement (including the method of paying such compensation) effectively balances
the financial rewards to the employee and the range and time horizon of risks associated withthe employee’s activities. The rules identify the following methods that can be used to establish
this balance: risk-adjustment of awards, deferral of payments, extended performance periods,
or “other appropriate methods.” The board (or committee) must evaluate the overall
effectiveness of the balancing methods used in the applicable incentive-based compensation
arrangement in reducing incentives for inappropriate risk-taking by the identified employee, as
well as the ability of the methods used to make payments sensitive to the full range of riskspresented by the employee’s activities.
D.

Policies, Procedures, and Reporting Requirements

The proposed rules require all covered financial institutions to have policies and procedures
governing the award of incentive-based compensation that balance the risk and reward forinstitutions of their respective size, complexity, and business activity, as well as the scope andnature of the incentive-based compensation arrangements. The policies and procedures shouldbe particularly focused on those employees who, individually or as a group, may expose theinstitution to material financial loss. Examples of employees who are unlikely to meet this test
include, for example, tellers, bookkeepers, couriers and data processing personnel.
In order for regulators to assess whether incentive-based compensation structures are excessive
in nature or could lead to material financial loss, all covered financial institutions will be
required to submit an annual report to their respective regulator that describes the structure of
their incentive-based compensation arrangements. The report will need to contain, at aminimum: (i) a description of the components of the institution’s incentive-based compensation
arrangements to covered persons, as well as the types of covered persons to which they apply;(ii) a description of the institution’s related policies and procedures on incentive-based
compensation; (iii) any material changes to such arrangements and policies and procedures
since the prior report; and (iv) the specific reasons why the institution views the structure of its
incentive-based compensation arrangements as not encouraging inappropriate risks byproviding covered persons with excessive compensation or incentive-based compensation that
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Memorandum – February 24, 2011

could lead to a material financial loss to the covered financial institution. In addition, covered
financial institutions with $50 billion or more in consolidated assets will be required to reporton their policies and procedures governing executive officers and other employees that havebeen identified by the institution as capable of exposing the institution to substantial losses.
However, covered financial institutions will not be required to disclose the actual compensationof any particular covered persons in the report.
***

For more information about these proposed rules and their impact on incentive-based
compensation arrangements at large financial institutions, please contact a member of the
Firm’s Executive Compensation and Employee Benefits Practice Group or Financial Institutions
Group.

This memorandum is for general informational purposes and should not be regarded as legal advice.
Furthermore, the information contained in this memorandum does not represent, and should not be
regarded as, the view of any particular client of Simpson Thacher & Bartlett LLP. Please contact yourrelationship partner if we can be of assistance regarding these important developments. The names andoffice locations of all of our partners, as well as additional memoranda, can be obtained from our website,www.simpsonthacher.com.

The contents of this publication are for informational purposes only. Neither this publication nor the lawyers who authored it are
rendering legal or other professional advice or opinions on specific facts or matters, nor does the distribution of this publication to
any person constitute the establishment of an attorney-client relationship. Simpson Thacher & Bartlett LLP assumes no liability inconnection with the use of this publication.

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Memorandum – February 24, 2011

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