Proposed Rule Summary
NCUA 12 CFR Part 751
Prepared by NASCUS Legislative & Regulatory Affairs Department
In conjunction with five other federal regulators, NCUA is proposing a rule that would require federally insured credit unions with assets of $1 billion or more to provide NCUA information about their incentive-based compensation for executives and other “risk taking” individuals. Given the $1 billion thresholds, NCUA notes the rule exempts 96% of federally insured credit unions. There are only 258 federally insured credit unions have assets above $1 billion.
The proposed rule would apply to federally insured credit unions and any privately insured credit unions applying for federal insurance.
Comments must be received by July 22, 2016. A copy of the proposed rule may be found here.
The rule would become effective 18 months after publication of a final rule. Incentive based compensation plans created before the effective date of a final rule would be grandfathered.
Section 956 of the Dodd-Frank Act required federal regulators prohibit types of incentive-based compensation arrangements, or any feature of any such arrangements, that regulators determine encourage inappropriate risks by a covered financial institution: (1) by providing an executive officer, employee, director, or principal shareholder of the covered financial institution with excessive compensation, fees, or benefits; or (2) that could lead to material financial loss to the covered financial institution. Under the Act, a covered financial institution also must disclose to its appropriate Federal regulator the structure of its incentive-based compensation arrangements sufficient to determine whether the structure provides excessive compensation, fees, or benefits or could lead to material financial loss to the institution.
Covered Entities and Individuals
The rule divides credit unions (and other covered entities) into 3 categories:
• Level 1 (greater than or equal to $250 billion);
• Level 2 (greater than or equal to $50 billion and less than $250 billion); and
• Level 3 (greater than or equal to $1 billion and less than $50 billion).
Note: While most of the proposed rule applies only to Level 1 and 2 entities (above $50 billion), NCUA has is reserving itself the authority to require a Level 3 credit union ($1 billion to $50 billion) to comply with provisions intended for the larger Level 1 & 2 credit unions.
The rule would apply to any senior executive, employee, or significant risk taker (credit unions over $50billion only) who receives incentive based compensation.
Requirements for the Board of Directors
The credit union’s board of directors will be required to:
- Conduct oversight of the covered institution’s incentive-based compensation program;
- Approve incentive-based compensation arrangements for senior executive officers, including amounts of awards and, at the time of vesting, payouts under such arrangements; and
- Approve material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers.
Record Keeping Requirements
The 2011 proposed rule contained an annual reporting requirement, which has been replaced by a recordkeeping requirement in the 2016 proposed rule.
All covered credit unions would be required to annually document incentive-based compensation arrangements and compliance with the rule. Those documents would have to be maintained for 7 years from time of creation (after the first 7 years after effective, credit unions would always be maintaining 7 years-worth of records on a rolling basis).
In addition to this basic requirement, more detailed record keeping requirements apply to Level 1 and Level 2 credit unions (taken together those over $50 billion in assets);
- Level 1 and Level 2 covered institutions – annual documentation must identify (1) senior executive officers and significant risk-takers, listed by legal entity, job function, organizational hierarchy, and line of business; (2) the incentive-based compensation arrangements for senior executive officers and significant risk-takers, including information on the percentage of incentive-based compensation deferred and form of award; (3) any forfeiture and downward adjustment or clawback reviews and decisions for senior executive officers and significant risk-takers; and (4) any material changes to the covered institution’s incentive-based compensation arrangements and policies.
- Level 1 and Level 2 covered institutions – required annual records must be created and maintained in a manner that would allow for an independent audit of incentive-based compensation arrangements, policies, and procedures.
Deferral, Forfeiture and Downward Adjustment, and Clawback Requirements (Level 1 & 2 Only)
The proposed rule contains tiered requirements for deferral of payments, risk of downward adjustment and forfeiture, and clawback for Level 1 and Level 2 credit union incentive based compensation plans.
- Level 1 credit union - required to defer at least 60% of a senior executive officer’s qualifying incentive-based compensation and 50% of a significant risk-taker’s qualifying incentive-based compensation for at least 4 years.
It would also be required to defer for at least 2 years after the end of the related performance period at least 60% of a senior executive officer’s incentive-based compensation awarded under a “long-term incentive plan” and 50% of a significant risk-taker’s incentive-based compensation awarded under a long-term incentive plan.
- Level 2 credit union - 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 3 years.
It must also defer for at least 1 year after the end of the related performance period at least 50% of a senior executive officer’s incentive-based compensation awarded under a long-term incentive plan and 40% of a significant risk-taker’s incentive-based compensation awarded under a long-term incentive plan.
Vesting during Deferral
Deferred compensation may vest no faster than on a pro-rata annual basis, beginning no earlier than the first anniversary of the end of the performance period for which the amounts were awarded.
The proposed rule would also prohibit Level 1 and Level 2 covered institutions from accelerating the payment of a covered person’s deferred incentive-based compensation, except in the case of death or disability of the covered person.
Level 1 and 2 credit unions are also prohibited from increasing the amount of deferred incentive based compensation during the deferral period. However, this prohibition does not include increases to value attributable solely to a change in share value, a change in interest rates, or payment of interest pursuant to terms set out at the time of the award.
Forfeiture and Downward Adjustment
A Level 1 or 2 credit unions must have provisions to reduce incentive-based compensation that has not yet been awarded as well as deferred incentive-based compensation. At a minimum, a Level 1 or Level 2 credit union must consider forfeiture and downward adjustment of incentive-based compensation of senior executive officers and significant risk-takers due to any of the following adverse outcomes at the credit union:
- Poor financial performance attributable to a significant deviation from the risk parameters set forth in the credit union’s policies and procedures
- Inappropriate risk taking, regardless of the impact on financial performance
- Material risk management or control failures
- Non-compliance with statutory, regulatory, or supervisory standards that results in: (A)Enforcement or legal action against the credit union brought by a federal or state regulator or agency; or
(B) A requirement that the credit union report a restatement of a financial statement to correct a material error
- Other aspects of conduct or poor performance as defined by the credit union
In determining the amount of incentive based compensation to be forfeited or adjusted downward, Level 1 and 2 credit unions must consider:
- The intent of the senior executive officer or significant risk-taker to operate outside the risk governance framework approved by the credit union’s board of directors or to depart from the credit union’s policies and procedures
- The senior executive officer’s or significant risk-taker’s level of participation in, awareness of, and responsibility for, the events triggering the forfeiture or downward adjustment review
- Any actions the senior executive officer or significant risk-taker took or could have taken to prevent the events triggering the forfeiture or downward adjustment
- The financial and reputational impact of the events triggering the forfeiture or downward adjustment review to the credit union, the line or sub-line of business, and individuals involved, as applicable, including the magnitude of any financial loss and the cost of known or potential subsequent fines, settlements, and litigation
- Any other relevant information, including past behavior and past risk outcomes attributable to the senior executive officer or significant risk-taker
Under the proposed rule, “forfeiture” means a reduction of the amount of deferred incentive-based compensation awarded to a person that has not vested and “downward adjustment” means a reduction of the amount of a covered person’s incentive-based compensation not yet awarded for any performance period that has already begun.
Level 1 and Level 2 credit unions would also be required to include claw-back provisions in the incentive-based compensation arrangements for senior executive officers and significant risk-takers. Claw-back is a means by which a credit union can recover vested incentive-based compensation from a senior executive officer or significant risk-taker. The claw-back provision would allow for recover of vested funds for 7 years after vesting. Claw-backs must be considered where:
- Misconduct resulted in significant financial or reputational harm to the credit union
- Fraud occurred
- Information used to determine incentive-based compensation was intentionally misrepresented
Risk Management and Controls
The proposed rule would require all Level 1 and Level 2 credit unions to have a risk management framework for their incentive-based compensation programs that:
- Is independent of any lines of business
- Includes an independent compliance program that provides for internal controls, testing, monitoring, and training with written policies and procedures
- Is commensurate with the size and complexity of the covered institution’s operations
- Provides for independent monitoring of: (1) incentive-based compensation plans to identify whether the plans appropriately balance risk and reward; (2) events related to forfeiture and downward adjustment and decisions of forfeiture and downward adjustment reviews; and (3) compliance of the incentive-based compensation program with the covered institution’s policies and procedures.
Level 1 and 2 credit unions are also subject to the following:
- Hedging – the credit union may not purchase a hedging/similar instrument on behalf of a covered person to hedge any decrease in the value of the incentive-based compensation
- Limits on compensation – the rules limits incentive based compensation for executives to 125% of the target amount and 150% of target amount for significant risk takers
- Volume limitations – incentive based compensation may not be based solely on volume or transaction revenue without regard to quality
- Peer performance – incentive based compensation may not be based solely on peer performance comparisons