significant portion of the incentive-based compensation awarded under
those arrangements is deferred for an adequate amount of time.
---------------------------------------------------------------------------

    \135\ This premise was identified in the 2010 Federal Banking
Agency Guidance, 75 FR at 36409, and was highlighted in the 2011 FRB
White Paper. The report reiterated the recommendation that ``[a]
substantial fraction of incentive compensation awards should be
deferred for senior executives of the firm because other methods of
balancing risk taking incentives are less likely to be effective by
themselves for such individuals.'' 2011 FRB White Paper, at 15.
    \136\ Gopalan, Milbourn, Song and Thakor, ``Duration of
Executive Compensation'' (December 18, 2012), at 29-30, available at
http://apps.olin.wustl.edu/faculty/thakor/Website%20Papers/Duration%20of%20Executive%20Compensation.pdf.
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    As discussed above, in addition to the institution's senior
executive officers, the significant risk-takers at Level 1 and Level 2
covered institutions may have the ability to expose the institution to
the risk of material financial loss. In order to help ensure that the
incentive-based compensation arrangements for these individuals
appropriately balance risk and reward and do not encourage

them to engage in inappropriate risk-taking that could lead to material
financial loss, the proposed rule would extend the deferral requirement
to significant risk-takers at Level 1 and Level 2 covered institutions.
Deferral for significant risk-takers as well as executive officers
helps protect against material financial loss at the largest covered
institutions.

Sec.  __.7(a) Deferral

    As a tool to balance risk and reward, deferral generally consists
of four components: the proportion of incentive-based compensation
required to be deferred, the time horizon of the deferral, the speed at
which deferred incentive-based compensation vests, and adjustment
during the deferral period to reflect risks or inappropriate conduct
that manifest over that period of time.
    Section __.7(a) of the proposed rule would require Level 1 and
Level 2 covered institutions, at a minimum, to defer the vesting of a
certain portion of all incentive-based compensation awarded (the
deferral amount) to a senior executive officer or significant risk-
taker for at least a specified period of time (the deferral period).
The minimum required deferral amount and minimum required deferral
period would be determined by the size of the covered institution, by
whether the covered person is a senior executive officer or significant
risk-taker, and by whether the incentive-based compensation was awarded
under a long-term incentive plan or is qualifying incentive-based
compensation. Minimum required deferral amounts range from 40 percent
to 60 percent of the total incentive-based compensation award, and
minimum required deferral periods range from one year to four years, as
detailed below.
    Deferred incentive-based compensation of senior executive officers
and significant risk-takers at Level 1 and Level 2 covered institutions
would also be required to meet the following other requirements:
     Vesting of deferred amounts may occur no faster than on a
pro rata annual basis beginning on the one-year anniversary of the end
of the performance period;
     Unvested deferred amounts may not be increased during the
deferral period;
     For most Level 1 and Level 2 covered institutions,
substantial portions of deferred incentive-based compensation must be
paid in the form of both equity-like instruments and deferred cash;
     Vesting of unvested deferred amounts may not be
accelerated except in the case of death or disability; \137\ and
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    \137\ For covered persons at credit unions, NCUA's rule also
permits acceleration of payment if the covered person must pay
income taxes on the entire amount of an award, including deferred
amounts, at the time of award.
---------------------------------------------------------------------------

     All unvested deferred amounts must be placed at risk of
forfeiture and subject to a forfeiture and downward adjustment review
pursuant to section __.7(b).
    Except for the prohibition against accelerated vesting, the
prohibitions and requirements in section __.7(a) of the proposed rule
would apply to all unvested deferred incentive-based compensation,
regardless of whether the deferral of the incentive-based compensation
was necessary to meet the requirements of the proposed rule. For
example, if a covered institution chooses to defer incentive-based
compensation above the amount required to be deferred under the rule,
the additional amount would be required to be subject to forfeiture. In
another example, if a covered institution would be required to defer a
portion of a particular covered person's incentive-based compensation
for four years, but chooses to defer that compensation for ten years,
the deferral would be subject to forfeiture during the entire ten-year
deferral period. Applying the requirements and prohibitions of section
__.7(a) to all unvested deferred incentive-based compensation is
intended to maximize the balancing effect of deferred incentive-based
compensation, to make administration of the requirements and
prohibitions easier for covered institutions, and to facilitate the
Agencies' supervision for compliance.
    Compensation that is not incentive-based compensation and is
deferred only for tax purposes would not be considered ``deferred
incentive-based compensation'' for purposes of the proposed rule.

Sec.  __.7(a)(1) and Sec.  __.7(a)(2) Minimum Deferral Amounts and
Deferral Periods for Qualifying Incentive-Based Compensation and
Incentive-Based Compensation Awarded Under a Long-Term Incentive Plan

    The proposed rule would require a Level 1 covered institution to
defer at least 60 percent of each senior executive officer's qualifying
incentive-based compensation \138\ for at least four years, and at
least 60 percent of each senior executive officer's incentive-based
compensation awarded under a long-term incentive plan for at least two
years beyond the end of that plan's performance period. A Level 1
covered institution would be required to defer at least 50 percent of
each significant risk-taker's qualifying incentive-based compensation
for at least four years, and at least 50 percent of each significant
risk-taker's incentive-based compensation awarded under a long-term
incentive plan for at least two years beyond the end of that plan's
performance period.
---------------------------------------------------------------------------

    \138\ As described above, incentive-based compensation that is
not awarded under a long-term incentive plan would be defined as
qualifying incentive-based compensation under the proposed rule.
---------------------------------------------------------------------------

    Similarly, the proposed rule would require a Level 2 covered
institution to defer at least 50 percent of each senior executive
officer's qualifying incentive-based compensation for at least three
years, and at least 50 percent of each senior executive officer's
incentive-based compensation awarded under a long-term incentive plan
for at least one year beyond the end of that plan's performance period.
A Level 2 covered institution would be required to defer at least 40
percent of each significant risk-taker's qualifying incentive-based
compensation for at least three years, and at least 40 percent of each
significant risk-taker's incentive-based compensation awarded under a
long-term incentive plan for at least one year beyond the end of that
plan's performance period.
    In practice, a Level 1 or Level 2 covered institution typically
evaluates the performance of a senior executive officer or significant
risk-taker during and after the performance period. As the performance
period comes to a close, the covered institution determines an amount
of incentive-based compensation to award the covered person for that
performance period. Senior executive officers and significant risk-
takers may be awarded incentive-based compensation at a given time
under multiple incentive-based compensation plans that have performance
periods that come to a close at that time. Although they end at the
same time, those performance periods may have differing lengths, and
therefore may not completely overlap. For example, long-term incentive
plans, which have a minimum performance period of three years, would
consider performance in at least two years prior to the year the
performance period ends, while annual incentive plans would only
consider performance in the year of the performance period.
    For purposes of determining the amount of incentive-based
compensation that would be required to be deferred and the actual
amount that

would be deferred, a Level 1 or Level 2 covered institution generally
should use the present value of the incentive-based compensation at the
time of the award. In determining the value of awards for this purpose,
Level 1 and Level 2 covered institutions generally should use
reasonable valuation methods consistent with methods used in other
contexts.\139\
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    \139\ See, e.g., Topic 718 of the FASB Accounting Standards
Codification (formerly FAS 123(R); Black-Scholes method for valuing
options.
---------------------------------------------------------------------------

Pro Rata Vesting
    The requirements of this section would permit the covered
institution to immediately pay, or allow to vest, all of the incentive-
based compensation that is awarded that is not required to be deferred.
All incentive-based compensation that is deferred would be subject to a
deferral period that begins only once the performance period comes to a
close. During this deferral period, indications of inappropriate risk-
taking may arise, leading the covered institution to consider whether
the covered person should not be paid the entire amount originally
awarded.
    The incentive-based compensation that would be required by the rule
to be deferred would not be permitted to vest 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 compensation was awarded. In
other words, a covered institution would be allowed to make deferred
incentive-based compensation eligible for vesting during the deferral
period on a schedule that paid out equal amounts on each anniversary of
the end of the relevant performance period. A covered institution would
also be permitted to make different amounts eligible for vesting each
year, so long as the cumulative total of the deferred incentive-based
compensation that has been made eligible for vesting on each
anniversary of the end of the performance period is not greater than
the cumulative total that would have been eligible for vesting had the
covered institution made equal amounts eligible for vesting each year.
    For example, if a Level 1 covered institution is required to defer
$100,000 of a senior executive officer's incentive-based compensation
for four years, the covered institution could choose to make $25,000
available for vesting on each anniversary of the end of the performance
period for which the $100,000 was awarded. The Level 1 covered
institution could also choose to make different amounts available for
vesting at different times during the deferral period, as long as: The
total amount that is made eligible for vesting on the first anniversary
is not more than $25,000; the total amount that has been made eligible
for vesting by the second anniversary is not more than $50,000; and the
total amount that has been made eligible for vesting by the third
anniversary is not more than $75,000. In this example, the Level 1
covered institution would be permitted to make eligible for vesting
$10,000 on the first anniversary, $30,000 on the second anniversary
(bringing the total for the first and second anniversaries to $40,000),
$30,000 on the third anniversary (bringing the total for the first,
second, and third anniversaries to $70,000), and $30,000 on the fourth
anniversary.
    A Level 1 or Level 2 covered institution should consider the
vesting schedule at the time of the award, and the present value at
time of award of each form of incentive-based compensation, for the
purposes of determining compliance with this requirement. Level 1 and
Level 2 covered institutions generally should use reasonable valuation
methods consistent with methods used in other contexts in valuing
awards for purposes of this rule.
    This approach would provide a covered institution with some
flexibility in administering its specific deferral program. For
example, a covered institution would be permitted to make the full
deferred amount of incentive-based compensation awarded for any given
year eligible for vesting in a lump sum at the conclusion of the
deferral period (i.e., ``cliff vesting''). Alternatively, a covered
institution would be permitted to make deferred amounts eligible for
vesting in equal increments at the end of each year of the deferral
period. Except in the case of acceleration allowed in sections
__.7(a)(1)(iii)(B) and __.7(a)(2)(iii)(B), the proposed rule does not
allow for vesting of amounts required to be deferred (1) faster than on
a pro rata annual basis; or (2) beginning earlier than the first
anniversary of the award date.
    The Agencies recognize that some or all of the incentive-based
compensation awarded to a senior executive officer or significant risk-
taker may be forfeited before it vests. For an example of how these
requirements would work in practice, please see Appendix A of this
Supplementary Information section.
    This restriction is intended to prevent covered institutions from
defeating the purpose of the deferral requirement by allowing vesting
of most of the required deferral amounts immediately after the award
date. In addition, the proposed approach aligns with both what the
Agencies understand is common practice in the industry and with the
requirements of many foreign supervisors.
Acceleration of Payments
    The Agencies propose that the acceleration of vesting and
subsequent payment of incentive-based compensation that is required to
be deferred under this proposed rule generally be prohibited for
covered persons at Level 1 and Level 2 covered institutions. This
restriction would apply to all deferred incentive-based compensation
required to be deferred under the proposed rule, whether it was awarded
as qualifying incentive-based compensation or under a long-term
incentive plan. This prohibition on acceleration would not apply to
compensation that the employee or the employer elects to defer in
excess of the amounts required under the proposed rule or for time
periods that exceed the required deferral periods or in certain other
limited circumstances, such as the death or disability of the covered
person.
    NCUA's proposed rule would permit acceleration of payment if
covered persons at credit unions were subject to income taxes on the
entire amount of an incentive-based compensation award even before
deferred amounts vest. Incentive-based compensation for executives of
not-for-profit entities is subject to income taxation under a different
provision of the Internal Revenue Code \140\ than that applicable to
executives of other covered institutions. The result is that credit
union executives' incentive-based compensation awards may be subject to
immediate taxation on the entire award, even deferred amounts.\141\ The
ability to accelerate payment would be a limited exception only
applicable to income tax liability and would only apply to the extent
credit union executives must pay income tax on unvested amounts during
the deferral period. Also, any amounts advanced to pay income tax
liabilities for deferrals must be taken in proportion to the vesting
schedule. For example, a credit union executive may have deferrals of
$200,000 for each of three years ($600,000 total) and a total tax
liability of $240,000 for the deferred amount of an award. The advanced
tax

payments would result in an annual reduction of $80,000 per deferred
payment, resulting in a new vesting amount of $120,000 for each year of
the deferral period.
---------------------------------------------------------------------------

    \140\ 26 U.S.C. 457(f).
    \141\ The Agencies understand that the taxation of unvested
deferred awards of covered persons at other covered institutions is
based on other provisions of the Internal Revenue Code. See, e.g.,
26 U.S.C. 409A.
---------------------------------------------------------------------------

    Many institutions currently allow for accelerated vesting in the
case of death or disability. Some current incentive-based compensation
arrangements, such as separation agreements, between covered persons
and covered institutions provide for accelerated vesting and payment of
deferred incentive-based compensation that has not yet vested upon the
occurrence of certain events.\142\ Many institutions also currently
provide for the accelerated vesting of deferred incentive-based
compensation awarded to their senior executive officers, particularly
compensation awarded in the form of equity, in connection with a change
in control of the company \143\ (sometimes as part of a ``golden
parachute''). Shareholder proxy firms and some institutional investors
have raised concerns about such golden parachutes,\144\ and golden
parachutes are restricted by law under certain circumstances, including
if an institution is in troubled condition.\145\ Finally, in current
incentive-based compensation arrangements, events triggering
acceleration commonly include leaving the employment of a covered
institution for a new position (either any new position or only certain
new positions, such as employment at a government agency), an
acquisition or change in control of the covered institution, or upon
the death or disability of the employee.\146\
---------------------------------------------------------------------------

    \142\ Several commenters argued that the 2011 Proposed Rule's
deferral requirements should not apply upon the death, disability,
retirement, or acceptance of government employment of covered
persons, or a change in control of the covered institution,
effectively arguing for the ability of covered institutions to
accelerate incentive-based compensation under these circumstances.
    \143\ See, e.g., Equilar, ``Change-in-Control Equity
Acceleration Triggers'' (March 19, 2014), available at http://www.equilar.com/reports/8-change-in-control-equity-acceleration-triggers.html (Noting that although neither Institutional
Shareholder Services (ISS) nor Glass Lewis state that a single
trigger plan will automatically result in an ``against''
recommendation, both make it clear that they view the single versus
double trigger issue as an important factor in making their
decisions. ISS, in particular, suggests in its policies that double
trigger vesting of equity awards is currently the best market
practice).
    \144\ Institutional Shareholders Services, ``2015 U.S.
Compensation Policies, Frequently Asked Questions'' (February 9,
2015) (``ISS Compensation FAQs''), available at https://www.issgovernance.com/file/policy/2015-us-comp-faqs.pdf; and
Institutional Shareholders Services, ``U.S. Corporate Governance
Policy: 2013 Updates'' (November 16, 2012), available at https://www.issgovernance.com/file/files/2013USPolicyUpdates.pdf.
    \145\ See 12 U.S.C. 1828(k) and 12 CFR part 359 (generally
applicable to banks and holding companies).
    \146\ See, e.g., 2012 James F. Reda & Associates, ``Study of
Executive Termination Provisions Among Top 200 Public Companies
(December 2012), available at www.jfreda.com; Equilar, ``Change-in-
Control Equity Acceleration Triggers'' (March 19, 2014), available
athttp://www.equilar.com/reports/8-change-in-control-equity-acceleration-triggers.html.
---------------------------------------------------------------------------

    The Federal Banking Agencies have found that the acceleration of
deferred incentive-based compensation to covered persons is generally
inappropriate because it weakens the balancing effect of deferral and
eliminates the opportunity for forfeiture during the deferral period as
information concerning risks taken during the performance period
becomes known. The acceleration of vesting and payment of deferred
incentive-based compensation in other circumstances, such as when the
covered person voluntarily leaves the institution, could also provide
covered persons with an incentive to retire or leave a covered
institution if the covered person is aware of risks posed by the
covered person's activities that are not yet apparent to or fully
understood by the covered institution. Acceleration of payment could
skew the balance of risk-taking incentives provided to the covered
person if the circumstances under which acceleration is allowed are
within the covered person's control. The proposed rule would prohibit
acceleration of deferred compensation that is required to be deferred
under this proposed rule in most circumstances given the potential to
undermine risk balancing mechanisms.
    In contrast, the circumstances under which the Agencies would allow
acceleration of payment, namely death or disability of the covered
person, generally are not subject to the covered person's control, and,
therefore, are less likely to alter the balance of risk-taking
incentives provided to the covered person. In other cases where
acceleration is permitted, effective governance and careful assessment
of potential risks, as well as specific facts and circumstances are
necessary in order to protect against creating precedents that could
undermine more generally the risk balancing effects of deferral.
Therefore, the Agencies have proposed to permit only these limited
exceptions.
    Under the proposed rule, the prohibition on acceleration except in
cases of death or disability would apply only to deferred amounts that
are required by the proposed rule so as not to discourage additional
deferral, or affect institutions that opt to defer incentive-based
compensation exceeding the requirements. For example, if an institution
defers compensation until retirement as a retention tool, but the
institution then merges into another company and ceases to exist,
retention may not be a priority. Thus, acceleration would be permitted
for any deferred incentive-based compensation amounts above the amount
required to be deferred or that was deferred longer than the minimum
deferral period to allow those amounts to be paid out closer in time to
the merger.
    Similarly, the acceleration of payment NCUA's rule permits if a
covered person of a credit union faces up-front income tax liability on
the deferred amounts of an award is not an event subject to the covered
person's control. This exception will not apply unless the covered
person is actually subject to income taxes on deferred amounts for
which the covered person has not yet received payment, and equalizes
the effect of deferral for covered persons at credit unions and covered
persons at most other covered institutions. This limited exception is
not intended to alter the balance of risk-taking incentives.
Qualifying Incentive-Based Compensation and Incentive-Based
Compensation Awarded Under a Long-Term Incentive Plan
    The minimum required deferral amounts would be calculated
separately for qualifying incentive-based compensation and incentive-
based compensation awarded under a long-term incentive plan, and those
amounts would be required to be deferred for different periods of time.
For the purposes of calculating qualifying incentive-based compensation
awarded for any performance period, a covered institution would
aggregate incentive-based compensation awarded under any incentive-
based compensation plan that is not a long-term incentive plan. The
required deferral percentage (40, 50, or 60 percent) would be
multiplied by that total amount to determine the minimum deferral
amount. In a given year, if a senior executive officer or significant
risk-taker is awarded qualifying incentive-based compensation under
multiple plans that have the same performance period (which is less
than three years), the award under each plan would not be required to
meet the minimum deferral requirement, so long as the total amount that
is deferred from all of the amounts awarded under those plans meets the
minimum required percentage of total qualifying incentive-based
compensation relevant to that covered person.

    For example, under the proposal, a significant risk-taker at a
Level 2 covered institution might be awarded $60,000 under a plan with
a one-year performance period that applies to all employees in her line
of business and $40,000 under a plan with a one-year performance period
that applies to all employees of the covered institution. For that
performance period, the significant risk-taker has been awarded a total
of $100,000 in qualifying incentive-based compensation, so she would be
required to defer a total of $40,000. The covered institution could
defer amounts awarded under either plan or under both plans, so long as
the total amount deferred was at least $40,000. For example, the
covered institution could choose to defer $20,000 from the first plan
and $20,000 from the second plan. The covered institution could also
choose to defer nothing awarded under the first plan and the entire
$40,000 awarded under the second plan.
    For a full example of how these requirements would work in the
context of a more complete incentive-based compensation arrangement,
please see Appendix A of this preamble.
    In contrast, the minimum required deferral percentage would apply
to all incentive-based compensation awarded under each long-term
incentive plan separately. In a given year, if a senior executive
officer or significant risk-taker is awarded incentive-based
compensation under multiple long-term incentive plans that have
performance periods of three years or more, each award under each plan
would be required to meet the minimum deferral requirement.\147\ Based
on supervisory experience, the Federal Banking Agencies have found that
it would be extremely rare for a covered person to be awarded
incentive-based compensation under multiple long-term incentive plans
in one year.
---------------------------------------------------------------------------

    \147\ For example, if a Level 1 covered institution awarded a
senior executive officer $100,000 under one long-term incentive plan
and $200,000 under another long-term incentive-plan, the covered
institution would be required to defer at least $60,000 of the
amount awarded under the first long-term incentive plan and at least
$120,000 of the amount awarded under the second long-term incentive
plan. The Level 1 covered institution would not be permitted to meet
the deferral requirements by deferring, for example, $10,000 awarded
under the first long-term incentive plan and $170,000 awarded under
the second long-term incentive plan.
---------------------------------------------------------------------------

    The proposed rule would require deferral for the same percentage of
qualifying incentive-based compensation as of incentive-based
compensation awarded under a long-term incentive plan. However, the
proposed rule would require that deferred qualifying incentive-based
compensation meet a longer minimum deferral period than deferred
incentive-based compensation awarded under a long-term incentive plan.
As with the shorter performance period for qualifying incentive-based
compensation, the period over which performance is measured under a
long-term incentive plan is not considered part of the deferral period.
    Under the proposed rule, both deferred qualifying incentive-based
compensation and deferred incentive-based compensation awarded under a
long-term incentive plan would be required to meet the vesting
requirements separately. In other words, deferred qualifying incentive-
based compensation would not be permitted to vest faster than on a on a
pro rata annual basis, even if deferred incentive-based compensation
awarded under a long-term incentive plan vested on a slower than pro
rata basis. Each deferred portion is bound by the pro rata requirement.
    For an example of how these requirements would work in practice,
please see Appendix A of this Supplementary Information section.
    Incentive-based compensation provides an inducement for a covered
person at a covered institution to advance the strategic goals and
interests of the covered institution while enabling the covered person
to share in the success of the covered institution. Incentive-based
compensation may also encourage covered persons to take undesirable or
inappropriate risks, or to sell unsuitable products in the hope of
generating more profit and thereby increasing the amount of incentive-
based compensation received. Covered persons may also be tempted to
manipulate performance results in an attempt to make performance
measurements look better or to understate the actual risks such
activities impose on the covered institution's balance sheet.\148\
Incentive-based compensation should therefore also provide incentives
for prudent risk-taking in the long term and for sound risk management.
---------------------------------------------------------------------------

    \148\ For example, towards the end of the performance period,
covered persons who have not yet met the target performance measures
could be tempted to amplify risk taking or take other actions to
meet those targets and receive the maximum incentive-based
compensation. Without deferral, there would be no additional review
applied to the risk-taking activities that were taken during the
defined performance period to achieve those target performance
measures.
---------------------------------------------------------------------------

    Deferral of incentive-based compensation awards involves a delay in
the vesting and payout of an award to a covered person beyond the end
of the performance period. The deferral period allows for amounts of
incentive-based compensation to be adjusted for actual losses to the
covered institution or for other aspects of performance that become
clear during the deferral period before those amounts vest or are paid.
These aspects include inappropriate risk-taking and misconduct on the
part of the covered person. More generally, deferral periods that
lengthen the time between the award of incentive-based compensation and
vesting, combined with forfeiture, are important tools for aligning the
interests of risk-takers with the longer-term interests of covered
institutions.\149\ Deferral periods that are sufficiently long to allow
for a substantial portion of the risks from the covered person's
activities to manifest are likely to be most effective in ensuring that
risks and rewards are adequately balanced.\150\
---------------------------------------------------------------------------

    \149\ There have been a number of academic papers that argue
that deferred compensation provides incentives for executives to
consider the long-term health of the firm. For example, Eaton and
Rosen (1983) note that delaying compensation is a way of bonding
executives to the firm and providing incentives for them to focus on
long-term performance of the firm. See Eaton and Rosen, ``Agency,
Delayed Compensation, and the Structure of Executive Remuneration,''
38 Journal of Finance 1489, at 1489-1505; see also Park and Sturman,
``How and What You Pay Matters: The Relative Effectiveness of Merit
Pay, Bonus, and Long-Term Incentives on Future Job Performance''
(2012), available at http://scholarship.sha.cornell.edu/cgi/viewcontent.cgi?article=1121&context=articles.
    \150\ The length of the deferral period has been a topic of
discussion in the literature. Edmans (2012) argues that deferral
periods of two to three years are too short. He also argues that
deferral should be longer for institutions where the decisions of
the executives have long-term consequences. Bebchuk et al (2010)
argue that deferral provisions alone will not prevent executives
from putting emphasis on short-term prices because executives that
have been in place for many years will have the opportunity to
regularly cash out. They argue that executives should be required to
hold a substantial number of shares and options until retirement.
See also Edmans, Alex, ``How to Fix Executive Compensation,'' The
Wall Street Journal (February 27, 2012); Bebchuk, Lucian, Cohen, and
Spamann, ``The Wages of Failure: Executive Compensation at Bear
Stearns and Lehman 2000-2008,'' 27 Yale Journal on Regulation 257,
257-282 (2010); Bhagat, Sanjai, Bolton and Romano, ``Getting
Incentives Right: Is Deferred Bank Executive Compensation
Sufficient?,'' 31 Yale Journal on Regulation 523 (2014); Bhagat,
Sanjai and Romano, ``Reforming Financial Executives' Compensation
for the Long Term,'' Research Handbook on Executive Pay (2012);
Bebchuk and Fried, ``Paying for Long-Term Performance,'' 158
University of Pennsylvania Law Review, 1915 (2010).
---------------------------------------------------------------------------

    Deferral periods allow covered institutions an opportunity to more
accurately judge the nature and scale of risks imposed on covered
institutions' balance sheets by a covered person's performance for
which incentive-based compensation has been awarded, and to better
understand and identify risks that

result from such activities as they are realized. These include risks
imposed by inappropriate risk-taking or misconduct, and risks that may
manifest as a result of lapses in risk management or risk oversight.
For example, the risks associated with some business lines, such as
certain types of lending, may require many years before they
materialize.
    Though it is difficult to set deferral periods that perfectly match
the time it takes risks undertaken by the covered persons of covered
institutions to become known, longer periods allow more time for
incentive-based compensation to be adjusted between the time of award
and the time incentive-based compensation vests.\151\ At the same time,
deferral periods that are inordinately long may reduce the
effectiveness of incentive-based compensation arrangements because
employees more heavily discount the potential impact of such
arrangements. Thus, it is important to strike a reasonable balance
between providing effective incentives and allowing sufficient time to
validate performance measures over a reasonable period of deferral. The
specific deferral periods and amounts proposed in the proposed rule are
also consistent with current practice at many institutions that would
be Level 1 or Level 2 covered institutions, and with compensation
requirements in other countries.\152\ In drafting the requirements in
sections __.7(a)(1) and __.7(a)(2), the Agencies took into account the
comments received regarding similar requirements in the 2011 Proposed
Rule.\153\
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    \151\ Some empirical literature has found a link between the
deferral of compensation and firm value, firm performance, risk, and
the manipulation of earnings. Gopalan et al (2014) measure the
duration of executive compensation by accounting for the vesting
schedules in compensation. They argue that the measure is a proxy
for the executives' horizon. They find that longer duration of
compensation is present at less risky institutions and institutions
with better past stock performance. They also find that longer
duration is associated with less manipulation of earnings. Chi and
Johnson (2009) find that longer vesting periods for stocks and
options are related to higher firm value. See Gopalan,
Radhakrishnan, Milbourn, Song and Thakor, ``Duration of Executive
Compensation,'' 59 The Journal of Finance 2777 (2014); Chi, Jianxin,
and Johnson, ``The Value of Vesting Restrictions on Managerial Stock
and Option Holdings'' (March 9, 2009) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1136298.
    \152\ Moody's Investor Service, ``Global Investment Banks:
Reformed Pay Policies Still Pose Risks to Bondholders'' (``Moody's
Report'') (December 9, 2014); McLagan, ``Mandatory Deferrals in
Incentive Programs'' (March 2013), available at http://www.mclagan.com/crb/downloads/McLagan_Mandatory_Deferral_Flash_Survey_Report_3-29-2013.pdf.
    \153\ Commenters on the 2011 Proposed Rule expressed differing
views on the proposed deferral requirements and the deferral-related
questions posed by the Agencies. For example, some commenters
expressed the view that the deferral requirements for incentive-
based compensation awards for executive officers were appropriate.
Some commenters argued that deferral would create a longer-term
focus for executives and help to ensure they are not compensated on
the basis of short-term returns that fail to account for long-term
risks. Many commenters also argued that the deferral requirements
should be strengthened by extending the required minimum deferral
period or minimum percentage of incentive compensation deferred. For
example, these commenters urged the Agencies to require a five-year
deferral period, instead of the three-year period that was proposed,
or to disallow ``pro rata'' payments within the proposed three-year
deferral period. These commenters also expressed the view that the
Agencies' proposal to require covered financial institutions to
defer 50 percent of their annual compensation would result in an
insufficient amount of incentive-based compensation being at risk of
potential adjustment, because the risks posed by those executive
officer can take longer to become apparent. Other commenters argued
that all covered institutions subject to this rulemaking should
comply with the deferral requirements regardless of their size.
    On the other hand, many commenters recommended that deferral not
be required or argued that, if deferral were to be required, the
three-year and 50 percent deferral minimums provided in the 2011
Proposed Rule were sufficient. Some commenters recommended that the
deferral requirements not be applied to smaller covered
institutions. Some commenters also suggested that unique aspects of
certain types of covered institutions, such as investment advisers
or smaller banks within a larger consolidated organization, should
be considered when imposing deferral and other requirements on
incentive-based compensation arrangements. A number of commenters
suggested that applying a prescriptive deferral requirement,
together with other requirements under the 2011 Proposed Rule, would
make it more difficult for covered institutions to attract and
retain key employees in comparison to the ability of organizations
not subject to such requirements to recruit and retain the same
employees.
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    The Agencies have proposed the three- and four-year minimum
deferral periods because these deferral periods, taken together with
the typically one-year performance period, would allow a Level 1 or
Level 2 covered institution four to five years, or the majority of a
traditional business cycle, to identify outcomes associated with a
senior executive officer's or significant risk-taker's performance and
risk-taking activities. The business cycle reflects periods of economic
expansion or recession, which typically underpin the performance of the
financial sector. The Agencies recognize that credit cycles, which
revolve around access to and demand for credit and are influenced by
various economic and financial factors, can be longer.\154\
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    \154\ From 1945 to 2009, the average length of the business
cycle in the U.S. was approximately 5.7 years. See The National
Bureau of Economic Research, ``U.S. Business Cycle Expansions and
Contractions, available at http://www.nber.org/cycles/cyclesmain.html. Many researchers have found that credit cycles are
longer than business cycles. For example, Drehmann et al (2012)
estimate an average duration of credit cycles from 10 to 20 years.
See Drehmann, Mathias, Borio and Tsatsaronis, ``Characterising the
Financial Cycle: Don't Lose Sight of the Medium Term!'' Bank for
International Settlements, Working Paper, No. 380 (June 2012),
available at http://www.bis.org/publ/work380.htm. Aikman et al
(2015) found that the credit cycle ranges from eight to 20 years.
See Aikman, Haldane, and Nelson, ``Curbing the Credit Cycle,'' 125
The Economic Journal 1072 (June 2015).
---------------------------------------------------------------------------

    However, the Agencies are also concerned with striking the right
balance between allowing covered persons to be fairly compensated and
not encouraging inappropriate risk-taking. The Agencies are concerned
that extending deferral periods for too long may lead to a covered
person placing little or no value on the incentive-based compensation
that only begins to vest far out in the future. This type of
discounting of the value of long-deferred awards may be less effective
as an incentive, positive or negative, and consequently for balancing
the benefit of these types of awards.\155\
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    \155\ See Pepper and Gore, ``The Economic Psychology of
Incentives: An International Study of Top Managers,'' 49 Journal of
World Business 289 (2014); PRA, Consultation Paper PRA CP15/14/FCA
CP14/14: Strengthening the alignment of risk and reward: new
remuneration rules (July 2014) available at http://www.bankofengland.co.uk/pra/Documents/publications/cp/2014/cp1514.pdf.
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    As described above, since the Agencies proposed the 2011 Proposed
Rule, the Agencies have gained significant supervisory experience while
encouraging covered institutions to adopt improved incentive-based
compensation practices. The Federal Banking Agencies note in particular
improvements in design of incentive-based compensation arrangements
that help to more appropriately balance risk and reward. Regulatory
requirements for sound incentive-based compensation arrangements at
financial institutions have continued to evolve, including those being
implemented by foreign regulators. Consideration of international
practices and standards is particularly relevant in developing
incentive-based compensation standards for large financial institutions
because they often compete for talented personnel internationally.
    Based on supervisory experience, although exact amounts deferred
may vary across employee populations at large covered institutions, the
Federal Banking Agencies have observed that, since the financial crisis
that began in 2007, most deferral periods at financial institutions
range from three to five years, with three years being the most common
deferral period.\156\ Consistent with this observation, the FSB
standards suggest deferral periods ``not less than

three years,'' and the average deferral period at significant
institutions in FSB member countries is now between three and four
years.\157\ The PRA requires deferral of seven years for senior
managers as defined under the Senior Managers Regime, five years for
risk managers as defined under the EBA regulatory technical standard on
identification of material risk-takers, and three to five years as per
the CRD IV minimum for all other material risk-takers.\158\ CRD IV sets
a minimum deferral period of ``at least three to five years.'' For
senior management, significant institutions \159\ are expected to apply
deferral of ``at least five years.'' \160\ Swiss regulations \161\
require that for members of senior management, persons with relatively
high total remuneration, and persons whose activities have a
significant influence on the risk profile of the firm, the time period
for deferral should last ``at least three years.''
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    \156\ See 2011 FRB White Paper, at 15.
    \157\ FSB, Implementing the FSB Principles for Sound
Compensation Practices and their Implementation Standards: Fourth
Progress Report (``2015 FSB Compensation Progress Report'') (2015),
available at http://www.fsb.org/2015/11/fsb-publishes-fourth-progress-report-on-compensation-practices.
    \158\ See UK Remuneration Rules. The United Kingdom deferral
standards apply on a group-wide basis and apply to banks, building
societies, and PRA-designated investment firms, but do not currently
cover investment advisors outside of consolidated firms.
    \159\ CRD IV defines institutions that are significant ``in
terms of size, internal organisation and nature, scope and
complexity of their activities.'' Under the EBA Guidance on Sound
Remuneration Policies, significant institutions means institutions
referred to in Article 131 of Directive 2013/36/EU (global
systemically important institutions or `G-SIIs,' and other
systemically important institutions or `O-SIIs'), and, as
appropriate, other institutions determined by the competent
authority or national law, based on an assessment of the
institutions' size, internal organisation and the nature, the scope
and the complexity of their activities. Some, but not all, national
regulators have provided further guidance on interpretation of that
term, including the FCA which provides a form of methodology to
determine if a firm is ``significant'' based on quantitative tests
of balance sheet assets, liabilities, annual fee commission income,
client money and client assets.
    \160\ See EBA Remuneration Guidelines.
    \161\ See FINMA Remuneration Circular 2010.
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    The requirements in the proposed rule regarding amounts deferred
are also consistent with observed better practices and the standards
established by foreign regulators. The Board's summary overview of
findings during the early stages of the 2011 FRB White Paper \162\
observed that ``deferral fractions set out in the FSB Principles and
Implementation Standards \163\ are sometimes used as a benchmark (60
percent or more for senior executives, 40 percent or more for other
individual ``material risk takers,'' which are not the same as
``covered employees'') and concluded that deferral fractions were at or
above these benchmarks at both the U.S. banking organizations and
foreign banking organizations that participated in the horizontal
review.
---------------------------------------------------------------------------

    \162\ See FRB 2011 Report, at 31.
    \163\ Specifically, the FSB Implementation Standards encourage
that ``a substantial portion of variable compensation, such as 40 to
60 percent, should be payable under deferral arrangements over a
period of years'' and that ``proportions should increase
significantly along with the level of seniority and/or
responsibility . . . for the most senior management and the most
highly paid employees, the percentage of variable compensation that
is deferred should be substantially higher, for instance, above 60
percent.''
---------------------------------------------------------------------------

    The proportion of incentive-based compensation awards observed to
be deferred at financial institutions during the Board's horizontal
review was substantial. For example, on average senior executives
report more than 60 percent of their incentive-based compensation is
deferred,\164\ and some of the most senior executives had more than 80
percent of their incentive-based compensation deferred with additional
stock retention requirements after deferred stock vests. Most
institutions assigned deferral rates to employees using a fixed
schedule or ``cash/stock table'' under which employees that received
higher incentive-based compensation awards generally were subject to
higher deferral rates, although deferral rates for the most senior
executives were often set separately and were higher than those for
other employees.\165\ The proposed rule's higher deferral rates for
senior executive officers would be consistent with this observed
industry practice of requiring higher deferral rates for the most
senior executives. Additionally, by their very nature, senior executive
officer positions tend to have more responsibility for strategic
decisions and oversight of multiple areas of operations, and these
responsibilities warrant requiring higher percentages of deferral and
longer deferral periods to safeguard against inappropriate risk-taking.
---------------------------------------------------------------------------

    \164\ ``Deferral'' for these reports is defined by the
institutions and may include long-term incentive plans without
additional deferral.
    \165\ See 2011 FRB White Paper, at 15.
---------------------------------------------------------------------------

    This proposed rule is also consistent with standards being
developed internationally. The PRA expects that ``where any employee's
variable remuneration component is [pound]500,000 or more, at least 60
percent should be deferred.'' \166\ European Union regulations require
that ``institutions should set an appropriate portion of remuneration
that should be deferred for a category of identified staff or a single
identified staff member at or above the minimum proportion of 40
percent or respectively 60 percent for particularly high amounts.''
\167\ The EU also publishes a report on Benchmarking of Remuneration
Practices at Union Level and Data on High Earners \168\ that provides
insight into amounts deferred across various lines of business within
significant institutions across the European Union. While amounts
varied by areas of operations, average deferral levels for identified
staff range from 54 percent in retail banking to more than 73 percent
in investment banking.
---------------------------------------------------------------------------

    \166\ See PRA, Supervisory Statement SS27/15: Remuneration (June
2015), available at http://www.bankofengland.co.uk/pra/Documents/publications/ss/2015/ss2715.pdf.
    \167\ See EBA Remuneration Guidelines.
    \168\ See, e.g., EBA, Benchmarking of Remuneration Practices at
Union Level and Data on High Earners, at 39, Figure 46 (September
2015), available at http://www.eba.europa.eu/-/eba-updates-on-remuneration-practices-and-high-earners-data-for-2013-across-the-eu.
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    The proposed rule's enhanced requirements for Level 1 institutions
are consistent with international standards. Many regulators apply
compensation standards in a proportional or tiered fashion. The PRA,
for example, classifies three tiers of firms based on asset size and
applies differentiated standards across this population.
Proportionality Level 1 includes firms with greater than [pound]50
billion in consolidated assets; Proportionality Level 2 includes firms
with between [pound]15 billion and [pound]50 billion in consolidated
assets; and Proportionality Level 3 includes firms with less than
[pound]15 billion in consolidated assets. The PRA also recognizes
``significant'' firms. Proportionality Level 3 firms are typically not
subject to provisions on retained shares, deferral, or performance
adjustment.
    Under the proposed rule, incentive-based compensation awarded under
a long-term incentive plan would be treated separately and differently
than amounts of incentive-based compensation awarded under annual
performance plans (and other qualifying incentive-based compensation)
for the purposes of the deferral requirements. Deferral of incentive-
based compensation and the use of longer performance periods (which is
the hallmark of a long-term incentive plan) both are useful tools for
balancing risk and reward in incentive-based compensation arrangements
because both allow for the passage of time that allows the covered
institution to have more information about a covered person's risk-
taking activity and its possible outcomes. Both methods allow

awards or payments to be made after some or all risk outcomes are
realized or better known. However, longer performance periods and
deferral of vesting are distinct risk balancing methods.\169\
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    \169\ The 2011 Proposed Rule expressly recognized this
distinction (``The Proposed Rule identifies four methods that
currently are often used to make compensation more sensitive to
risk. These methods are Risk Adjustment of Awards . . . Deferral of
Payment . . . Longer Performance Periods . . . Reduced Sensitivity
to Short-Term Performance.''). See 76 FR at 21179.
---------------------------------------------------------------------------

    As noted above, the Agencies took into account the comments
received regarding similar deferral requirements in the 2011 Proposed
Rule. In response to the proposed deferral requirement in the 2011
Proposed Rule, which did not distinguish between incentive-based
compensation awarded under a long-term incentive plan and other
incentive-based compensation, several commenters argued that the
Agencies should allow incentive-based compensation arrangements that
use longer performance periods, such as a three-year performance
period, to count toward the mandatory deferral requirement. In
particular, some commenters argued that institutions that use longer
performance periods should be allowed to start the deferral period at
the beginning of the performance period. In this way, they argued, a
payment made at the end of a three-year performance period has already
been deferred for three years for the purposes of the deferral
requirement.
    As discussed above, deferral allows for time to pass after the
conclusion of the performance period. It introduces a period of time in
between the end of the performance period and vesting of the incentive-
based compensation during which risks may mature without the employee
taking additional risks to affect that earlier award.
    Currently, institutions commonly use long-term incentive plans
without subsequent deferral and thus there is no period following the
multi-year performance period that would permit the covered institution
to apply forfeiture or other reductions should it become clear that the
covered person engaged in inappropriate risk-taking. Without deferral,
the incentive-based compensation is awarded and vests at the end of the
multi-year performance period.\170\ In contrast, during the deferral
period, the covered person's incentive-based compensation award is
fixed and the vesting could be affected by information about a covered
person's risk-taking activities during the performance period that
becomes known during the deferral period.
---------------------------------------------------------------------------

    \170\ An employee may be incentivized to take additional risks
near the end of the performance period to attempt to compensate for
poor performance early in the period of the long-term incentive
compensation plan. For example, as noted above, towards the end of a
multi-year performance period, covered persons who have not yet met
the target performance measures could be tempted to amplify risk
taking or take other actions to meet those targets and receive the
maximum long-term incentive plan award with no additional review
applied to the risk-taking activities that were taken during the
defined performance period to achieve those target performance
measures.
---------------------------------------------------------------------------

    For a long-term incentive plan, the period of time between the
beginning of the performance period and when incentive-based
compensation is awarded is longer than that of an annual plan. However,
the period of time between the end of the performance period and when
incentive-based compensation is awarded is the same for both the long-
term incentive plan and for the annual plan. Consequently, while a
covered institution may have more information about the risk-taking
activities of a covered person that occurred near the beginning of the
performance period for a long-term incentive plan than for an annual
plan, the covered institution would have no more information about
risk-taking activities that occur near the end of the performance
period. The incentive-based compensation awarded under the long-term
incentive plan would be awarded without the benefit of additional
information about risk-taking activities near the end of the
performance period.
    Therefore, the proposed rule would treat incentive-based
compensation awarded under a long-term incentive plan similarly to, but
not the same as, qualifying incentive-based compensation for purposes
of the deferral requirement. Under the proposed rule, the incentive-
based compensation awarded under a long-term incentive plan would be
required to be deferred for a shorter amount of time than qualifying
incentive-based compensation, although the period of time elapsing
between the beginning of the performance period and the actual vesting
would be longer. A shorter deferral period would recognize the fact
that the longer performance period of a long-term incentive plan allows
some time for information to surface about risk-taking activities
undertaken at the beginning of the performance period. The longer
performance period allows covered institutions to adjust the amount
awarded under long-term incentive plans for poor performance during the
performance period. Yet, since no additional time would pass between
risk-taking activities at the end of the performance period and the
award date, the proposed rule would allow a shorter deferral period
than would be necessary for qualifying incentive-based compensation.
    The percentage of incentive-based compensation awarded that would
be required to be deferred would be the same for incentive-based
compensation awarded under a long-term incentive plan and for
qualifying incentive-based compensation. However, because of the
difference in the minimum required deferral period, the minimum
deferral amounts for qualifying incentive-based compensation and for
incentive-based compensation awarded under a long-term incentive plan
would be required to be calculated separately. In other words, any
amount of qualifying incentive-based compensation that a covered
institution chooses to defer above the minimum required would not
decrease the minimum amount of incentive-based compensation awarded
under a long-term plan that would be required to be deferred, and vice
versa.
    For example, a Level 2 covered institution that awards a senior
executive officer $50,000 of qualifying incentive-based compensation
and $20,000 under a long-term incentive plan would be required to defer
at least $25,000 of the qualifying incentive-based compensation and at
least $10,000 of the amounts awarded under the long-term incentive
plan. The Level 2 covered institution would not be permitted to defer,
for example, $35,000 of qualifying incentive-based compensation and no
amounts awarded under the long-term incentive plan, even though that
would result in the deferral of 50 percent of the senior executive
officer's total incentive-based compensation. For a full example of how
these requirements would work in the context of a more complete
incentive-based compensation arrangement, please see Appendix A of this
preamble.
    For incentive-based compensation awarded under a long-term
incentive plan, section __.7(a)(2) of the proposed rule would require
that minimum deferral periods for senior executive officers and
significant risk-takers at a Level 1 covered institution extend to two
years after the award date and minimum deferral periods at a Level 2
covered institution extend to one year after the award date. For long-
term incentive plans with performance periods of three years,\171\ this

requirement would delay the vesting of the last portion of this
incentive-based compensation until five years after the beginning of
the performance period at Level 1 covered institutions and four years
after the beginning of the performance period at Level 2 covered
institutions. Thus, while the deferral period from the award date is
shorter for incentive-based compensation awarded under a long-term
incentive plan, the delay in vesting from the beginning of the
performance period would generally be the same under the most common
qualifying incentive-based compensation and long-term incentive plans.
---------------------------------------------------------------------------

    \171\ Many studies of incentive-based compensation at large
institutions have found that long-term incentive plans commonly have
performance periods of three years. See Cook Report; Moody's Report.
---------------------------------------------------------------------------

    Under the proposed rule, the incentive-based compensation that
would be required by the rule to be deferred would not be permitted to
vest faster than on a pro rata annual basis beginning no earlier than
the first anniversary of the end of the performance period. This
requirement would apply to both deferred qualifying incentive-based
compensation and deferred incentive-based compensation awarded under a
long-term incentive plan.
    The Federal Banking Agencies have also observed that the minimum
required deferral amounts and deferral periods that would be required
under the proposed rule are generally consistent with industry practice
at larger covered institutions that are currently subject to the 2010
Federal Banking Agency Guidance, although the Agencies recognize that
some institutions would need to revise their individual incentive-based
compensation programs and others were not subject to the 2010 Federal
Banking Agency Guidance. In part because the 2010 Federal Banking
Agency Guidance and compensation regulations imposed by international
regulators \172\ currently encourage banking institutions to increase
the proportion of compensation that is deferred to reflect higher
levels of seniority or responsibility, current practice for the largest
international banking institutions reflects substantial levels of
deferral for such individuals. Many of those individuals would be
senior executive officers and significant risk-takers under the
proposed rule. Under current practice, deferral typically ranges from
40 percent for less senior significant risk-takers to more than 60
percent for senior executives.\173\ The Agencies note that current
practice for the largest international banking institutions reflects
average deferral periods of at least three years.\174\
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    \172\ Most members of the FSB, for instance, have issued
regulations, or encourage through guidance and supervisory practice,
deferral standards that meet the minimums set forth in the FSB's
Implementation Standards. See 2015 FSB Compensation Progress Report
(concluding ``almost all FSB jurisdictions have now fully
implemented the P&S for banks.''). The FSB standards state that ``a
substantial portion of variable compensation, such as 40 to 60
percent, should be payable under deferral arrangements over a period
of years and these proportions should increase significantly along
with the level of seniority and/or responsibility. The deferral
period should not be less than three years. See FSB Principles and
Implementation Standards.
    \173\ FSB member jurisdictions provided data for the purposes of
the 2015 FSB Compensation Progress Report indicating that while the
percentage of variable remuneration deferred varies significantly
between institutions and across categories of staff, for the
surveyed population of senior executives, the percentage of deferred
incentive-based compensation averaged approximately 50 percent. See
2015 FSB Compensation Progress Report.
    \174\ See Moody's Report.
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    The deferral requirements of the proposed rule for senior executive
officers and significant risk-takers at the largest covered
institutions are also consistent with international standards on
compensation. The European Union's 2013 law on remuneration paid by
financial institutions requires deferral for large firms, among other
requirements.\175\ The PRA and the FCA initially adopted the European
Union's law and requires covered companies to defer 40 to 60 percent of
``senior manager,'' ``risk manager,'' and ``material risk-taker''
compensation. The PRA and FCA recently updated their implementing
regulations to extend deferral periods to seven years for senior
managers and up to five years for certain other persons.\176\ The
proposed deferral requirements are also generally consistent with the
FSB's Principles for Sound Compensation Practices and their related
implementation standards issued in 2009.\177\ Having standards that are
generally consistent across jurisdictions would be important both to
enable institutions subject to multiple regimes to fulfill the
requirements of all applicable regimes, and to ensure that covered
institutions in the United States would be on a level playing field
compared to their non-U.S. peers in the global competition for talent.
---------------------------------------------------------------------------

    \175\ In June 2013, the European Union adopted CRD IV, which
sets out requirements on compensation structures, policies, and
practices that applies to all banks and investment firms subject to
the CRD. CRD IV provides that at least 50 percent of total variable
remuneration should consist of equity-linked interests and at least
40 percent of the variable component must be deferred over a period
of three to five years. Directive 2013/36/EU of the European
Parliament and of the Council of 26 June 2013 (effective January 1,
2014).
    \176\ See UK Remuneration Rules. In the case of a material risk-
taker who performs a PRA senior management function, the pro rata
vesting requirement applies only from year three onwards (i.e., the
required deferral period is seven years, with no vesting to take
place until three years after award).
    \177\ FSB Principles and Implementation Standards.
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    7.1. The Agencies invite comment on the proposed requirements in
sections __.7(a)(1) and (a)(2).
    7.2. Are minimum required deferral periods and percentages
appropriate? If not, why not? Should Level 1 and Level 2 covered
institutions be subject to different deferral requirements, as in the
proposed rule, or should they be treated more similarly for this
purpose and why? Should the minimum required deferral period be
extended to, for example, five years or longer in certain cases and
why?
    7.3. Is a deferral requirement for senior executive officers and
significant risk-takers at Level 1 and Level 2 covered institutions
appropriate to promote the alignment of employees' incentives with the
risk undertaken by such covered persons? If not, why not? For example,
comment is invited on whether deferral is generally an appropriate
method for achieving incentive-based compensation arrangements that
appropriately balance risk and reward for each type of senior executive
officer and significant risk-taker at these institutions or whether
there are alternative or more effective ways to achieve such balance.
    7.4. Commenters are also invited to address the possible impact
that the required minimum deferral provisions for senior executive
officers and significant risk-takers may have on larger covered
institutions and whether any deferral requirements should apply to
senior executive officers at Level 3 institutions.
    7.5. A number of commenters to the 2011 Proposed Rule suggested
that applying a prescriptive deferral requirement, together with other
requirements under that proposal, would make it more difficult for
covered institutions to attract and retain key employees in comparison
to the ability of organizations not subject to such requirements to
recruit and retain the same employees. What implications does the
proposed rule have on ``level playing fields'' between covered
institutions and non-covered institutions in setting forth minimum
deferral requirements under the rule?
    7.6. The Agencies invite comment on whether longer performance
periods can provide risk balancing benefits similar to those provided
by deferral, such that the shorter deferral periods for incentive-based
compensation awarded under long-term incentive plans in the proposed
rule would be appropriate.
    7.7. Would the proposed distinction between the deferral
requirements for

qualifying incentive-based compensation and incentive-based
compensation awarded under a long-term incentive plan pose practical
difficulties for covered institutions or increase compliance burdens?
Why or why not?
    7.8. Would the requirement in the proposed rule that amounts
awarded under long-term incentive plans be deferred result in covered
institutions offering fewer long-term incentive plans? If so, why and
what other compensation plans will be used in place of long-term
incentive plans and what negative or positive consequences might
result?
    7.9. Are there additional considerations, such as tax or accounting
considerations, that may affect the ability of Level 1 or Level 2
covered institutions to comply with the proposed deferral requirement
or that the Agencies should consider in connection with this provision
in the final rule? Commenters on the 2011 Proposed Rule noted that
employees of an investment adviser to a private fund hold partnership
interests and that any incentive allocations paid to them are typically
taxed at the time of allocation, regardless of whether these
allocations have been distributed, and consequently, employees of an
investment adviser to a private fund that would have been subject to
the deferral requirement in the 2011 Proposed Rule would have been
required to pay taxes relating to incentive allocations that they were
required to defer. Should the determination of required deferral
amounts under the proposed rule be adjusted in the context of
investment advisers to private funds and, if so, how? Could the tax
liabilities immediately payable on deferred amounts be paid from the
compensation that is not deferred?
    7.10. The Agencies invite comment on the circumstances under which
acceleration of payment should be permitted. Should accelerated vesting
be allowed in cases where employees are terminated without cause or
cases where there is a change in control and the covered institution
ceases to exist and why? Are there other situations for which
acceleration should be allowed? If so, how can such situations be
limited to those of necessity?
    7.11. The Agencies received comment on the 2011 Proposed Rule that
stated it was common practice for some private fund adviser personnel
to receive payments in order to enable the recipients to make tax
payments on unrealized income as they became due. Should this type of
practice to satisfy tax liabilities, including tax liabilities payable
on unrealized amounts of incentive-based compensation, be permissible
under the proposed rule, including, for example, as a permissible
acceleration of vesting under the proposed rule? Why or why not? Is
this a common industry practice?

Sec.  __.7(a)(3) Adjustments of Deferred Qualifying Incentive-Based
Compensation and Deferred Long-Term Incentive Plan Compensation Amounts

    Under section __.7(a)(3) of the proposed rule, during the deferral
period, a Level 1 or Level 2 covered institution would not be permitted
to increase a senior executive or significant risk-taker's unvested
deferred incentive-based compensation.\178\ In other words, any
deferred incentive-based compensation, whether it was awarded as
qualifying incentive-based compensation or under a long-term incentive
plan, would be permitted to vest in an amount equal to or less than the
amount awarded, but would not be permitted to increase during the
deferral period.\179\ Deferred incentive-based compensation may be
decreased, for example, under a forfeiture and downward adjustment
review as would be required under section __.7(b) of the proposed rule,
discussed below. It may also be adjusted downward as a result of
performance that falls short of agreed upon performance measure
targets.
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    \178\ This requirement is distinct from the prohibition in
section 8(b) of the proposed rule, discussed below.
    \179\ Accelerated vesting would be permitted in limited
circumstances under sections __.7(a)(1)(iii)(B) and
__.7(a)(2)(iii)(B), as described above.
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    As discussed in section 8(b), under some incentive-based
compensation plans, covered persons can be awarded amounts in excess of
their target amounts if the covered institution or covered person's
performance exceed performance targets. As explained in the discussion
on section 8(b), this type of upside leverage in incentive-based
compensation plans may encourage covered persons to take inappropriate
risks. Therefore, the proposed rule would limit maximum payouts to
between 125 and 150 percent of the pre-set target. In a similar vein,
the Agencies are concerned that allowing Level 1 and Level 2 covered
institutions to provide for additional increases in amounts that are
awarded but deferred may encourage senior executive officers and
significant risk-takers to take more risk during the deferral period
and thus may not balance risk-taking incentives. This concern is
especially acute when covered institutions require covered persons to
meet more aggressive goals than those established at the beginning of
the performance period in order to ``re-earn'' already awarded, but
deferred incentive-based compensation.
    Although increases in the amount awarded, as described above, would
be prohibited by the proposed rule, increases in the value of deferred
incentive-based compensation due solely to a change in share value, a
change in interest rates, or the payment of reasonable interest or a
reasonable rate of return according to terms set out at the award date
would not be considered increases in the amount awarded for purposes of
this restriction. Thus, a Level 1 or Level 2 covered institution would
be permitted to award incentive-based compensation to a senior
executive officer or significant risk-taker in the form of an equity or
debt instrument, and, if that instrument increased in market value or
included a provision to pay a reasonable rate of interest or other
return that was set at the time of the award, the vesting of the full
amount of that instrument would not be in violation of the proposed
rule.
    For an example of how these requirements would work in practice,
please see Appendix A of this SUPPLEMENTARY INFORMATION section.
    7.12. The Agencies invite comment on the requirement in section
__.7(a)(3).

Sec.  __.7(a)(4) Composition of Deferred Qualifying Incentive-Based
Compensation and Deferred Long-Term Incentive Plan Compensation for
Level 1 and Level 2 Covered Institutions

    Section __.7(a)(4) of the proposed rule would require that deferred
qualifying incentive-based compensation or deferred incentive-based
compensation awarded under a long-term incentive plan of a senior
executive officer or significant risk-taker at a Level 1 or Level 2
covered institution meet certain composition requirements.
Cash and Equity-Like Instruments
    Covered institutions award incentive-based compensation in a number
of forms, including cash-based awards, equity-like instruments, and in
a smaller number of cases, incentive-based compensation in the form of
debt or debt-like instruments such as deferred cash. First, the
proposed rule would require that, at Level 1 and Level 2 covered
institutions \180\ that issue equity

or are the affiliates of covered institutions that issue equity,
deferred incentive-based compensation for senior executive officers and
significant risk-takers include substantial portions of both deferred
cash and equity-like instruments throughout the deferral period. The
Agencies recognize that the form of incentive-based compensation that a
senior executive officer or significant risk-taker receives can have an
impact on the incentives provided and thus their behavior. In
particular, having incentive-based compensation in the form of equity-
like instruments can align the interests of the senior executive
officers and significant risk-takers with the interests of the covered
institution's shareholders. Thus, the proposed rule would require that
a senior executive officer's or significant risk-taker's deferred
incentive-based compensation include a substantial portion of equity-
like instruments.
---------------------------------------------------------------------------

    \180\ In the cases of the Board, FDIC and OCC, this requirement
would not apply to a Level 1 and Level 2 covered institution that
does not issue equity itself and is not an affiliate of an
institution that issues equity. Credit unions and certain mutual
savings associations, mutual savings banks, and mutual holding
companies do not issue equity and do not have a parent that issues
equity. For those institutions, imposing this requirement would have
little benefit, as no equity-like instruments would be based off of
the equity of the covered institution or one of its parents. In the
case of FHFA, this requirement would not apply to a Level 1 or Level
2 covered institution that does not issue equity or is not permitted
by FHFA to use equity-like instruments as compensation for senior
executive officers and significant risk-takers.
---------------------------------------------------------------------------

    Similarly, having incentive-based compensation in the form of cash
can align the interests of the senior executive officers and
significant risk-takers with the interests of other stakeholders in the
covered institution.\181\ Thus, the proposed rule would require that a
senior executive officer's or significant risk-taker's deferred
incentive-based compensation include a substantial portion of cash.
---------------------------------------------------------------------------

    \181\ Generally, in the case of resolution or bankruptcy,
deferred incentive-based compensation in the form of cash would be
treated similarly to other unsecured debt.
---------------------------------------------------------------------------

    The value of equity-like instruments received by a covered person
increases or decreases in value based on the value of the equity of the
covered institution, which provides an implicit method of adjusting the
underlying value of compensation as the share price of the covered
institution changes as a result of better or worse operational
performance. Deferred cash may increase in value over time pursuant to
an interest rate, but its value generally does not vary based on the
performance of the covered institution. These two forms of incentive-
based compensation present a covered person with different incentives
for performance, just as a covered institution itself faces different
incentives when issuing debt or equity-like instruments.\182\
---------------------------------------------------------------------------

    \182\ Jensen and Meckling (1976) were the first to point out
that the structure of compensation should reflect all of the
stakeholders in the firm--both equity and debt holders, an idea
further explored by Edmans and Liu (2013). Faulkender et al. (2012)
argue that a compensation program that relies too heavily on stock-
based compensation can lead to excessive risk taking, manipulation,
and distract from long-term value creation. Empirical research has
found that equity-based pay increases risk at financial firms
Balanchandarn et al. 2010). See Jensen and Metcking, ``Theory of the
Firm: Managerial Behavior, Agency Costs, and Ownership Structure,''
3 Journal of Financial Economics 305 (July 1, 1976); Edmans and Liu,
``Inside Debt,'' 15 Review of Finance 75 (June 29, 2011);
Faulkender, Kadyrzhanova, Prabhala, and Senbet, ``Executive
Compensation: An Overview of Research on Corporate Practices and
Proposed Reforms,'' 22 Journal of Applied Corporate Finance 107
(2010); and Balachandran, Kogut, and Harnal, ``The Probability of
Default, Excess Risk and Executive Compensation: A Study of
Financial Service Firms from 1995 to 2008,'' working paper (June
2010), available at http://www.insead.edu/facultyresearch/areas/accounting/events/documents/excess_risk_bank_revisedjune21bk.pdf.
---------------------------------------------------------------------------

    For purposes of this proposed rule, the Agencies consider
incentive-based compensation paid in equity-like instruments to include
any form of payment in which the final value of the award or payment is
linked to the price of the covered institution's equity, even if such
compensation settles in the form of cash. Deferred cash can be
structured to share many attributes of a debt instrument. For instance,
while equity-like instruments have almost unlimited upside (as the
value of the covered institution's shares increase), deferred cash that
is structured to resemble a debt instrument can be structured so as to
offer limited upside and can be designed with other features that align
more closely with the interests of the covered institution's
debtholders than its shareholders.\183\
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    \183\ There has been a recent surge in research on the use of
compensation that has a payoff structure similar to debt, or
``inside debt.'' See, e.g., Wei and Yermack, ``Investor Reactions to
CEOs Inside Debt Incentives,'' 24 Review of Financial Studies 3813
(2011) (finding that bond prices rise, equity prices fall, and the
volatility of both bond and stock prices fall for firms where the
CEO has sizable inside debt and arguing the results indicate that
firms with higher inside debt have lower risk; Cassell, Huang,
Sanchez, and Stuart, ``Seeking Safety: The Relation between CEO
Inside Debt Holding and the Riskiness of Firm Investment and
Financial Policies,'' 103 Journal of Financial Economics 518 (2012)
(finding higher inside debt is associated with lower volatility of
future firm stock returns, research and development expenditures,
and financial leverage, and more diversification and higher asset
liquidity and empirical research finding that debt holders recognize
the benefits of firms including debt-like components in their
compensation structure); Anantharaman, Divya, Fang, and Gong,
``Inside Debt and the Design of Corporate Debt Contracts,'' 60
Management Science 1260 (2013) (finding that higher inside debt is
associated with a lower cost of debt and fewer debt covenants);
Bennett, Guntay and Unal, ``Inside Debt and Bank Default Risk and
Performance During the Crisis,'' FDIC Center for Financial Research
Working Paper No. 2012-3 (finding that banks that had higher inside
debt before the recent financial crisis had lower default risk and
higher performance during the crisis and that banks with higher
inside debt had supervisory ratings that indicate that they had
stronger capital positions, better management, stronger earnings,
and being in a better position to withstand market shocks in the
future); Srivastav, Abhishek, Armitage, and Hagendorff, ``CEO Inside
Debt Holdings and Risk-shifting: Evidence from Bank Payout
Policies,'' 47 Journal of Banking & Finance 41 (2014) (finding that
banks with higher inside debt holdings have a more conservative
dividend payout policy); Chen, Dou, and Wang, ``Executive Inside
Debt Holdings and Creditors' Demand for Pricing and Non-Pricing
Protections,'' working paper (2010) (finding that higher inside debt
is associated with lower interest rates and less restrictive debt
covenants and that in empirical research, specifically on banks,
similar patterns emerge). In addition, the Squam Lake Group has done
significant work on the use of debt based structures. See, e.g.,
Squam Lake Group, ``Aligning Incentives at Systemically Important
Financial Institutions'' (2013) available at http://www.squamlakegroup.org/Squam%20Lake%20Bonus%20Bonds%20Memo%20Mar%2019%202013.pdf. In their
paper ``Enhancing Financial Stability in the Financial Services
Industry: Contribution of Deferred Cash Compensation,'' forthcoming
in the Federal Reserve Bank of New York's Economic Policy Review
(available at https://www.newyorkfed.org/research/epr/index.html),
Hamid Mehran and Joseph Tracy highlight three channels through which
deferred cash compensation can help mitigate risk: Promoting
conservatism, inducing internal monitoring, and creating a liquidity
buffer.
---------------------------------------------------------------------------

    Where possible, it is important for the incentive-based
compensation of senior executive officers and significant risk-takers
at Level 1 and Level 2 covered institutions to have some degree of
balance between the amounts of deferred cash and equity-like
instruments received. With the exception of the limitation of use of
options discussed below, the Agencies propose to provide covered
institutions with flexibility in meeting the general balancing
requirement under section __.7(a)(4)(i) and thus have not proposed
specific percentages of deferred incentive-based compensation that must
be paid in each form.
    Similar to the rest of section __.7, the requirement in section
__.7(a)(4)(i) would apply to deferred incentive-based compensation of
senior executive officers and significant risk-takers of Level 1 and
Level 2 covered institutions. As discussed above, these covered persons
are the ones most likely to have a material impact on the financial
health and risk-taking of the covered institution. Importantly for this
requirement, these covered persons are also the most likely to be able
to influence the value of the covered institution's equity and debt.
    7.13. The Agencies invite comment on the composition requirement
set out in section __.7(a)(4)(i) of the proposed rule.

    7.14. In order to allow Level 1 and Level 2 covered institutions
sufficient flexibility in designing their incentive-based compensation
arrangements, the Agencies are not proposing a specific definition of
``substantial'' for the purposes of this section. Should the Agencies
more precisely define the term ``substantial'' (for example, one-third
or 40 percent) and if so, should the definition vary among covered
institutions and why? Should the term ``substantial'' be interpreted
differently for different types of senior executive officers or
significant risk-takers and why? What other considerations should the
Agencies factor into level of deferred cash and deferred equity
required? Are there particular tax or accounting implications attached
to use of particular forms of incentive-based compensation, such as
those related to debt or equity?
    7.15. The Agencies invite comment on whether the use of certain
forms of incentive-based compensation in addition to, or as a
replacement for, deferred cash or deferred equity-like instruments
would strengthen the alignment between incentive-based compensation and
prudent risk-taking.
    7.16. The Agencies invite commenters' views on whether the proposed
rule should include a requirement that a certain portion of incentive-
based compensation be structured with debt-like attributes. Do debt
instruments (as opposed to equity-like instruments or deferred cash)
meaningfully influence the behavior of senior executive officers and
significant risk-takers? If so, how? How could the specific attributes
of deferred cash be structured, if at all, to limit the amount of
interest that can be paid? How should such an interest rate be
determined, and how should such instruments be priced? Which attributes
would most closely align use of a debt-like instrument with the
interest of debt holders and promote risk-taking that is not likely to
lead to material financial loss?
Options
    Under section __.7(a)(4)(ii), for senior executive officers and
significant risk-takers at Level 1 and Level 2 covered institutions
that receive incentive-based compensation in the form of options, the
total amount of such options that may be used to meet the minimum
deferral amount requirements is limited to, no more than 15 percent of
the amount of total incentive-based compensation awarded for a given
performance period. A Level 1 or Level 2 covered institution would be
permitted to award incentive-based compensation to senior executive
officers and significant risk-takers in the form of options in excess
of this limitation, and could defer such compensation, but the
incentive-based compensation in the form of options in excess of the 15
percent limit would not be counted towards meeting the minimum deferral
requirements for senior executive officers and significant risk-takers
at these covered institutions.
    For example, a Level 1 covered institution might award a
significant risk-taker $100,000 in incentive-based compensation at the
end of a performance period: $80,000 in qualifying incentive-based
compensation, of which $25,000 is in options, and $20,000 under a long-
term incentive plan, all of which is delivered in cash. The Level 1
covered institution would be required to defer at least $40,000 of the
qualifying incentive-based compensation and at least $10,000 of the
amount awarded under the long-term incentive plan. Under the draft
proposed rule, the amount that could be composed of options and count
toward the overall deferral requirement would be limited to 15 percent
of the total amount of incentive-based compensation awarded. In this
example, the Level 1 covered institution could count $15,000 in options
(15 percent of $100,000) toward the requirement to defer $40,000 of
qualifying incentive-based compensation. For an example of how these
requirements would work in the context of a more complete incentive-
based compensation arrangement, please see Appendix A of this preamble.
    This requirement would thus limit the total amount of incentive-
based compensation in the form of options that could satisfy the
minimum deferral amounts in sections __.7(a)(1)(i) and __.7(a)(1)(ii).
Any incentive-based compensation awarded in the form of options would,
however, be required to be included in calculating the total amount of
incentive-based compensation awarded in a given performance period for
purposes of calculating the minimum deferral amounts at Level 1 and
Level 2 covered institutions as laid out in sections __.7(a)(1)(i) and
__.7(a)(2)(ii).
    Options can be a significant and important part of incentive-based
compensation arrangements at many covered institutions. The Agencies
are concerned, however, that overreliance on options as a form of
incentive-based compensation could have negative effects on the
financial health of a covered institution due to options' emphasis on
upside gains and possible lack of responsiveness to downside
risks.\184\
---------------------------------------------------------------------------

    \184\ In theory, since the payoffs from holding stock options
are positively related to volatility of stock returns, options
create incentives for executives to increase the volatility of share
prices by engaging in riskier activities. See, e.g., Guay, W.R.,
``The Sensitivity of CEO Weather to Equity Risk: An Analysis of the
Magnitude and Determinants,'' 53 Journal of Financial Economics 43
(1999); Cohen, Hall, and Viceira, ``Do Executive Stock Options
Encourage Risk Taking?'' working paper (2000) available at http://www.people.hbs.edu/lviceira/cohallvic3.pdf; Rajgopal and Shvelin,
``Empirical Evidence on the Relation between Stock Option
Compensation and Risk-Taking,'' 33 Journal of Accounting and
Economics 145 (2002); Coles, Daniel, and Naveen, ``Managerial
Incentives and Risk-Taking,'' 79 Journal of Financial Economics 431
(2006); Chen, Steiner, and Whyte, ``Does Stock Option-Based
Executive Compensation Induce Risk-Taking? An Analysis of the
Banking Industry,'' 30 Journal of Banking & Finance 916 (2006);
Mehran, Hamid and Rosenberg, ``The Effect of Employee Stock Options
on Bank Investment Choice, Borrowing and Capital,'' Federal Reserve
Bank of New York Staff Reports No. 305 (2007) available at https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr305.pdf.
    Beyond the typical measures of risk, the academic literature has
found a relation between executive stock option holdings and risky
behavior. See, e.g., Denis, Hanouna, and Sarin, ``Is There a Dark
Side to Incentive Compensation?'' 12 Journal of Corporate Finance
467 (2006) (finding that there is a significant positive association
between the likelihood of securities fraud allegations and the
executive stock option incentives); Bergstresser and Phillippon,
``CEO Incentives and Earnings Management,'' 80 Journal of Financial
Economics 511 (2006) (finding that the use of discretionary accruals
to manipulate reported earnings was more pronounced at firms where
CEO's compensation was more closely tied to stock and option
holdings).
---------------------------------------------------------------------------

    The risk dynamic for senior executive officers and significant
risk-takers changes when options are awarded because options offer
asymmetric payoffs for stock price performance. Options may generate
very high payments to covered persons when the market price of a
covered institution's shares rises, representing a leveraged return
relative to shareholders. Payment of incentive-based compensation in
the form of options may therefore increase the incentives under some
market conditions for covered persons to take inappropriate risks in
order to increase the covered institution's short-term share price,
possibly without giving appropriate weight to long-term risks.
    Moreover, unlike restricted stock, options are limited in how much
they decrease in value when the covered institution's shares decrease
in value.\185\ Thus, options may not be an effective tool for causing a
covered person to adjust his or her behavior to manage downside risk.
For senior executive officers and significant risk-takers, whose
activities can materially impact the firm's stock price, incentive-
based

compensation based on options may therefore create greater incentive to
take inappropriate risk or provide inadequate disincentive to manage
risk. For these reasons, the Agencies are proposing to limit to 15
percent the amount permitted to be used in meeting the minimum deferral
requirements.
---------------------------------------------------------------------------

    \185\ This would be the case if the current market price for a
share is less than or equal to the option's strike price (i.e., the
option is not ``in the money'').
---------------------------------------------------------------------------

    In proposing to limit, but not prohibit, the use of options to
fulfill the proposed rule's deferral requirements, the Agencies have
sought to conservatively apply better practice while still allowing for
some flexibility in the design and operation of incentive-based
compensation arrangements. The Agencies note that supervisory
experience at large banking organizations and analysis of compensation
disclosures, as well as the views of some commenters to the 2011
Proposed Rule, indicate that many institutions have recognized the
risks of options as an incentive and have reduced their use of options
in recent years.
    The proposed rule's 15 percent limit on options is consistent with
current industry practice, which is moving away from its historical
reliance on options as part of incentive-based compensation. Since the
financial crisis that began in 2007, institutions on their own
initiative and those working with the Board have decreased the use of
options in incentive-based compensation arrangements generally such
that for most organizations options constitute no more than 15 percent
of an institution's total incentive-based compensation. Restricted
stock unit awards have now emerged as the most common form of equity
compensation and are more prevalent than stock options at all employee
levels.\186\ Further, a sample of publicly available disclosures from
large covered institutions shows minimal usage of stock options among
CEOs and other named executive officers; out of a sample of 14 covered
institutions reviewed by the Agencies, only two covered institutions
awarded stock options as part of their incentive-based compensation in
2015. Only one of those two covered institutions awarded options in
excess of 15 percent of total compensation, and the excess was small.
Thus, the proposed rule's limit on options has been set at a level that
would, in the Agencies' views, help mitigate concerns about the use of
options in incentive-based compensation while still allowing
flexibility for covered institutions to use options in a manner that is
consistent with the better practices that have developed following the
recent financial crisis.\187\
---------------------------------------------------------------------------

    \186\ Bachelder, Joseph E., ``What Has Happened To Stock
Options,'' New York Law Journal (September 19, 2014).
    \187\ Rajgopal and Shvelin, ``Empirical Evidence on the Relation
between Stock Option Compensation and Risk-Taking,'' 33 Journal of
Accounting and Economics 145 (2002); Bettis, Bizjak, and Lemmon,
``Exercise Behavior, Valuation, and the Incentive Effects of
Employee Stock Options,'' 76 Journal of Financial Economics 445; ISS
Compensation FAQs.
---------------------------------------------------------------------------

    7.17. The Agencies invite comment on the restrictions on the use of
options in incentive-based compensation in the proposed rule. Should
the percent limit be higher or lower and if so, why? Should options be
permitted to be used to meet the deferral requirements of the rule? Why
or why not? Does the use of options by covered institutions create,
reduce, or have no effect on the institution's risk of material
financial loss?
    7.18. Does the proposed 15 percent limit appropriately balance the
benefits of using options (such as aligning the recipient's interests
with that of shareholders) and drawbacks of using options (such as
their emphasis on upside gains)? Why or why not? Is the proposed 15
percent limit the appropriate limit, or should it be higher or lower?
If it should be higher or lower, what should the limit be, and why?
    7.19. Are there alternative means of addressing the concerns raised
by options as a form of incentive-based compensation other than those
proposed?

Sec.  __.7(b) Forfeiture and Downward Adjustment

    Section __.7(b) of the proposed rule would require Level 1 and
Level 2 covered institutions to place incentive-based compensation of
senior executive officers and significant risk-takers at risk of
forfeiture and downward adjustment and to subject incentive-based
compensation to a forfeiture and downward adjustment review under a
defined set of circumstances. As described below, a forfeiture and
downward adjustment review would be required to identify senior
executive officers or significant risk-takers responsible for the
events or circumstances triggering the review. It would also be
required to consider certain factors when determining the amount or
portion of a senior executive officer's or significant risk-taker's
incentive-based compensation that should be forfeited or adjusted
downward.
    In general, the forfeiture and downward adjustment review
requirements in section __.7(b) would require a Level 1 or Level 2
covered institution to consider reducing some or all of a senior
executive officer's or significant risk-taker's incentive-based
compensation when the covered institution becomes aware of
inappropriate risk-taking or other aspects of behavior that could lead
to material financial loss. The amount of incentive-based compensation
that would be reduced would depend upon the severity of the event, the
impact of the event on the covered institution, and the actions of the
senior executive officer or significant risk-taker in the event. The
covered institution could accomplish this reduction of incentive-based
compensation by reducing the amount of unvested deferred incentive-
based compensation (forfeiture), by reducing the amount of incentive-
based compensation not yet awarded for a performance period that has
begun (downward adjustment), or through a combination of both
forfeiture and downward adjustment. The Agencies have found that the
possibility of a reduction in incentive-based compensation in the
circumstances identified in section __.7(b)(2) of the rule is needed in
order to properly align financial reward with risk-taking by senior
executive officers and significant risk-takers at Level 1 and Level 2
covered institutions.
    The possibility of forfeiture and downward adjustment under the
proposed rule would play an important role not only in better aligning
incentive-based compensation payouts with long-run risk outcomes at the
covered institution but also in reducing incentives for senior
executive officers and significant risk-takers to take inappropriate
risk that could lead to material financial loss at the covered
institution. The proposed rule would also require covered institutions,
through policies and procedures,\188\ to formalize the governance and
review processes surrounding such decision-making, and to document the
decisions made.
---------------------------------------------------------------------------

    \188\ See sections __.11(b) and __.11(c).
---------------------------------------------------------------------------

    While forfeiture and downward adjustment reviews would be required
components of incentive-based compensation arrangements for senior
executive officers and significant risk-takers at Level 1 and Level 2
covered institutions under the proposed rule, and are one way for
covered institutions to take into account information about performance
that becomes known over time, such reviews would not alone be
sufficient to appropriately balance risk and reward, as would be
required under section __.4(c)(1). Incentive-based compensation
arrangements for those

covered persons would also be required to comply with the specific
requirements of sections __.4(d), __.7(a), __.7(c) and __.8. As
discussed above, to achieve balance between risk and reward, covered
institutions should examine incentive-based compensation arrangements
as a whole, and consider including provisions for risk adjustments
before the award is made, and for adjustments resulting from forfeiture
and downward adjustment review during the deferral period.

Sec.  __.7(b)(1) Compensation at Risk

    Under the proposed rule, a Level 1 or Level 2 covered institution
would be required to place at risk of forfeiture 100 percent of a
senior executive officer's or significant risk-taker's deferred and
unvested incentive-based compensation, including unvested deferred
amounts awarded under long-term incentive plans. Additionally, a Level
1 or Level 2 covered institution would be required to place at risk of
downward adjustment all of a senior executive officer's or significant
risk-taker's incentive-based compensation that has not yet been
awarded, but that could be awarded for a performance period that is
underway and not yet completed.
    Forfeiture and downward adjustment give covered institutions an
appropriate set of tools through which consequences may be imposed on
individual risk-takers when inappropriate risk-taking or misconduct,
such as the events identified in section __.7(b)(2), occur or are
identified. They also help ensure that a sufficient amount of
compensation is at risk. Certain risk management failures and
misconduct can take years to manifest, and forfeiture and downward
adjustment reviews provide covered institutions an opportunity to
adjust the ultimate amount of incentive-based compensation that vests
based on information about risk-taking or misconduct that comes to
light after the performance period. A senior executive officer or
significant risk-taker should not be rewarded for inappropriate risk-
taking or misconduct, regardless of when the covered institution learns
of it.
    Some evidence of inappropriate risk taking, risk management
failures and misconduct may not be immediately apparent to the covered
institution. To provide a strong disincentive for senior executive
officers and significant risk-takers to engage in such conduct, which
may lead to material financial loss to the covered institution, the
Agencies are proposing to require that all unvested deferred incentive-
based compensation and all incentive-based compensation eligible to be
awarded for the performance period in which the covered institution
becomes aware of the conduct be available for forfeiture and downward
adjustment under the forfeiture and downward adjustment review. A
covered institution would be required to consider all incentive-based
compensation available, in the form of both unvested deferred
incentive-based compensation and yet-to-be awarded incentive-based
compensation, when considering forfeiture or downward adjustments, even
if the incentive-based compensation does not specifically relate to the
performance in the period in which the relevant event occurred.
    For example, a significant risk-taker of a Level 1 covered
institution might engage in misconduct in June 2025, but the Level 1
covered institution might not become aware of the misconduct until
September 2028. The Level 1 covered institution would be required to
consider downward adjustment of any amounts available under any of the
significant risk-taker's incentive-based compensation plans with
performance periods that are still in progress as of September 2028
(for example, an annual plan with a performance period that runs from
January 1, 2028, to December 31, 2028, or a long-term incentive plan
with a performance period that runs from January 1, 2027, to December
31, 2030). The Level 1 covered institution would also be required to
consider forfeiture of any amounts that are deferred, but not yet
vested, as of September 2028 (for example, amounts that were awarded
for a performance period that ran from January 1, 2026, to December 31,
2026, and that have been deferred and do not vest until December 31,
2030). For an additional example of how these requirements would work
in practice, please see Appendix A of this Supplementary Information
section.

Sec.  __.7(b)(2) Events Triggering Forfeiture and Downward Adjustment
Review

    Section __.7(b) of the proposed rule would require a Level 1 or
Level 2 covered institution to conduct a forfeiture and downward
adjustment review based on certain identified adverse outcomes.
    Under section __.7(b), events \189\ that would be required to
trigger a forfeiture and downward adjustment review include: (1) Poor
financial performance attributable to a significant deviation from the
risk parameters set forth in the covered institution's policies and
procedures; (2) inappropriate risk-taking, regardless of the impact on
financial performance; (3) material risk management or control
failures; and (4) non-compliance with statutory, regulatory, or
supervisory standards that results in: Enforcement or legal action
against the covered institution brought by a Federal or state regulator
or agency; or a requirement that the covered institution report a
restatement of a financial statement to correct a material error.
Covered institutions would be permitted to define additional triggers
based on conduct or poor performance. Generally, in the Agencies'
supervisory experience as earlier described, the triggers are
consistent with current practice at the largest financial institutions,
although many covered institutions have triggers that are more granular
in nature than those proposed and cover a wider set of adverse
outcomes. The proposed enumerated adverse outcomes are a set of minimum
standards.
---------------------------------------------------------------------------

    \189\ The underlying, or contractual, forfeiture language used
by institutions need not be identical to the triggers enumerated in
this section, provided the covered institution's triggers capture
the full set of outcomes outlined in section 7(b)(2) of the rule.
For example, a trigger at a covered institution that read ``if an
employee improperly or with gross negligence fails to identify,
raise, or assess, in a timely manner and as reasonably expected,
risks and/or concerns with respect to risks material to the
institution or its business activities,'' would be considered
consistent with the minimum parameters set forth in the trigger
identified in section 7(b)(2)(ii) of the rule.
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    As discussed later in this SUPPLEMENTARY INFORMATION section,
covered institutions would be required to provide for the independent
monitoring of all events related to forfeiture and downward
adjustment.\190\ When such monitoring, or other risk surveillance
activity, reveals the occurrence of events triggering forfeiture and
downward adjustment reviews, Level 1 and Level 2 covered institutions
would be required to conduct those reviews in accordance with section
__.7(b). Covered institutions may choose to coordinate the monitoring
for triggering events under section __.9(c)(2) and the forfeiture and
downward adjustment reviews with broader risk surveillance activities.
Such coordinated reviews could take place on a schedule identified by
the covered institution. Schedules may vary among covered institutions,
but they should occur often enough to appropriately monitor risks and
events related to forfeiture and downward adjustment. Larger covered
institutions with more complex operations are likely to need to conduct
more frequent

reviews to ensure effective risk management.
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    \190\ See section __.9(c)(2).
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    Poor financial performance can indicate that inappropriate risk-
taking has occurred at a covered institution. The Agencies recognize
that not all inappropriate risk-taking does, in fact, lead to poor
financial performance, but given the risks that are posed to the
covered institutions by poorly designed incentive-based compensation
programs and the statutory mandate of section 956, it is appropriate to
prohibit incentive-based compensation arrangements that reward such
inappropriate risk-taking. Therefore, if evidence of past inappropriate
risk-taking becomes known, the proposed rule would require a Level 1 or
Level 2 covered institution to perform a forfeiture and downward
adjustment review in order to assess whether the relevant senior
executive officer's or significant risk-taker's incentive-based
compensation should be affected by the inappropriate risk-taking.
    Similarly, material risk management or control failures may allow
for inappropriate risk-taking that may lead to material financial loss
at a covered institution. Because the role of senior executive officers
and significant risk-takers, including those in risk management and
other control functions whose role is to identify, measure, monitor,
and control risk, the material failure by covered persons to properly
perform their responsibilities can be especially likely to put an
institution at risk. Thus, if evidence of past material risk management
or control failures becomes known, the proposed rule would require a
Level 1 or Level 2 covered institution to perform a forfeiture and
downward adjustment review, to assess whether a senior executive
officer or significant risk-taker's incentive-based compensation should
be affected by the risk management or control failure. Examples of risk
management or control failures would include failing to properly
document or report a transaction or failing to properly identify and
control the risks that are associated with a transaction. In each case,
the risk management or control failure, if material, could allow for
inappropriate risk-taking at a covered institution that could lead to
material financial loss.
    Finally, a covered institution's non-compliance with statutory,
regulatory, or supervisory standards may also reflect inappropriate
risk-taking that may lead to material financial loss at a covered
institution. The proposed rule would require a forfeiture and downward
adjustment review whenever any such non-compliance (1) results in an
enforcement or legal action against the covered institution brought by
a Federal or state regulator or agency; or (2) requires the covered
institution to restate a financial statement to correct a material
error. The Federal Banking Agencies have found that it is appropriate
for a covered institution to conduct a forfeiture and downward
adjustment review under these circumstances because in many cases a
statutory, regulatory, or supervisory standard may have been put in
place in order to prevent a covered person from taking an inappropriate
risk. In addition, non-compliance with a statute, regulation, or
supervisory standard may also give rise to inappropriate compliance
risk for a covered institution. A forfeiture and downward adjustment
review would allow the institution to assess whether this type of non-
compliance should affect a senior executive officer or significant
risk-taker's incentive-based compensation.

Sec.  __.7(b)(3) Senior Executive Officers and Significant Risk-Takers
Affected by Forfeiture and Downward Adjustment

    A forfeiture and downward adjustment review would be required to
consider forfeiture and downward adjustment of incentive-based
compensation for a senior executive officer and significant risk-taker
with direct responsibility or responsibility due to the senior
executive officer or significant risk-taker's role or position in the
covered institution's organizational structure, for the events that
would trigger a forfeiture and downward adjustment review as described
in section __.7(b)(2). Covered institutions should consider not only
senior executive officers or significant risk-takers who are directly
responsible for an event that triggers a forfeiture or downward
adjustment review, but also those senior executive officers or
significant risk-takers whose roles and responsibilities include areas
where failures or poor performance contributed to, or failed to
prevent, a triggering event. This requirement would discourage senior
executive officers and significant risk-takers who can influence
outcomes from failing to report or prevent inappropriate risk. A
covered institution conducting a forfeiture and downward adjustment
review may also consider forfeiture for other covered persons at its
discretion.

Sec.  __.7(b)(4) Determining Forfeiture and Downward Adjustment Amounts

    The proposed rule sets out factors that Level 1 and Level 2 covered
institutions must consider, at a minimum, when making a determination
to reduce incentive-based compensation as a result of a forfeiture or
downward adjustment review. A Level 1 or Level 2 covered institution
would be responsible for determining how much of a reduction in
incentive-based compensation is warranted, consistent with the policies
and procedures it establishes under Sec.  __.11(b), and should be able
to support its decisions that such an adjustment was appropriate if
requested by its appropriate Federal regulator. In reducing the amount
of incentive-based compensation, covered institutions may reduce the
dollar amount of deferred cash or cash to be awarded, may lower the
amount of equity-like instruments that have been deferred or were
eligible to be awarded, or some combination thereof. A reduction in the
value of equity-like instruments due to market fluctuations would not
be considered a reduction for purposes of this review.
    The proposed minimum factors that would be required to be
considered when determining the amount of incentive-based compensation
to be reduced are: (1) The intent of the senior executive officer or
significant risk-taker to operate outside the risk governance framework
approved by the covered institution's board of directors or to depart
from the covered institution's policies and procedures; (2) the senior
executive officer's or significant risk-taker's level of participation
in, awareness of, and responsibility for, the events triggering the
review; (3) any actions the senior executive officer or significant
risk-taker took or could have taken to prevent the events triggering
the review; (4) the financial and reputational impact of the events
\191\ triggering the review as set forth in section __.7(b)(2) on the
covered institution, 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; (5) the causes of the events triggering the review,
including any decision-making

by other individuals; and (6) any other relevant information, including
past behavior and risk outcomes linked to past behavior attributable to
the senior executive officer or significant risk-taker.
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    \191\ Reputational impact or harm related to the actions of
covered individuals refers to a potential weakening of confidence in
an institution as evidenced by negative reactions from customers,
shareholders, bondholders and other creditors, consumer and
community groups, the press, or the general public. Reputational
impact is a factor currently considered by some institutions in
their existing forfeiture policies. See, e.g., Wells Fargo & Company
2016 Proxy Statement, page 47, available at https://www08.wellsfargomedia.com/assets/pdf/about/investor-relations/annual-reports/2016-proxy-statement.pdf; and Citigroup 2016 Proxy
Statement, page 74, available at http://www.citigroup.com/citi/investor/quarterly/2016/ar16cp.pdf?ieNocache=611.
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    The considerations identified constitute a minimum set of
parameters that would be utilized for exercising the discretion
permissible under the proposed rule while still holding senior
executive officers and significant risk-takers accountable for
inappropriate risk-taking and other behavior that could encourage
inappropriate risk-taking that could lead to risk of material financial
loss at covered institutions. For example, a covered institution might
identify a pattern of misconduct stemming from activities begun three
years before the review that ultimately leads to an enforcement action
and reputational damage to the covered institution. A review of facts
and circumstances, including consideration of the minimum review
parameters set forth in the proposed rule, could reveal that one
individual knowingly removed transaction identifiers in order to
facilitate a trade or trades with a counterparty on whom regulators had
applied Bank Secrecy Act or Anti-Monetary Laundering sanctions. Several
of the senior executive officer's or significant risk-taker's peers
might have been aware of this pattern of behavior but did not report it
to their managers. Under the proposed rule, the individual who
knowingly removed the identifiers would, in most cases, be subject to a
greater reduction in incentive-based compensation than those who were
aware of but not participants in the misconduct. However, those peers
that were aware of the misconduct, managers supervising the covered
person directly involved in the misconduct, and control staff who
should have detected but failed to detect the behavior would be
considered for a reduction, depending on their role in the
organization, and assuming the peers are now senior executive officers
or significant risk-takers.
    The Agencies do not intend for these proposed factors to be
exhaustive and covered institutions should consider additional factors
where appropriate. In addition, covered institutions generally should
impact incentive-based compensation as a result of forfeiture and
downward adjustment reviews to reflect the severity of the event that
triggered the review and the level of an individual's involvement.
Covered institutions should be able to demonstrate to the appropriate
Federal regulator that the impact on incentive-based compensation was
appropriate given the particular set of facts and circumstances.
    7.20. The Agencies invite comment on the forfeiture and downward
adjustment requirements of the proposed rule.
    7.21. Should the rule limit the events that require a Level 1 or
Level 2 covered institution to consider forfeiture and downward
adjustment to adverse outcomes that occurred within a certain time
period? If so, why and what would be an appropriate time period? For
example, should the events triggering forfeiture and downward
adjustment reviews be limited to those events that occurred within the
previous seven years?
    7.22. Should the rule limit forfeiture and downward adjustment
reviews to reducing only the incentive-based compensation that is
related to the performance period in which the triggering event(s)
occurred? Why or why not? Is it appropriate to subject unvested or
unawarded incentive-based compensation to the risk of forfeiture or
downward adjustment, respectively, if the incentive-based compensation
does not specifically relate to the performance in the period in which
the relevant event occurred or manifested? Why or why not?
    7.23. Should the rule place all unvested deferred incentive-based
compensation, including amounts voluntarily deferred by Level 1 and
Level 2 covered institutions or senior executive officers or
significant risk-takers, at risk of forfeiture? Should only that
unvested deferred incentive-based compensation that is required to be
deferred under section __.7(a) be at risk of forfeiture? Why or why
not?
    7.24. Are the events triggering a review that are identified in
section __.7(b)(2) comprehensive and appropriate? If not, why not?
Should the Agencies add ``repeated supervisory actions'' as a
forfeiture or downward adjustment review trigger and why? Should the
Agencies add ``final enforcement or legal action'' instead of the
proposed ``enforcement or legal action'' and why?
    7.25. Is the list of factors that a Level 1 or Level 2 covered
institution must consider, at a minimum, in determining the amount of
incentive-based compensation to be forfeited or downward adjusted by a
covered institution appropriate? If not, why not? Are any of the
factors proposed unnecessary? Should additional factors be included?
    7.26. Are the proposed parameters for forfeiture and downward
adjustment review sufficient to provide an appropriate governance
framework for making forfeiture decisions while still permitting
adequate discretion for covered institutions to take into account
specific facts and circumstances when making determinations related to
a wide variety of possible outcomes? Why or why not?
    7.27. Should the rule include a presumption of some amount of
forfeiture for particularly severe adverse outcomes and why? If so,
what should be the amount and what would those outcomes be?
    7.28. What protections should covered institutions employ when
making forfeiture and downward adjustment determinations?
    7.29. In order to determine when forfeiture and downward adjustment
should occur, should Level 1 and Level 2 covered institutions be
required to establish a formal process that both looks for the
occurrence of trigger events and fulfills the requirements of the
forfeiture and downward adjustment reviews under the proposed rule? If
not, why not? Should covered institutions be required as part of the
forfeiture and downward adjustment review process to establish formal
review committees including representatives of control functions and a
specific timetable for such reviews? Should the answer to this question
depend on the size of the institution considered?

Sec.  __.7(c) Clawback

    As used in the proposed rule, the term ``clawback'' means a
mechanism by which a covered institution can recover vested incentive-
based compensation from a covered person. The proposed rule would
require Level 1 and Level 2 covered institutions to include clawback
provisions in incentive-based compensation arrangements for senior
executive officers and significant risk-takers that, at a minimum,
would allow for the recovery of up to 100 percent of vested incentive-
based compensation from a current or former senior executive officer or
significant risk-taker for seven years following the date on which such
compensation vests. Under section __.7(c) of the proposed rule, all