The proposed rule would subject covered institution subsidiaries of
a depository institution holding company that is a Level 1 or Level 2
covered institution to the same requirements as the depository
institution holding company. In this manner, the proposed rule would
capture the effect that risk-taking within the subsidiaries of a
depository institution holding company could have on the parent, and
the negative externalities that could result for taxpayers.
    For example, covered persons at a $10 billion BD subsidiary of a
depository institution holding company that is a Level 1 covered
institution would be treated as covered persons of a Level 1 covered
institution and subject to the proposed requirements and prohibitions
applicable to covered persons at a Level 1 covered institution. One
benefit of the proposed approach is the implementation simplicity of
the proposed rule since the parent institution's size would determine
the requirements for all covered persons in the covered institution's
corporate structure. Such an approach also has the advantage that it
may cover situations where the subsidiary could potentially expose the
consolidated institution to substantial risks. This could be the case
if for example the parent institution has provided capital to the
subsidiary and the subsidiary is large enough that its failure would
represent a significant loss for the parent institution. Moreover, such
an approach curbs the possibility that a covered institution might
place significant risk-takers in a smaller unregulated subsidiary, in
order to evade the compensation restrictions of the proposed rule for
individuals with authority to expose the institution to significant
amounts of risk.
    There may also be costs associated with the proposed consolidation
approach. The main disadvantage of such approach is that it may impose
requirements and prohibitions on individuals employed in smaller
subsidiaries that are less likely to be in a position to expose the
institution to significant risks. Thus, the assumptions underlying the
rule's consolidation may not be accurate in all cases. The proposed
rules' treatment of subsidiaries would depend on their size and the
size of their parent, and also on the effect that risk-taking within
those subsidiaries could have on the potential failure of the parent
institution and the potential risk that such a failure could impose on
the overall financial system and the subsequent negative externality
that this could create for taxpayers. For example, if the parent
institution does not explicitly provide capital or implicitly guarantee
the subsidiary's positions, the proposed rules would impose similar
requirements on the incentive-based compensation of individuals with
different abilities to expose the institution to risk. Such
compensation requirements may impose costs on individuals in these
subsidiaries, and it might affect the ability of these subsidiaries to
compete for managerial talent with stand-alone companies of the same
size as the subsidiary. If that were the case, the subsidiaries of
larger parent institutions may have to provide additional pay to
individuals to compensate for the relatively stricter compensation
requirements and prohibitions. If these additional compensation
requirements are significantly costly, there may be incentives for
smaller subsidiaries to spin-off from their parents and operate as
stand-alone firms to avoid the stricter compensation requirements that
would be applicable based on the size of the parent institution.
    Additionally, the costs of the proposed consolidation approach
would depend on how different the current incentive-based compensation
arrangements of a subsidiary are from those of its parent institution.
If the compensation arrangements of BDs' and IAs' covered persons are
similar to those of their parent institutions (e.g., they use similar
deferral percentages and terms, prohibit hedging, etc.), then the
proposed consolidation approach is not likely to lead to significant
compliance costs for BDs and IAs. The 2010 Federal Banking Agency
Guidance has significantly limited differences in compensation
arrangements between financial institutions and their subsidiaries. If,
however, the compensation arrangements at BDs and IAs more closely
resemble the compensation structures of financial institutions of
similar size, than the proposed rule's consolidation requirement may
lead to significant compliance costs. Unconsolidated Level 3 BDs and
IAs are most likely to be affected by this proposition. The parent
institutions of Level 3 BDs, to the extent that they are owned by one,
are mainly Level 1 and Level 2 covered institutions. Although the SEC
does not have data about the parent institutions of Level 3 IAs, the
SEC expects that they would also be mainly Level 1 and Level 2 covered
institutions. As shown above, compensation practices at Level 3 parent
institutions differ significantly from Level 1 and Level 2 parent
institutions on a number of dimensions: They defer a smaller fraction
of NEOs incentive-based compensation (Table 7A), defer cash less
frequently (Table 7A), and tend to use more options as part of their
incentive-based compensation (Table 6A) compared to Level 1 and Level 2
parent institutions. They also rather infrequently prohibit hedging
with respect to non-employee directors that receive incentive-based
compensation (Table 10A). If the compensation arrangements of
unconsolidated Level 3 BDs and IAs are similar to those of Level 3
parent institutions, under the proposed rule they would need to make
significant

changes to certain features of their compensation arrangements to be
compliant with the proposed rule. On the other hand, to the extent that
their current compensation practices are not optimal from the
perspective of taxpayers and other stakeholders of such BDs and IAs,
there may be potential benefits. This point holds for the remainder of
the economic analysis where the SEC discusses the potential costs and
benefits to unconsolidated Level 3 BDs and IAs of a larger covered
institution from applying the proposed rule requirements and
prohibitions.
    An alternative to the proposed consolidation approach would be to
use the subsidiary's size to determine its status as a Level 1, Level
2, or Level 3 covered institution. For example, a $10 billion BD
subsidiary of a Level 1 depository institution holding company would be
treated as a Level 3 covered institution and covered persons within the
subsidiary would be subject to all requirements and prohibitions
applicable to a Level 3 covered institution. This alternative approach
would not entail the potential costs identified in the proposed
approach described above. However, differential application of the rule
depending on subsidiary size could provide covered institutions with an
incentive to re-organize their operations by placing significant risk-
takers into relatively smaller subsidiaries to bypass the proposed
requirements. This type of behavior, however, might be mitigated in
some circumstances by the proposed rule's prohibition on such indirect
actions: A covered institution must not indirectly, or through or by
any other person, do anything that would be unlawful for such covered
institution to do directly under this part. Moreover, this type of
behavior would be constrained by the fact that the SEC's capital
requirements for broker-dealers require that the broker-dealer itself
carry the necessary capital for all broker-dealer positions.\401\
Additionally, the rule's definition of a significant risk-taker would
treat any employee of the subsidiary with the ability to commit certain
amount of capital or to create risks for the parent institution as a
significant risk-taker of the parent, further limiting the ability of
institutions to bypass the proposed requirements by placing such
individuals into relatively smaller subsidiaries.
---------------------------------------------------------------------------

    \401\ See 17 CFR 15c3-1(a).
---------------------------------------------------------------------------

E. Potential Costs and Benefits of the Proposed Rule's Requirements and
Prohibitions
    In the following sections, the SEC provides an analysis of the
potential costs and benefits associated with the proposed rule's
requirements and prohibitions and possible alternatives.\402\ For
purposes of this analysis, the SEC addresses the potential economic
effects for covered BDs and IAs resulting from the statutory mandate
and from the SEC's exercise of discretion together, recognizing that it
is often difficult to separate the costs and benefits arising from
these two sources. The SEC also requests comment on any economic effect
the proposed requirements may have on covered BDs and IAs. The SEC
appreciates comments that include both qualitative information and data
quantifying the costs and the benefits identified in the analysis or
alternative implementations of the proposed rule.
---------------------------------------------------------------------------

    \402\ Commenters on the 2011 Proposed Rule suggested more
expansive discussion and analysis of economic effects of the
proposed rulemaking on items such as the ability of covered
institutions to compete for talent acquisition and retention (See,
for example, letters by the U.S. Chamber and FSR), and also on the
effects of the rule on risk taking incentives and its consequences
for covered institutions' ability to compete (See, for example,
FSR). Below, the SEC's economic analysis outlines and discusses
potential economic effects of the various rule provisions, including
items identified in comment letters discussing economic
considerations.
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1. Limitations on Excessive Compensation
    The proposed rule would prohibit covered institutions from
establishing or maintaining any type of incentive-based compensation
arrangement, or any feature of any such arrangement, that encourages
inappropriate risk-taking by providing a covered person with excessive
compensation, fees, or benefits or that could lead to material loss for
the institution.
    The proposed rule would not define excessive compensation; instead,
it would use a principles-based approach that would provide covered
institutions with the flexibility to structure incentive-based
compensation arrangements that do not constitute excessive compensation
based on several factors that are outlined below. These factors would
include: The total size of a covered person's compensation; the
compensation history of the covered person and other individuals with
comparable expertise at the institution; the financial condition of the
covered institution; compensation practices at comparable institutions
based upon such factors as asset size, geographic location, and the
complexity of the covered institution's operations and assets; for
post-employment benefits, the projected total cost and benefit to the
covered institution; and any connection between the covered person and
any fraudulent act or omission, breach of trust or fiduciary duty, or
insider abuse with regard to the covered institution.
    The flexibility that the proposed rule provides would likely
benefit covered institutions by allowing them to tailor the incentive-
based compensation arrangements to the skills and job requirements of
each covered person and to the nature of a particular institution's
business and the risks thereof instead of applying a ``one size fits
all'' approach. The differences in the size, complexity,
interconnectedness, and degree of competition in the market for
managerial talent among the institutions covered by the proposed rule
make excessive compensation difficult to define universally.
    As mentioned above, a principles-based approach is likely to
provide greater discretion to covered institutions in tailoring
compensation arrangements that do not provide incentives for
inappropriate risk-taking. Such discretion may potentially allow for
differential interpretation among covered institutions on what
constitutes excessive compensation and as a consequence, differential
compensation arrangements even for similar institutions could be
designed. Given the flexibility inherent under a principles-based
approach, it is also possible that in fact some compensation contracts
to covered persons constitute excessive compensation that could lead to
inappropriate risk-taking, particularly if the compensation setting
process is not efficient or unbiased.\403\ It is also possible that
boards of directors may find it difficult to evaluate whether a
compensation arrangement creates excessive compensation that could lead
to inappropriate risk-taking. As such, it is likely that governance
mechanisms in place would be crucial for institutions to benefit from
the flexibility of the principles-based approach and avoid the
potential costs described above.
---------------------------------------------------------------------------

    \403\ For example, see Coles, J., Daniel, N., and Naveen, L. Co-
opted Boards. 2014. Review of Financial Studies 27, 1751-1796.
---------------------------------------------------------------------------

    An alternative would be a more prescriptive approach in defining
compensation arrangements that constitute excessive compensation. For
example, an explicit definition of excessive compensation could be
provided for covered institutions. As mentioned above, such an approach
has

the disadvantage of restricting compensation arrangement options for
covered institutions and thus an increased likelihood that inefficient
compensation arrangements would be applied to at least some covered
institutions, given the significant differences among covered
institutions and covered persons.
2. Performance Measures
    The proposed rule would require covered institutions to use a
variety of performance measures when determining the incentive-based
compensation of covered persons. Incentive-based compensation
arrangements would be required to include a mix of financial (i.e.,
accounting and stock-based) measures and non-financial measures, with
the ability for non-financial measures to override financial measures
when appropriate. Additionally, any amounts to be awarded under the
arrangement would be subject to adjustment to reflect actual losses,
inappropriate risks taken, compliance deficiencies, or other measures
or aspects of financial and non-financial performance.
    There is evidence in the economic literature suggesting that non-
financial measures of performance are incremental predictors of long-
term financial performance relative to financial measures of
performance, and provide important information about executives'
performance.\404\ Moreover, non-financial measures of performance in
compensation arrangements may better capture progress or milestones of
strategic goals that may be unique to specific institutions.\405\ Thus,
the proposed requirement to use a mix of the two types of measures
would likely provide more relevant information to enable covered
institutions to set up incentive compensation arrangements for covered
persons. In addition, the flexibility that the proposed rule would
provide to covered institutions to adjust the compensation awards based
on various factors would allow covered institutions to tailor their
compensation arrangements to their specific circumstances.
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    \404\ See, e.g., Banker, R., G. Potter, and D. Srinivasan, 1999.
An Empirical Investigation of an Incentive Plan that Includes
Nonfinancial Performance Measures. The Accounting Review 75, 65-92.
The study examines whether non-financial measures of performance,
specifically customer satisfaction, are incremental predictors of
future performance and whether inclusion of such measures of
performance in compensation contracts is efficient. The study finds
that customer satisfaction is incremental in predicting future
financial performance and inclusion of such performance measure in
compensation contracts leads to improved future performance.
    \405\ See, e.g., Ittner, C., D. Larcker, and T. Randall, 2003.
Performance Implications of Strategic Performance Measurement in
Financial Services Firms. Accounting, Organizations and Society 28,
715-741. The study uses a sample of 140 U.S. financial services
firms to examine the relation between measurement system
satisfaction, economic performance, and two general approaches to
strategic performance measurement: Greater measurement diversity and
improved alignment with firm strategy and value drivers. The study
finds evidence that firms making more extensive use of a broad set
of financial and non-financial measures than firms with similar
strategies or value drivers have higher measurement system
satisfaction and stock market returns.
---------------------------------------------------------------------------

    The baseline analysis suggests that many of the public parent
institutions of some BDs and IAs already use a mix of financial and
non-financial measures in determining the incentive-based compensation
awards of senior executive officers. To the extent that BDs and IAs use
a similar mix of measures to determine the incentive-based compensation
awards of their senior executive officers, the SEC expects the costs of
compliance with this provision of the proposed rule to be relatively
low. If BDs and IAs do not use the same mixture of financial and non-
financial measures as their parents, or do not rely on non-financial
measures when determining the compensation of their senior executive
officers and significant risk-takers, the compliance costs associated
with this particular rule requirement may be significant. Such costs
may be in the form of additional expenditures related to hiring
compensation consultants and/or lawyers to design compensation schemes
and assure the compliance of newly designed compensation schemes with
the proposed rule.
    The SEC has attempted to quantify such costs using data reported by
Level 1, Level 2, and Level 3 covered institutions that are parents of
BDs and IAs. Table 14 provides some summary statistics on the use of
compensation consultants and the fees paid to those over the period
2007-2014.\406\ Based on the results in the table, Level 1 and Level 2
covered institutions use on average two compensation consultants, while
Level 3 covered institutions use one compensation consultant on
average. If a Level 1 BD or IA has to hire compensation consultant(s)
to help them meet this rule requirement, it may incur costs of
approximately $185,515 per year. If an unconsolidated Level 2 BD or IA
has to hire compensation consultant(s) to help them meet this rule
requirement, it may incur costs of approximately $77,000 per year.\407\
If an unconsolidated Level 3 BD or IA, because of the consolidation
requirement, has to hire compensation consultant(s) to help meet this
rule requirement, it may incur costs of approximately $18,788 per year.
These costs could be higher if the compensation consultant is asked to
provide additional services other than compensation consulting
services. These costs could be lower, however, if the parent
institutions of BDs and IAs already employ compensation consultants and
could extend their services to meet the proposed rule requirements for
BDs and IAs.
---------------------------------------------------------------------------

    \406\ Data used in the table comes from the ISS database.
    \407\ We note that while we report the median consulting fee for
covered institutions in Table 14, the average compensation
consultant fees are higher. For example, for Level 1 covered
institutions the average consulting fee is $198,673, for Level 2
covered institutions the average consulting fee is $293,501, and for
Level 3 covered institutions the average consulting fee is $59,828.
The presence of outliers in the compensation consulting fee data and
the small sample size are the reason for the large difference
between average and median consulting fee.

    Table 14--The Use and Costs of Compensation Consultants by Certain Level 1, Level 2, and Level 3 Covered
                             Institutions That Are Parents of BDs and IAs, 2007-2014
----------------------------------------------------------------------------------------------------------------
                                                                                Median fees
                                                                      Average     for consulting
                                                                     number of      services to      Number of
                                                                   compensation         the        institutions
                                                                    consultants    compensation
                                                                       used          committee
----------------------------------------------------------------------------------------------------------------
Level 1.........................................................               2         185,515               7
Level 2.........................................................               2          77,000               9
Level 3.........................................................               1          18,788               6
----------------------------------------------------------------------------------------------------------------

3. Board of Directors
    Additionally, the proposed rule would require that the board of
directors of covered institutions oversee a covered institution's
incentive-based compensation program, and approve incentive-based
compensation arrangements for senior executive officers or any material
exceptions or adjustments to incentive-based compensation policies or
arrangements.
    Since overseeing and approving executive compensation arrangements
is one of the primary functions of the compensation committee of the
corporate board, the SEC believes that this rule requirement would not
impose significant compliance costs on covered institutions that
already have compensation committees. Moreover, because the baseline
analysis suggests that the majority of the parents of some covered
institutions already employ most of the requirements and limitations of
the proposed rule, it may not be particularly costly for boards of
directors or compensation committees to comply with the proposed rule.
However, there might be additional compliance costs for covered
institutions if the board of directors or the compensation committee
have to exert incremental effort (i.e., meet more frequently) in
designing and approving compensation arrangements. Additionally, if
because of the rule's definition of significant risk-takers the
compensation committee of a covered institution has to cover a much
larger number of employees and consider additional factors than it does
at present, this may increase compliance costs.
    For covered BDs and IAs that do not have compensation committees,
the board of directors as a whole may be able to oversee and approve
executive compensation arrangements. Thus, for such BDs and IAs the
compliance costs of this rule requirement could result in more time
being spent for the board of directors on these issues, which might
entail higher directors' fees and possibly additional compensation
consulting costs.
4. Disclosure and Recordkeeping
    The proposed rule would require all covered institutions to create
annually and maintain for a period of at least 7 years records that
document the structure of all its incentive-based compensation
arrangements and demonstrate compliance with the proposed rule. At a
minimum, these must include copies of all incentive-based compensation
plans, a record of who is subject to each plan, and a description of
how the incentive-based compensation program is compatible with
effective risk management and controls.
    The SEC is proposing an amendment to Exchange Act Rule 17a-4(e)
\408\ and Investment Advisers Act Rule 204-2 \409\ to require that
registered broker-dealers maintain and investment advisers,
respectively, the records required by the proposed rule, in accordance
with the recordkeeping requirements of Exchange Act Rule 17a-4 and
Investment Advisers Act Rule 204-2, respectively. Exchange Rule 17a-4
and Investment Advisers Act Rule 204-2 establish the general formatting
and storage requirements for records that registered broker-dealers and
investment advisers, respectively, are required to keep. For the sake
of consistency with other broker-dealer and investment adviser records,
the SEC believes that registered broker-dealers and investment
advisers, respectively, should also keep the records required by the
proposed rule, in accordance with these requirements.
---------------------------------------------------------------------------

    \408\ 17 CFR 240.17a-4(e).
    \409\ 17 CFR 275.204-2.
---------------------------------------------------------------------------

    The proposed recordkeeping requirement would assist covered BDs and
IAs in monitoring incentive-based compensation awards and payments and
comparing them with actual risk outcomes to determine whether
incentive-based compensation payments to senior executive officers and
significant risk-takers lead to inappropriate risk-taking. The proposed
recordkeeping requirement would also help BDs and IAs to modify the
incentive-based compensation arrangements of senior executive officers
and significant risk-takers, if, over time, incentive-based
compensation paid does not appropriately reflect risk outcomes. These
records would be available to SEC staff for examination, which may
enhance compliance and facilitate oversight.
    This proposed requirement would likely impose compliance costs on
covered institutions. The SEC expects the magnitude of the compliance
costs to depend on whether broker-dealers and investment advisers
already have a system in place to generate information regarding their
compensation practices for internal use (e.g., for reports to the board
of directors or the compensation committee) or for required disclosures
under the Exchange Act (for reporting companies). To the extent that
such existing platforms can be expanded to produce the records required
under the proposed rule, the SEC expects this requirement to impose
lower compliance costs on these institutions. The compliance costs
associated with this particular proposed rule requirement would likely
be higher for covered institutions that may not be generating such
information, if for example they are not subject to related reporting
obligations, or may not keep the type and detail of records that would
be required under the proposed rule. Given that all Level 1 and
unconsolidated Level 2 BDs, and most unconsolidated Level 3 BDs and
IAs, are non-reporting companies, the SEC expects that the
recordkeeping costs associated with the rule may be substantial for
these BDs and IAs. The SEC notes, however, that because it does not
have information on the compensation reporting and recordkeeping at the
subsidiary level, the SEC may be overestimating compliance costs for
BDs and IAs with reporting parent institutions. For example, if the
parent institution reports and keeps records of the incentive-based
compensation arrangements at the subsidiary level, and on the same
scale and detail as required by the proposed rule, it is possible that
the compliance costs for such BDs could be lower than the compliance
costs for BDs with non-reporting parent institutions. Since the SEC
does not have data on how many covered IAs have parent institutions, it
is also possible that a significant number of these IAs may be stand-
alone companies and therefore could have higher costs to comply with
the proposed rule compared to covered IAs and BDs that are part of
reporting parent institutions.
    According to the 2010 Federal Banking Agency Guidance, a banking
organization should provide an appropriate amount of information
concerning its incentive compensation arrangements for executive and
non-executive employees and related risk-management, control, and
governance processes to shareholders to allow them to monitor and,
where appropriate, take actions to restrain the potential for such
arrangements and processes to encourage employees to take imprudent
risks. Such disclosures should include information relevant to
employees other than senior executive officers. The scope and level of
the information disclosed by the institution should be tailored to the
nature and complexity of the institution and its incentive compensation
arrangements. Thus, private covered institutions that are banking
institutions and apply the policies of the 2010 Federal Banking Agency
Guidance may already be

collecting the information that would be required by the proposed rule.
The SEC expects the compliance costs to be lower for such covered
institutions, to the extent that there is an overlap between the
information collected under the 2010 Federal Banking Agency Guidance
and the information that would be required for disclosure and
recordkeeping under the proposed rule. The BDs and IAs that are stand-
alone non-reporting firms or have non-reporting parent institutions
that are not banking institutions would most likely be the ones to
incur higher compliance costs of disclosure and recordkeeping.
    By requiring covered institutions to create and maintain records of
incentive-based compensation arrangements for covered persons at all
covered BDs and IAs, the proposed recordkeeping requirement is expected
to facilitate the SEC's ability to monitor incentive-based compensation
arrangements and could potentially strengthen incentives for covered
institutions to comply with the proposed rule. As a consequence, an
increase in investor confidence that covered institutions are less
likely to be incentivizing inappropriate actions through compensation
arrangements may occur and potentially result in greater market
participation and allocative efficiency, thereby potentially
facilitating capital formation. As discussed above, it is difficult for
the SEC to estimate compliance costs related to the specific provision.
However, for covered institutions that do not currently have a similar
reporting system in place, there could be significant fixed costs that
may disproportionately burden smaller covered BDs and IAs and hinder
competition. Overall, the SEC does not expect the effects of the
proposed recordkeeping requirements on efficiency, competition and
capital formation to be significant.
5. Reservation of Authority
    Under the proposed rule, an Agency may require a Level 3 covered
institution with average total consolidated assets greater than or
equal to $10 billion and less than $50 billion to comply with some or
all of the provisions of Sec. Sec.  5 and 7 through 11of the proposed
rule applicable to Level 1 and Level 2 covered institutions if the
agency determines that such Level 3 covered institution's complexity of
operations or compensation practices are consistent with those of a
Level 1 or Level 2 covered institution.
    This proposed rule requirement would allow the SEC to treat senior
executive officers and significant risk-takers at BDs and IAs that have
total consolidated assets below $50 billion as covered persons of a
Level 1 or Level 2 covered institution, because, for example, the
complexity of the BDs' and IAs' operations or risk profile could have a
significant impact on the overall financial system and could generate
negative spillover effects for taxpayers. As a result, the number of
BDs and IAs that would be subject to the portions of the proposed rule
applicable to Level 1 and Level 2 covered institutions may increase
relative to the estimates presented in the baseline.\410\
---------------------------------------------------------------------------

    \410\ As discussed above in the Baseline section, as of the end
of 2014, there were 33 BDs with total consolidated assets between
$10 and $50 billion. Due to the lack of data, the SEC cannot
determine the number of IAs with total consolidated assets between
$10 and $50 billion.
---------------------------------------------------------------------------

    The proposed requirement may increase compliance costs for these
BDs and IAs. As shown above, Level 3 parent institutions differ
significantly from Level 1 and Level 2 parent institutions on a number
of dimensions: They tend to defer a smaller fraction of NEOs incentive-
based compensation (Table 7A), tend to defer cash less frequently
(Table 7A), and tend to use more options as part of their incentive-
based compensation (Table 6A) compared to Level 1 and Level 2 parent
institutions. They also use rather infrequently the prohibition of
hedging with respect to non-employee directors that receive incentive-
based compensation (Table 9A). If the compensation arrangements of
Level 3 BDs and IAs are similar to those of Level 3 parent
institutions, then for Level 3 BDs and IAs that are designated as Level
1 or Level 2 covered BDs and IAs by an Agency, the proposed rule is
likely to require significant changes to certain features of their
compensation arrangements to be in compliance.
F. Potential Costs and Benefits of Additional Requirements and
Prohibitions for Level 1 and 2 Covered Institutions
1. Mandatory Deferral
    The proposed rule would require a minimum amount of annual
incentive-based compensation to be deferred for a minimum number of
years for senior executive officers and significant risk-takers at
Level 1 and Level 2 covered institutions. For senior executive officers
and significant risk-takers at Level 1 and Level 2 BDs and IAs, such
requirement is expected to establish a minimum accountability horizon
with respect to the outcomes of actions of these individuals, including
the realization of longer-term risks that may be associated with such
actions.
    As discussed above, from an economic standpoint, managerial actions
carry associated risks, and the horizon over which such risks unfold is
uncertain. If the risk realization horizon is longer than the
performance period used to measure and compensate the performance of
senior executive officers and significant risk-takers, they may have an
incentive to undertake projects that deliver strong short-term
performance at the potential expense of long-term value. A minimum
compensation deferral period aims to curb incentives for such undesired
behavior by increasing senior executive officers' and significant risk-
takers' accountability for the potential adverse outcomes of their
actions that may be realized in the long run, which in turn may
discourage short-termism and inappropriate risk-taking and as a
consequence lower the likelihood of default for the covered institution
and the potential risk such a default could pose to the greater
financial system.
    As discussed above, the proposed minimum deferral periods required
by the proposed rule for Level 1 and Level 2 BDs and IAs covered
institutions would relate to the horizons over which the risks in these
institutions may be realized. The deferral periods are likely to
overlap with a traditional business cycle to identify outcomes
associated with a senior executive officer's or significant risk-
taker's performance and risk-taking activities. As noted, the business
cycle reflects periods of economic expansion or recession, which
typically underpin the performance of the financial sector. There might
be specific facts and circumstances (for example, the variety of assets
held, the changing nature of those assets over time, the normal
turnover in assets held by financial institutions, and the complexity
of the business models of BDs and IAs) that may affect the horizon over
which risks may be realized for particular covered institutions, so a
uniform deferral period may be more or less aligned with the horizon
over which a particular covered institution realizes certain risks.
    With regard to the type of incentive-based compensation instruments
to be deferred, the rule proposes to require deferred compensation to
consist of substantial amounts of both cash and equity-linked
instruments. Whereas deferred equity-linked compensation would be
subject to both upside potential (for example, if the stock price of
the firm increases during the deferral period) and downside risk, the
cash component of deferred compensation

would be mainly subject to downside risk, thus resembling the payoff
structure of a debt security. More specifically, the cash component of
deferred compensation would not appreciate in value if firm performance
during the deferral period is positive, but would be subject to
downward adjustment, forfeiture, and clawback if, for example, the
executive has engaged in inappropriate risk-taking that results in poor
performance during the performance, deferral and post-deferral periods
respectively. This asymmetry in the payoff structure of the cash
component of deferred compensation is expected to provide incentives
for responsible risk-taking by covered persons thus lowering the
likelihood of default at these institutions as well as the
corresponding risk to the greater financial system posed by certain
large, complex, and interconnected institutions.\411\ Economic studies
suggest a negative relation between pre-crisis levels of managerial
debt holdings and measures of default risk during the crisis for bank
holding companies--bank holding companies whose executives held larger
debt holdings were less likely to default.\412\
---------------------------------------------------------------------------

    \411\ The academic literature provides evidence regarding the
effect of compensation instruments resembling a debtholder's payoff
and the effect of such compensation instruments on various aspects
of the agency costs of debt. For example, there is evidence of a
negative relation between levels of inside debt and the cost of
debt; see Anantharaman et al. 2013. Inside debt and the design of
corporate debt contracts. Management Science 60, 1260-1280. Also,
studies have documented a negative relation between inside debt and
restrictiveness of debt covenants and demand for accounting
conservatism, and a positive relation between CEO inside debt and
firm liquidation values; see Chen, F., Y. Dou, and X. Wang. 2010.
Executive Inside Debt Holdings and Creditors' Demand for Pricing and
Non-Pricing Protections. Working Paper. With respect to the
mechanism through which inside debt holdings lead to lower firm
risk, evidence suggests that such firms apply more conservative
investment as well as financing choices. Inside debt in particular
has been shown to be negatively related to future stock return
volatility, a market-based measure of risk; see Cassell, Cory A.,
Shawn X. Huang, Juan Manuel Sanchez, and Michael D. Stuart. 2012.
The relation between CEO inside debt holdings and the riskiness of
firm investment and financial policies. Journal of Financial
Economics 103, 588-610.
    It must be noted that the academic literature proxies for such
debt-like compensation instruments mostly through pensions and other
forms of deferred compensation. Such instruments may not fully
resemble the characteristics of deferred cash under the rule,
particularly with respect to the horizon of deferral as well as the
vesting schedules (pro-rata vs. cliff-vesting).
    \412\ See Bennett et al. (2015). Inside Debt, Bank Default Risk,
and Performance during the Crisis. Journal of Financial
Intermdiation 24, 487-513. The study examines the relation between
pre-crisis levels of inside equity vs. inside debt holdings by bank
holding company CEOs and risk and performance of these BHCs during
the crisis. The findings reveal a negative relation between pre-
crisis CEO inside debt holdings and default risk during the crisis,
and higher supervisory ratings for these BHCs before the crisis.
---------------------------------------------------------------------------

    As mentioned above, 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. Having standards that are generally
consistent across jurisdictions would ensure that covered institutions
in the United States, compared to their non-U.S. peers, are on a level
playing field in the global competition for talent.
    The mandatory deferral requirements of the proposed rule may impose
significant costs on affected BDs and IAs.\413\ As a consequence of the
mandatory deferral requirement, the wealth of covered persons would be
likely less diversified and more tied to prolonged periods of a covered
institution's performance. This potential deterioration of wealth
diversification may induce covered persons to demand an increase in pay
which could result in higher compensation-related costs for covered
institutions.\414\ This increase in compensation costs may be necessary
in order for covered institutions to be able to both attract and retain
human talent. The SEC notes, however, that there may be other factors
affecting the ability of a covered institution to attract and retain
human talent, such as the supply of talent and non-pecuniary benefits
of employment at covered institutions. These factors may exacerbate or
mitigate the potential increase in compensation costs. For example, if
senior executive officers and significant risk-takers value non-
pecuniary job benefits such as prestige, networking, and visibility,
these benefits may offset the costs associated with deterioration in
the diversification of their portfolios.
---------------------------------------------------------------------------

    \413\ Several commenters raised accounting related issues with
respect to covered institutions' financial statements under the
proposed rule (see, e.g., KPMG, CEC) and tax related issues with
respect to individuals affected by the proposed rule (see, e.g.,
KPMG, MFA, SIFMA, CEC, PEGCC).
    \414\ Three commenters argued that the proposed rule could
result in unintended consequences such as higher fixed compensation
or other benefits (See FSR, WLF, U.S. Chamber).
---------------------------------------------------------------------------

    As a result of the proposed compensation deferral requirement,
covered persons at BDs and IAs may be incentivized to curb
inappropriate risk-taking given the increased accountability over their
actions. There could be situations, however, where bonus deferral could
actually lead to an increase in risk-taking incentives.\415\ For
example, if firm performance during the deferral period significantly
declines and causes a significant loss in the value of deferred
compensation, senior executive officers and significant risk-takers
could potentially have an incentive to engage in high-risk actions in
an effort to recoup at least some of the value of their deferred
compensation.
---------------------------------------------------------------------------

    \415\ See Leisen, D. (2014). Does Bonus Deferral Reduce Risk
Taking? Working Paper. The paper develops a model comparing risk-
taking incentives from bonuses with and without deferral. The
results challenge the common belief that bonus deferral
unequivocally leads to reduced risk-taking incentives; under certain
conditions, deferral of bonus could lead to stronger risk-taking
incentives during the deferral period.
---------------------------------------------------------------------------

    As discussed above, deferral of the cash component of compensation
resembles the payoff structure of debt and as a consequence may expose
managerial compensation to risk without a corresponding upside. Whereas
this may provide incentives to covered persons to avoid actions that
would expose a covered institution to higher likelihood of default and
for important institutions risks to the financial system, such
incentives may result in misalignment of interests between managers and
shareholders and potentially harm shareholder value. Several studies
suggest that managers with significant debt instruments in their
compensation arrangement tend to undertake a more conservative approach
in managing their firms.\416\ The significant use of debt in
compensation arrangements is viewed negatively by shareholders: Stock
prices of companies whose executives hold significant debt positions
experience a decrease upon disclosure of such compensation
arrangements.\417\ Thus, whereas the utilization of debt-like
instruments in compensation arrangements in important institutions may
lower the risk to the greater financial system, this may come at the
expense of shareholder value at these institutions. One commenter
suggested that the proposed rule could cause covered institutions to
perform in a less competitive way given lower incentives for risk-
taking.\418\
---------------------------------------------------------------------------

    \416\ See Anantharaman, D., V.W. Fang, and G. Gong. 2014. Inside
Debt and the Design of Corporate Debt Contracts. Management Science
60, 1260-1280; Chen et al. (2010); and Cassell et al. (2012).
    \417\ See Wei, C., and Yermack, D. (2011).
    \418\ See FSR.
---------------------------------------------------------------------------

    Alternatively, the Agencies could have proposed higher deferral
percentages and/or longer deferral horizons. Some commenters \419\
suggested more stringent deferral requirements, such as a longer
deferral

horizon,\420\ a higher percentage subject to deferral,\421\ and holding
the entire deferred amount back until the end of the deferral
period.\422\ For example, the Agencies could have selected a seven-year
deferral for senior executive officers and a five-year horizon deferral
horizon for significant risk-takers, similar to the rules that the
Prudential Regulation Authority has recently proposed in the UK. Such
long deferral periods may have allowed for longer-term risks to
materialize and thus be accounted for when calculating managerial
compensation. On the other hand, as mentioned above, longer deferral
periods could result in inappropriate risk-taking if firm performance
during the deferral period significantly declines and causes a
significant loss in the value of deferred compensation. Additionally, a
longer deferral period increases the probability that financial
performance is impacted by actions or factors that are not related to
covered persons' actions and as such result in an inefficient
compensation contract. Moreover, lengthening of the deferral period is
likely to lead to increased liquidity issues for covered persons since
their compensation cannot be cashed out on a timely basis to meet their
liquidity needs. Finally, it is also possible that further prolonging
of the deferral period could create incentives for institutions to
shift away from incentive-based compensation and increase the fixed
component of compensation. A potential consequence from such action may
be distortion of value-enhancing incentives that are generated through
incentive-based compensation. Another potential cost from deferral
requirements that are more strict could be that affected institutions
may not be able to compete and as a consequence lose talent to other
sectors that are not subject to the proposed rule.
---------------------------------------------------------------------------

    \419\ It should be noted that comments were based on the 2011
Proposed Rule's 3-year deferral period (as opposed to the 4-year
deferral period currently proposed).
    \420\ See AFR, Public Citizen, Chris Barnard, AFSCME, AFL-CIO,
Senator Brown.
    \421\ See AFR, Public Citizen, AFSCME.
    \422\ See AFR, Senator Brown, Public Citizen.
---------------------------------------------------------------------------

    Another alternative could be shorter deferral periods (e.g.,
deferral period of less than four years for the qualifying incentive-
based compensation of senior executive officers at Level 1 covered
institutions; for example, 3 years as in the 2011 Proposed Rule) and/or
smaller deferral percentages (e.g., deferral of less than 60 percent of
qualifying incentive-based compensation for senior executive officers
at Level 1 covered institutions; for example, 50 percent as in the 2011
Proposed Rule). A shorter deferral period and/or smaller deferral
percentage amount, however, may not provide adequate incentives to
covered persons to engage in responsible risk-taking. On the other
hand, if the risk realization horizon is actually shorter than the
deferral horizon proposed in the rule, then using a shorter deferral
period would avoid exposing covered persons' wealth to risks that do
not result from their actions and would also impose lower liquidity
constraints on undiversified executives. From the baseline analysis of
current compensation practices, it appears that all of the Level 1
public parent institutions and most of the Level 2 public parent
institutions of BDs and IAs already have deferral policies in place
similar to the proposed rule requirements. Currently, about 50 percent
to 75 percent of incentive-based compensation is deferred for a period
of about three years, and the deferral includes NEOs, non-NEOs and
significant risk-takers.
    If the compensation structure of BDs and IAs is similar to that of
their parent institutions, and the compensation structure of private
institutions is similar to that of public institutions, for the covered
BDs and IAs the implementation of the deferred aspect of the proposed
rule is unlikely to lead to significant compliance costs. The only
potentially significant compliance costs that such covered institutions
could incur with respect to the deferral requirement is related to the
deferral of cash compensation, which currently only 20 percent to 25
percent of Level 1 and Level 2 covered institutions defer, and the
prohibition on accelerated vesting, which very few of the Level 2
covered parent institutions currently use. On the other hand, if the
compensation practices of parent institutions are significantly
different than those at their subsidiaries, covered BDs and IAs could
experience significant compliance costs when implementing the proposed
deferral rule. Since the SEC does not have data on how many covered IAs
have parent institutions, it is also possible that a significant number
of these IAs may be stand-alone companies and therefore could have
higher costs to comply with the proposed rule compared to covered IAs
and BDs that are part of reporting parent institutions. As discussed
above, the SEC has data regarding the incentive-based compensation
arrangements at the depository institution holding company parents of
Level 1 and unconsolidated Level 2 and unconsolidated Level 3 BDs and
IAs because many of those bank holding companies are public reporting
companies under the Exchange Act. The SEC lacks information regarding
the compensation arrangements of BDs and IAs that are not so
affiliated, and hence the SEC cannot accurately assess the compliance
costs for those issuers. The same holds true if the incentive-based
compensation practices at BDs and IAs are generally different than
those at banking institutions, which most of their parent institutions
are. Lastly, because some BDs and IAs are subsidiaries of private
parent institutions, if there is a significant difference in the
compensation practices between public and private covered institutions
such private BDs and IAs could face larger compliance costs. To better
assess the effects of deferral on compliance costs for BDs and IAs the
SEC requests comments on these issues.
2. Options
    For senior executive officers and significant risk-takers at Level
1 and Level 2 covered institutions, the proposed rule would limit the
amount of stock option-based compensation that can qualify for
mandatory deferral at 15 percent, effectively placing a cap on the use
of stock options as part of the incentive-based compensation
arrangements for senior executive officers and significant risk-takers
at Level 1 and Level 2 covered institutions.\423\ This implies that 45
percent of incentive-based compensation would have to be in some other
form to fulfill the 60 percent deferral amount for a senior executive
officer or significant risk-taker at a Level 1 and Level 2 covered
institution. As discussed in the Broad Economic Considerations section,
the payoff structure from stock options is asymmetric and thus
generates incentives for executives to undertake risks. For the
financial services industry in general, economic studies find that
higher levels of stock options in compensation arrangements of publicly
traded bank CEOs are positively related to multiple measures of risk,
such as equity volatility.\424\ Thus, limiting the

use of stock options in compensation arrangements could result, on
average, in lower risk-taking incentives for senior executive officers
and significant risk-takers at Level 1 and Level 2 covered
institutions. As previously noted, however, the link between stock
options and risk-taking is not indisputable. For example, a study that
examined the effect of a decrease in the provision of stock options in
compensation arrangements due to an unfavorable change in accounting
rules regarding option expensing, did not identify decreased risk-
taking by executives as a response to a decrease in stock options
awards.\425\
---------------------------------------------------------------------------

    \423\ If stock options awarded are not part of incentive-based
compensation, there is no limit to such awards.
    \424\ See Mehran, H., Rosenberg, J. 2009. The Effect of CEO
Stock Options on Bank Investment Choice, Borrowing, and Capital.
Federal Reserve Bank of New York. The study finds a positive
relation between the use of stock options in bank CEO compensation
arrangements and risk-taking as evident by higher levels of equity
and asset volatility. The paper also finds that the increased risk
exposure in these banks comes from riskier project choices rather
than increased use of leverage.
    See DeYoung, R., Peng, E., Yan, M. 2013. Executive Compensation
and Business Policy Choices at U.S. Commercial Banks. Journal of
Financial and Quantitative Analysis 48, 165-196.
    See Chen, C., Steiner, T., Whyte, A. 2006. Does stock option-
based executive compensation induce risk-taking? An analysis of the
banking industry. Journal of Banking and Finance 30, 915-945. The
paper examines whether option-based compensation is related to
various measures of risk for a sample of commercial banks. Option-
based compensation is positively related to various market measures
of risk such as systematic and idiosyncratic risk. However,
causality cannot be inferred; risk also has an effect on the
structure of compensation arrangements.
    \425\ See Hayes, R., Lemmon, M., Qiu, M., 2012. `Stock options
and managerial incentives for risk taking: Evidence from FAS 123R'.
Journal of Financial Economics 105, 174-190. This study examines the
effect of changes in option-based compensation, due to a change in
the accounting treatment of stock options in 2005, on risk-taking
behavior. Firms significantly reduce the use of stock options in
compensation arrangements as a response to the unfavorable treatment
of stock options in financial statements. However, the study finds
little evidence that the decline in option usage resulted in less
risky investment and financial policies.
---------------------------------------------------------------------------

    The unique characteristics of the financial services sector
compared to the rest of the economy--significantly higher
leverage,\426\ interconnectedness with other institutions and markets,
and the possibility for negative externalities--may create a conflict
of interest between shareholders (managers) of important financial
institutions and taxpayers with respect to the optimal level of risk-
taking. In other words, shareholders may enjoy the upside of risk-
taking actions whereas taxpayers and other stakeholders have to bear
the costs associated with such risk-taking. While the literature does
not specifically reference BDs and IAs, but rather the financial
services sector more generally, the SEC believes that the global point
may be applicable to BDs and IAs given that these entities constitute a
segment of the financial services sector. In addition, many BDs and IAs
that would be covered by the proposed rule are subsidiaries of bank
holding companies and as such these studies may be relevant for them.
Thus, for BDs and IAs the use of options in compensation arrangements
could potentially amplify this conflict of interest as it provides
covered persons with an asymmetric payoff structure and an incentive to
undertake risks that may be optimal from shareholders' point of view
but may provide risk-taking incentives to management that could lead to
higher likelihood of default at these institutions and potentially
increase the risk to the greater financial system. Consequently,
capping the use of stock options and curbing covered persons'
incentives for inappropriate risk-taking at BDs and IAs could decrease
their likelihood of default, better align managers' incentives with
those of a broader group of stakeholders and limit potential negative
externalities generated by the default of particularly important
institutions.\427\ However, although BDs and IAs are financial
institutions, any generalization based on the findings in the
literature may not be very accurate because BDs and IAs also have some
differences with respect to other financial institutions. For example,
BDs and IAs differ from other financial institutions with respect to
business models, nature of the risks posed by the institutions, and the
nature and identity of the persons affected by those risks.
---------------------------------------------------------------------------

    \426\ See Bolton, P., Mehran, H., Shapiro, J. 2011. Executive
Compensation and Risk Taking. Federal Reserve Bank of New York Staff
Reports, available at: https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr456.pdf. The report shows the
significant difference between the composition of financing for the
average non-financial firm (having about 40% of debt on its balance
sheet), as opposed to the average financial institution (having at
least 90% of debt on its balance sheet).
    \427\ See French et al., 2010. The Squam Lake Report: Fixing the
Financial System. Journal of Applied Corporate Finance 22, 8-21; and
McCormack, J., Weiker, J. 2010. Rethinking `Strength of Incentives'
for Executives of Financial Institutions. Journal of Applied
Corporate Finance 22, 25-72.
---------------------------------------------------------------------------

    To the extent that the asymmetric payoff structure of options
encourages covered persons at BDs and IAs to undertake risks that are
also suboptimal from a shareholders' point of view, the proposed rule's
limitation on the use of options as part of compensation arrangements
may also improve incentive alignment between executives and
shareholders. However, as discussed in the Broad Economic
Considerations section, executives may be reluctant to undertake value-
increasing but risky projects due to the undiversified nature of their
wealth and as such may engage in actions that lower firm value (i.e.,
forgo risky but value-increasing projects). For example, an economic
study found that low sensitivity of compensation to risk resulted in a
loss of firm value due to suboptimal risk-taking by executives in these
companies.\428\ Mechanisms that are put in place to curb such undesired
behavior by executives include incentive-based compensation components
whose value is generally increasing in risk, such as stock options.
Thus, risk-taking incentives induced by options may be valuable in
order to provide covered persons at BDs and IAs with incentives to take
risks that are desirable by shareholders. As a consequence, a potential
cost of the proposed limit to the use of stock options in incentive-
based compensation arrangements at covered institutions is the
potential for such limit to generate sub-optimally low risk-taking
incentives for the covered persons at BDs and IAs, potentially leading
to lower shareholder values for these institutions.
---------------------------------------------------------------------------

    \428\ See Low, A., 2009. Managerial risk-taking behavior and
equity-based compensation. Journal of Financial Economics 92, 470-
490. The study examines changes in risk-taking by CEOs whose firms
have become more protected from a takeover due to a change in anti-
takeover laws. The study finds that CEOs with compensation
arrangements with a low sensitivity of compensation to volatility
decrease risk-taking following the adoption of the anti-takeover
law, and that such a decrease in risk-taking activity is value
destroying. The study also shows that as a response, firms increase
the sensitivity of CEO compensation to volatility to encourage risk-
taking following the adoption of the anti-takeover law.
---------------------------------------------------------------------------

    Limiting the amount of stock option based compensation that can
qualify for mandatory deferral at 15 percent suggests that a covered
institution could theoretically award up to 55 percent of its annual
incentive-based compensation in the form of stock options (for senior
executive officers and significant risk-takers at Level 1 and Level 2
covered institutions). Based on the SEC's baseline analysis, it appears
that the use of options is increasingly infrequent in incentive-based
compensation arrangements at public parent institutions of BDs and IAs.
Stock options at Level 1 covered institutions represent about 4 percent
of total incentive-based compensation, while at Level 2 covered
institutions they represent about 20 percent.
    If the compensation structure of BDs and IAs is similar to that of
their parent institutions, and the compensation structure of private
institutions is similar to that of public institutions, the specific
restriction imposed by the proposed rule would be unlikely to affect
the usage of options at Level 1 or unconsolidated Level 2 BDs and IAs
and would likely result in insignificant compliance costs. On the other
hand, if the compensation practices of parent institutions are
significantly different from those at their subsidiaries, covered BDs
and IAs could experience

significant compliance costs when implementing the specific requirement
of the proposed rule. Since the SEC does not have data on how many
covered IAs have parent institutions, it is also possible that a
significant number of these IAs may be stand-alone companies and
therefore could have higher costs to comply with this specific
requirement of the proposed rule compared to covered IAs and BDs that
are part of reporting parent institutions.
    As discussed above, BDs and IAs could also incur direct economic
costs such as decrease in firm value if the proposed rule leads to
lower than optimal use of options in senior executive officers and
significant risk-takers incentive-based compensation arrangements. The
same holds true if the compensation of BDs and IAs is generally
different than that of banking institutions, which most of their parent
institutions are. Lastly, because some BDs and IAs are subsidiaries of
private parent institutions, if there is a significant difference in
the compensation practices of public and private covered institutions
such BDs and IAs could face large compliance costs and direct economic
costs. The SEC does not have data for the use of options at
subsidiaries of Level 1 or Level 2 parents, and thus cannot quantify
the impact of the proposed rule on those institutions. To better assess
the effects of options on compliance costs for BDs and IAs, the SEC
requests comments on the use of options in the compensation structures
of BDs and IAs below.
    The Agencies could have selected as an alternative not to place a
limit on the use of stock options to meet the minimum required deferral
amount requirement for a performance period. Such an alternative would
provide covered persons at BDs and IAs with more incentives to
undertake risks compared to the alternative the SEC has chosen in the
proposed rule. Taxpayers would potentially be worse off under the
alternative since the combination of high leverage and government
guarantees, coupled with additional risk-taking incentives from stock
options could lead to inappropriate risk-taking from taxpayers' point
of view. Such an alternative likely would have led to a higher
probability of default at covered institutions. For important
institutions, such an alternative would also increase the likelihood of
risks at the institution also propagating to the greater financial
system. On the other hand, it is possible that shareholders would
potentially prefer increased risk-taking and as a consequence
compensation arrangements that encourage such behavior. From the SEC's
baseline analysis, provided that BDs and IAs have similar compensation
arrangements as their parents, the proposed rule should not
significantly affect existing compensation arrangements of covered
institutions.
3. Long-Term Incentive Plans
    For senior executive officers and significant risk-takers at Level
1 and Level 2 covered institutions the proposed rule would require a
minimum deferral period and a minimum deferral percentage amount of
incentive-based compensation awarded through long-term incentive plans
(LTIPs), where LTIPs are characterized by having a performance
measurement period of at least three years. The proposed rule would
require deferral of 60 percent (50 percent) of LTIP awards for senior
executive officers of Level 1 (Level 2) covered institutions, and
deferral of 50 percent (40 percent) of LTIP awards for significant
risk-takers of Level 1 (Level 2) covered institutions. The deferral
period for deferred LTIPs must be at least two years for covered
persons of Level 1 covered institutions and at least one year for
covered persons of Level 2 covered institutions.
    LTIPs are designed to reward long-term performance, performance
that is usually measured over the three-years following the beginning
of the performance period.\429\ Thus, these plans reward long-term
performance outcomes and as such generate incentives for long-term
value. LTIP awards can be in the form of cash or stock and these awards
occur at the end of the performance period. The amount of the award
depends on the degree to which the company meets some predetermined
performance milestones. These performance milestones can include a
variety of accounting-based performance measures, such as sales and
earnings, and research shows that the choice of performance measures is
related to company specific strategic goals.\430\ Requiring a minimum
percentage of LTIP awards to be deferred would lengthen the period over
which senior executive officers and significant risk-takers receive
compensation under these plans and subject such compensation to
downward adjustment during the performance measurement period (prior to
the award) as well as forfeiture and clawback during the deferral and
post-deferral periods respectively. Some studies have criticized LTIPs
for having short performance periods.\431\ The limited economic
literature on LTIPs currently does not provide a clear indication of
the effect of LTIPs on excessive risk-taking. The only study that
investigates the role of LTIPs \432\ suggests that companies that use
them experience improvement in operating performance and their NEOs do
not appear to take higher risks. Similar to the discussion on the
benefits and costs of mandatory deferral of other forms of incentive-
based compensation, deferral of the LTIP award could allow for long-
term risks taken by BD and IA senior executive officers and significant
risk-takers to materialize and thus for their compensation to be more
appropriately adjusted for the risks they have taken. LTIP deferral may
decrease risk-taking because covered persons may have an incentive to
manage the institution such that they receive their full compensation
under these plans. If the additional deferral of LTIPs lowers risk-
taking incentives at covered BDs and IAs to suboptimally low levels,
then firm value at these institutions could suffer as a consequence.
However, if the additional deferral of LTIPs mitigates incentives for
inappropriate risk-taking at covered BDs and IAs, then such outcome
would lower the likelihood of default at these institutions, better
align managers' incentives with those of a broader group of
stakeholders, and also lower the likelihood of negative externalities.
---------------------------------------------------------------------------

    \429\ See Frederic W. Cook & Co., Inc. The 2014 Top 250 Report:
Long-term incentive grant practices for executives.
    \430\ See Li and Wang (2014).
    \431\ See The alignment gap between creating value, performance
measurement, and long-term incentive design, IRRCI research report,
2014.
    \432\ See Li and Wang, 2014.
---------------------------------------------------------------------------

    As an alternative, the Agencies could have selected a larger
fraction of LTIPs to be deferred (e.g., more than 60 percent for senior
executive officer at a Level 1 covered institution) and increased the
LTIPs' deferral period (e.g., for more than two years for senior
executive officers and significant risk-takers at Level 1 covered
institutions). A longer deferral period for LTIPs would prolong the
exposure of senior executive officers' and significant risk-takers'
compensation to adverse outcomes of their actions. If outcomes of some
inappropriate risks are only realized in the longer-term, then
prolonging the deferral period for LTIPs would provide incentives to
senior executive officers and significant risk-takers to avoid such
actions. On the other hand, such an alternative might have exposed
senior executive officers and significant risk-takers to outcomes of
actions that they are less likely to have been responsible for.
Additionally, long deferral period for LTIPs could create potential

liquidity issues for senior executive officers and significant risk-
takers since their compensation cannot be cashed out on a timely basis
to meet their liquidity needs.\433\ It is also possible that a long
deferral period for LTIPs would create incentives for institutions to
pay higher fixed pay and as a consequence distort the value-enhancing
incentives that are generated through variable pay.
---------------------------------------------------------------------------

    \433\ Interest rates charged to covered persons on loans used to
cover their liquidity needs could proxy for the related cost stated
in the text. Such costs are likely to be determined by multiple
factors (for example, the macroeconomic environment) and vary over
time and by individuals making them difficult to quantify.
---------------------------------------------------------------------------

    As another alternative, the Agencies could have decided to exclude
LTIPs from the amount of incentive-based compensation that is to be
deferred in a given year. Such an alternative could have excluded a
major part of covered persons' incentive-based compensation
arrangements from the deferred amount. LTIPs typically have a
performance period of three years, which is shorter than the deferral
period proposed in the rulemaking. Under this alternative, not
including LTIPs as part of the deferred amount may have limited the
ability of the proposed rule to curb inappropriate risk-taking.
However, if the current use of LTIPs by covered institutions is
consistent with generating optimal risk-taking incentives from the
perspective of certain shareholders, then not subjecting LTIPs to
mandatory deferral would maintain these value-enhancing incentives.
4. Downward Adjustment and Forfeiture
    For senior executive officers and significant risk-takers at Level
1 and Level 2 covered institutions, the rule proposes placing at risk
of downward adjustment all incentive-based compensation amounts not yet
awarded for the current performance period and at risk of forfeiture
all deferred but not yet vested incentive-based compensation. As the
analysis in the baseline section suggests, the triggers for downward
adjustment and forfeiture consist of adverse outcomes such as poor
financial performance due to significant deviations from approved risk
parameters, inappropriate risk-taking (regardless of the impact on
financial performance), risk management or control failures, and non-
compliance with regulatory and supervisory standards resulting in
either legal action against the covered institution or a restatement to
correct a material error. The compensation of covered persons with
either direct accountability or failure of awareness of an undesirable
action would be subject to downward adjustment and/or forfeiture.
    With regard to the determination of the compensation amount to be
downward adjusted or forfeited, the proposed rule would condition the
magnitude of the adjustment or forfeiture amounts on both the intent
and the participation of covered persons in the event(s) triggering the
review, as well as the magnitude of costs generated by the related
actions (including financial performance, fines and litigation and
related reputational damage). Compensation would be subject to downward
adjustment and forfeiture during the performance period and the
deferral period, respectively. As a consequence, this requirement would
provide incentives to senior executive officers and significant risk-
takers at BDs and IAs to avoid inappropriate risk-taking since they
could be penalized in situations where inappropriate risks had been
undertaken, regardless of whether such risks resulted in poor
performance.
    The downward adjustment or forfeiture amounts is conditional on the
intent, responsibility and the magnitude of the financial loss caused
to the covered institution by inappropriate actions of covered persons.
In other words, the penalty imposed on the covered person would
increase with the intent, responsibility and the magnitude of financial
loss generated. This ``progressiveness'' characteristic in the proposed
rule requirement would imply that the covered person's incentive-based
compensation award would be increasingly at stake. Thus, covered
persons would be expected to have incentives to avoid excessive risk-
taking in order to secure at least part of incentive-based compensation
award.
    Additionally, provided that senior executive officers and
significant risk-takers at BDs and IAs may be deemed accountable and
risk their compensation for inappropriate actions that were undertaken
by other executives or significant risk-takers, they may have an
incentive to establish an effective governance system that would
monitor risk exposure. Such an incentive and the corresponding actions
would strengthen risk oversight within the covered institution and
potentially lower the probability that any inappropriate action taken
might go undetected. To this point, a recent economic study indicates
that bank holding companies with strong risk controls, as proxied by
the presence of an independent and strong risk committee, were found to
be exposed to lower tail risk, lower amount of underperforming loans,
and had better operating and financial performance during the financial
crisis.\434\
---------------------------------------------------------------------------

    \434\ See Ellul, A., Yerramilli, V. 2013. Stronger Risk
Controls, Lower Risk: Evidence from U.S. Bank Holding Companies.
Journal of Finance 68, 1757-1803.
---------------------------------------------------------------------------

    On the other hand, the risk of downward adjustment and forfeiture
could increase uncertainty on covered persons' expectations for
receiving the compensation. A possibility exists that risks a covered
person believes ex-ante to be appropriate may be classified as ex-post
inappropriate and thus trigger downward adjustment or forfeiture of
related compensation. Such uncertainty about the interpretation of
appropriate risk-taking could generate incentives for managers to take
approaches with respect to risk-taking that are not optimal from the
perspective of shareholders. Such an avoidance of risks, if it occurs,
could lead to lower firm value and losses for shareholders.
    Based on the SEC's baseline analysis of current compensation
practices, it appears that all of the Level 1 public parent
institutions and most of the Level 2 public parent institutions already
employ forfeiture with respect to deferred compensation. The forfeiture
rules are based on various triggers and apply to NEOs, non-NEOs and
significant risk-takers. Thus, if the compensation structure of BDs and
IAs is similar to that of their parent institutions, and the
compensation structure of private institutions is similar to that of
public institutions, the implementation of the proposed rule related to
forfeiture would be unlikely to lead to significant compliance costs.
On the other hand, if the compensation practices of parent institutions
are significantly different than those at their subsidiaries (e.g., BDs
and IAs do not use downward adjustment and forfeiture in their
compensation packages), covered BDs and IAs could experience
significant compliance costs when implementing this specific
requirement of the proposed rule. Since the SEC does not have data on
how many covered IAs have parent institutions, it is also possible that
a significant number of these IAs may be stand-alone companies and
therefore could have higher costs to comply with this specific
requirement of the proposed rule compared to covered IAs and BDs that
are part of reporting parent institutions. BDs and IAs could also incur
direct economic costs such as decrease in firm value if the proposed
rule requirements regarding downward adjustment or forfeiture lead to
less risk-taking than is optimal from shareholders' point of view. The
same

holds true if the compensation of BDs and IAs is generally different
than that of banking institutions, which most of their parent
institutions are.
    Lastly, because some BDs and IAs are subsidiaries of private parent
institutions, if there is a significant difference in the compensation
practices of public and private covered institutions such BDs and IAs
could face large compliance costs and direct economic costs. The SEC
does not have data for the use of downward adjustment and forfeiture at
subsidiaries of Level 1 or Level 2 parents, and thus cannot quantify
the impact of the rule for those institutions. To better assess the
effects of downward adjustment and forfeiture on compliance costs for
BDs and IAs. The SEC requests comments below.
5. Clawback
    For senior executive officers and significant risk-takers at Level
1 and Level 2 covered institutions, the proposed rule would require
clawback provisions in incentive-based compensation arrangements to
provide for the recovery of paid compensation for up to seven years
following the vesting date of such compensation. Such a clawback
requirement would be triggered when senior executive officers and
significant risk-takers are determined to have engaged in fraud,
intentional misrepresentation of information used to determine a
covered person's incentive-based compensation, or misconduct resulting
in significant financial or reputational harm to the covered
institution. Other existing provisions of law contain clawback
requirements that potentially have some overlap with those in the
proposed rulemaking. Thus, certain covered institutions may have
experience with recovering executive compensation via clawback. For
example, section 304 of the Sarbanes Oxley Act (``SOX'') contains a
recovery provision that is triggered when a restatement occurs as a
result of issuer misconduct. This provision applies only to the chief
executive officer (``CEO'') and chief financial officer (``CFO'') and
the amount of required recovery is limited to compensation received in
the year following the first improper filing.\435\ The Interim Final
Rules under section 111 of the Emergency Economic Stabilization Act of
2008 (``EESA'') required institutions receiving assistance under TARP
to mandate Senior Executive Officers to repay compensation if awards
based on statements of earnings, revenues, gains, or other criteria
that were later found to be materially inaccurate.\436\ Relative to
either SOX or EESA, the clawback requirement of the proposed rule is
more expansive in that its application is not only limited to CEOs and
CFOs but would cover any senior executive officer and significant risk-
taker in a Level 1 or Level 2 covered institution. In addition to the
broader scope of the clawback provision in the proposed rule regarding
covered persons, there is also a broader scope with respect to the
circumstances that would trigger clawback. More specifically, the
proposed rule includes misconduct that resulted in reputational or
financial harm to the covered institution as a trigger for clawback.
---------------------------------------------------------------------------

    \435\ See 15 U.S.C. 7243.
    \436\ Under EESA a ``Senior Executive Officer'' was defined as
an individual who is one of the top five highly paid executives
whose compensation was required to be disclosed pursuant to the
Securities Exchange Act of 1934. See Department of Treasury, TARP
Standards for Compensation and Corporate Governance; Interim Final
Rule (June 15, 2009), available at http://www.gpo.gov/fdsys/pkg/FR-2009-06-15/pdf/E9-13868.pdf.
---------------------------------------------------------------------------

    The inclusion of the clawback provision in the incentive-based
compensation of senior executive officers and significant risk-takers
at BDs and IAs could increase the horizon of accountability with
respect to the identified actions that are likely to bring harm to the
covered institution. As a consequence of the clawback horizon, senior
executive officers and significant risk-takers are likely to have lower
incentives to engage in actions that may put the covered institution at
risk in the longer run. Moreover, the proposed rule may also increase
incentives to senior executive officers and significant risk-takers to
put in place stronger mechanisms such as governance in an effort to
protect their incentive-based compensation from events that may trigger
a clawback. Finally, in addition to lowering the incentives of senior
executive officers and significant risk-takers for undesirable actions
that may harm the covered institution, stakeholders of the covered
institution are also expected to benefit from the clawback provision
since in the event of an action triggering a clawback, any recovered
incentive-based compensation amount would accrue to the institution.
    The fact that incentive-based compensation is to a large extent
determined by reported performance, coupled with the lowered incentives
for covered persons to intentionally misrepresent information, can lead
to improved financial reporting quality for covered institutions. Thus,
indirectly the potential to claw back incentive-based compensation that
is awarded on erroneous financial information could generate incentives
for high quality reporting. The literature finds that market penalties
for reporting failures, as captured by restatements of financial
reports, i.e., financial reports of (extremely) low quality, are non-
trivial and may translate into an increase in the cost of capital for
such firms.\437\ To the extent that the quality of financial reporting
increases as a result of the proposed rule, capital formation may be
fostered since the improved information environment may lead to a
decrease in the cost of raising capital for covered institutions.\438\
---------------------------------------------------------------------------

    \437\ See Palmrose, Z., Richardson, V., Scholz, S. 2004.
Determinants of Market Reactions to Restatement Announcements.
Journal of Accounting and Economics 37, 59-89. This study observes
an average abnormal return of -9% over the 2-day restatement
announcement window for a sample of restatements announced over the
1995-1999 period.
    See Hribar, P., Jenkins, N. 2004. The Effect of Accounting
Restatements on Earnings Revisions and the Estimated Cost of
Capital. Review of Accounting Studies 9, 337-356. This study
observes a significant increase in the cost of capital for firms
that restated their financial reports due to lower perceived
earnings quality and an increase in investors' required rate of
return.
    \438\ See Francis, J., LaFond, R., Olsson, P., Schipper, K.
2005. The Market Pricing of Accruals Quality. Journal of Accounting
and Economics 39, 295-327. This study observes a negative relation
between measures of earnings quality and costs of debt and equity.
The study focuses on the accrual component of earnings to infer
earnings quality since this component of earnings involves more
discretion in its estimation and is more prone to be manipulated by
firms.
---------------------------------------------------------------------------

    However, the relatively long clawback horizon may generate
uncertainty regarding incentive-based compensation of senior executive
officers and significant risk-takers. For example, that could be the
case if certain actions that trigger a clawback are outside of a
covered person's control. As a response to the potentially increased
uncertainty, senior executive officers and significant risk-takers may
demand higher levels of overall compensation, or substitution of
incentive-based compensation with other forms of compensation such as
salary. Such potential may distort incentives for risk-taking and as a
consequence lower shareholder value. Also, the increased allocation of
resources to the production of high-quality financial reporting may
divert resources from other activities that may be value enhancing.
Finally, covered persons may have a decreased incentive to pursue those
projects that would require more complex accounting judgments, perhaps
lowering shareholder value.\439\
---------------------------------------------------------------------------

    \439\ For example, if an executive is under pressure to meet an
earnings target, rather than manage earnings through accounting
judgments, the executive may elect to reduce or defer to a future
period research and development or advertising expenses. This could
improve reported earnings in the short-term, but could result in a
suboptimal level of investment that adversely affects performance in
the long run. See Chan, L., Chen, K., Chen, T., Yu, Y. 2012. The
effects of firm-initiated clawback provisions on earnings quality
and auditor behavior. Journal of Accounting and Economics 54, 180-
196.

---------------------------------------------------------------------------

    Moreover, the potential compliance costs related with the
implementation of the clawback provision could be significant. For
example, covered institutions may have to rely on the work of outside
experts to estimate the amount of incentive-based compensation to be
clawed back following a clawback trigger.
    Based on the SEC's baseline analysis, it appears that all of the
Level 1 covered institutions and most of the Level 2 covered
institutions already employ clawback policies with respect to deferred
compensation. The clawback policies are based on various triggers and
apply to NEOs, non-NEOs and significant risk-takers. Thus, if the BDs
and IAs have similar policies on clawback, and the compensation
structure of private institutions is similar to that of public
institutions, the implementation of the proposed clawback rule would
unlikely lead to significant compliance costs. On the other hand, if
the compensation practices of parent institutions are significantly
different than those at their subsidiaries (e.g., BDs and IAs do not
include clawback policies in their compensation packages), covered BDs
and IAs could experience significant compliance costs when implementing
the proposed rule. The same holds true if the compensation of BDs and
IAs is generally different than that of banking institutions, which
most of their parent institutions are. Additionally, since the SEC does
not have data on how many covered IAs have parent institutions, it is
also possible that a significant number of these IAs may be stand-alone
companies and therefore could have higher costs to comply with this
specific requirement of the proposed rule compared to covered IAs and
BDs that are part of reporting parent institutions.
    The SEC has attempted to quantify such costs using data in Table
14. We note that these costs are not necessarily going to be in
addition to the compliance costs discussed above, as covered
institutions may hire a compensation consultant to help them with
several requirements in the proposed rules.
    Lastly, because some BDs and IAs are subsidiaries of private parent
institutions, if there is a significant difference in the compensation
practices of public and private covered institutions such BDs and IAs
could face large compliance costs. The SEC does not have data for the
use of clawback at subsidiaries of Level 1 or Level 2 parents, and thus
cannot quantify the impact of the rule on those institutions. To better
assess the effects of clawback on compliance costs for BDs and IAs the
SEC requests detailed comments below.
6. Hedging
    The proposed rule would prohibit the purchase of any instrument by
a Level 1 or Level 2 covered institution to hedge against any decrease
in the value of a covered person's incentive-based compensation. As
discussed above, introducing a minimum mandatory deferral period for
incentive-based compensation aims at increasing long-term managerial
accountability, including long-term risk implications associated with
covered persons' actions. Using instruments to hedge against decreases
in firm value would provide downside insurance to covered persons'
wealth, including equity holdings that are part of deferred
compensation. If the value of (deferred) incentive-based compensation
is protected from potential downside through a hedging transaction,
this is likely to increase the covered person's tolerance to risk.
Thus, the effect of compensation deferral would likely be
weakened.\440\ For BDs and IAs that currently initiate hedges on behalf
of their covered persons, a benefit from the prohibition on hedging is
that the incentives of covered persons to exert effort could be
strengthened given the same compensation contract. This in turn would
imply a stronger alignment between executives' and taxpayers' and other
stakeholders' interests for the same amount of performance-based pay.
---------------------------------------------------------------------------

    \440\ See Bebchuk, L., Fried. J. Paying for long-term
performance. University of Pennsylvania Law Review 158, 1915-1959.
The paper argues that potential benefits from tying executive
compensation to long-term shareholder value are weakened when
executives are allowed to hedge against downside risk.
    See also Gao, H. 2010. Optimal compensation contracts when
managers can hedge. Journal of Financial Economics 97, 218-238. This
study shows that the ability to hedge against potential downside
makes the executive more risk tolerant. In other words, holding the
compensation arrangement constant, hedging is predicted to weaken
the sensitivity of compensation to performance and also the
sensitivity of compensation to risk. However, the study also shows
that for executives who can engage in low-cost hedging transactions,
compensation contracts tend to provide higher sensitivity of
executive pay to both performance and volatility.
---------------------------------------------------------------------------

    While the proposed rule intends to eliminate firm initiated
hedging, a personal hedging transaction by covered persons would still
be permitted (unless the institution prohibits such transactions from
occurring). Thus, a covered person at BDs and IAs could potentially
substitute the firm-initiated hedge with a personal hedging \441\
contract and restore any changes in incentives from the prohibition of
the firm-initiated hedge.
---------------------------------------------------------------------------

    \441\ Refer to Tables 7a and 7b for statistics regarding the
complete prohibition of hedging by parent institutions of BDs and
IAs.
---------------------------------------------------------------------------

    To the extent that the covered person's compensation contract is
not adjusted as a response to the elimination of the hedge, the covered
person would face stronger incentives to exert effort whereas her
tolerance for risk-taking would decrease with the prohibition on
hedging. Whether the resulting lower risk-taking tolerance is
beneficial for BDs and IAs is difficult to determine. On one hand, if
the covered persons' risk-taking incentives are at an optimal level
with the hedging transaction in place, then eliminating the hedge may
reduce their risk-taking incentives to levels that could be detrimental
for shareholder value. If this were the case, however, the
institution's compensation committees could adjust compensation
structures in a manner to achieve pre-prohibition risk-taking
incentives if the distortion from hedging prohibition is deemed to be
detrimental to firm value; however, some provisions of the proposed
rule could potentially constrain board of directors' flexibility to
make such adjustments.\442\ On the other hand, if covered persons had
incentives to undertake undesirable risks given the downside protection
provided by the hedge, then eliminating such protection could lead them
to engage in risk-taking which could lead to higher firm values.
---------------------------------------------------------------------------

    \442\ For example, boards of directors or compensation
committees at covered BDs and IAs would be constrained from
increasing the risk-taking incentives of covered persons through the
additional provision of stock options, if banning hedging lowers
risk-taking incentives to a sub-optimal level.
---------------------------------------------------------------------------

    Based on the SEC's baseline analysis, it appears that most Level 1
covered institutions (70 percent) and Level 2 covered institutions (60
percent) are already using prohibition on hedging with respect to
executive compensation of executives and significant risk-takers.
Additionally, 70 percent of Level 1 covered institutions and 100
percent of Level 2 covered institutions already prohibit hedging with
respect to executive compensation of non-employee directors. If BDs and
IAs have similar policies as their parent institutions, and the
compensation structure of private institutions is similar to that of
public institutions, the

implementation of the proposed rule in its part related to the
prohibition of hedging is unlikely to lead to significant compliance
costs. The cost of compliance with the proposed requirement of the rule
would mostly affect the few BDs and IAs whose parent institutions do
not currently implement such a prohibition. On the other hand, if the
compensation practices of parent institutions are significantly
different than those at their subsidiaries (e.g., BDs and IAs do not
prohibit hedging), covered BDs and IAs could experience significant
compliance costs when implementing the proposed rule. Since the SEC
does not have data on how many covered IAs have parent institutions, it
is also possible that a significant number of these IAs may be stand-
alone companies and therefore could have higher costs to comply with
this specific requirement of the proposed rule compared to covered IAs
and BDs that are part of reporting parent institutions. BDs and IAs
could also incur direct economic costs such as decrease in firm value
if the proposed prohibition on hedging leads to less risk-taking than
is optimal. The same holds true if the compensation of BDs and IAs is
generally different than that of banking institutions, which most of
their parent institutions are. If BDs and IAs do not prohibit hedging
and this provides incentives to their covered persons to undertake
undesirable risks because of the downside protection provided by the
hedge, then applying the rule provisions could lead to more appropriate
risk-taking.
    Lastly, because some BDs and IAs are subsidiaries of private parent
institutions, if there is a significant difference between the
compensation practices of public and private covered institutions such
BDs and IAs could face large compliance costs and direct economic
costs. The SEC does not have data for a prohibition of hedging at
subsidiaries of Level 1 or Level 2 private parents, and thus cannot
quantify the impact of the rule on those institutions. To better assess
the effects of the prohibition on hedging on compliance costs for BDs
and IAs the SEC requests comments below.
    As an alternative, some commenters suggested disclosure of hedging
transactions instead of prohibition.\443\ One commenter suggested
instead of prohibiting the use of hedging instruments to require full
disclosure of all outside transactions in financial markets by covered
persons, including hedging transactions, to the extent that these
transactions affect pay-performance sensitivity.\444\ This disclosure
should be made to the compensation committee of the board of directors
and the appropriate regulator, and the board of directors should attest
to the fact that these transactions do not distort proper risk-reward
balance in the compensation arrangement. According to the commenter,
sometimes covered persons may have legitimate purposes for engaging in
hedging transactions such as when they are exposed excessively to the
riskiness of the covered institution and need to rebalance their
personal portfolio. Such an alternative, however, might not prevent
covered persons from unwinding the effect of the mandatory deferral.
For example, it would not be easy to disentangle hedging transactions
that diminish individuals' exposure to the riskiness of the covered
institutions from transactions that reverse the effect of the deferral.
Additionally, the compensation committee might not have the expertise
to evaluate complex derivatives transactions.
---------------------------------------------------------------------------

    \443\ See CFP, FSR, SIFMA.
    \444\ See CFP.
---------------------------------------------------------------------------

7. Maximum Incentive-Based Compensation Opportunity
    The proposed rule would prohibit Level 1 and Level 2 covered
institutions from awarding incentive-based compensation to senior
executive officers and significant risk-takers in excess of 125 percent
(for senior executive officers) or 150 percent (for significant risk-
takers) of the target amount for that incentive-based compensation.
Placing a cap on the amount by which the incentive-based compensation
award can exceed the target would essentially limit the upside pay
potential due to performance and a potential impact of such restriction
could be to lower risk-taking incentives by senior executive officers
and significant risk-takers. That could be the case because the cap on
incentive-based compensation implies that managers would not be
rewarded for performance once the cap is reached.
    As discussed above, high levels of upside leverage could lead to
senior executive officers and significant risk-takers taking
inappropriate risks to maximize the potential for large amounts of
incentive-based compensation. Given the positive link between risk and
expected payoffs from managerial actions, a potential impact of such
restriction could be to lower risk-taking incentives by senior
executive officers and significant risk-takers. Whether such an effect
is beneficial or not for covered BDs and IAs firm value is likely to
depend on many factors including the level of the incentive-based
compensation targets set in compensation arrangements. If the proposed
cap excessively lowers appropriate risk-taking incentives, then firm
value could suffer. Moreover, another potential cost from the proposed
restriction is that effort inducing incentives may be diminished once
the cap is achieved, possibly misaligning the interests of shareholders
with those of managers. On the other hand, if the cap on incentive-
based compensation awards eliminates a range of payoffs that could only
be achieved by actions associated with taking suboptimally high risks,
then such a restriction would improve firm value.
    As the baseline analysis shows, the maximum incentive-based
compensation opportunity for Level 1 parent institutions is on average
155 percent and that for Level 2 parent institutions is on average 190
percent. Both are significantly higher than would be permitted under
the proposed rule. If BDs and IAs have similar policies as their parent
institutions, and the compensation structure of private institutions is
similar to that of public institutions, the implementation of the
proposed rule in its part related to maximum incentive-based
compensation opportunity could lead to significant compliance costs.
The cost could result from changing the current practices and, as a
result, potentially having to compensate senior executive officers and
significant risk-takers for the decreased ability to earn compensation
in excess of the target amount. If the current compensation practices
with regard to maximum incentive-based compensation opportunity are
optimal, it is possible than affected BDs and IAs could experience loss
of human capital. On the other hand, as discussed above, if the cap on
incentive-based compensation awards eliminates a range of payoffs that
could only be achieved by actions associated with taking suboptimally
high risks, then such a restriction would improve firm value. Since the
SEC does not have data on how many covered IAs have parent
institutions, it is also possible that a significant number of these
IAs may be stand-alone companies and therefore could have higher costs
to comply with this specific requirement of the proposed rule compared
to covered IAs and BDs that are part of reporting parent institutions.
    Additionally, because some BDs and IAs are subsidiaries of private
parent institutions, if there is a significant difference between the
compensation practices of public and private covered

institutions such BDs and IAs could face large compliance costs when
applying this rule requirement. The SEC does not have data on the use
of maximum incentive-based compensation opportunity at subsidiaries of
Level 1 or Level 2 private parents, and thus cannot quantify the impact
of the rule on those institutions. To better assess the effects of the
proposed limitations to the maximum incentive-based compensation
opportunity on compliance costs for BDs and IAs the SEC requests
comments below.
8. Acceleration of Payments
    The proposed rule would prohibit the acceleration of payment of
deferred regulatory incentive-based compensation except in cases of
death or disability of covered persons at Level 1 and Level 2 covered
institutions. This would prevent covered institutions from undermining
the effect from the mandatory deferral of incentive-based compensation
by accelerating the deferred payments to covered persons. It could,
however, negatively affect covered persons that decide to leave the
institution in search for other employment opportunities. In such
cases, these covered persons might have to forgo a significant portion
of their compensation.
    As the analysis in the Baseline section shows, most Level 1 parent
institutions (approximately 70 percent) already prohibit acceleration
of payments to their executives, while very few of the Level 2 parent
institutions do. The only exceptions are in cases of death or
disability. Given that current practices of BDs' and IAs' Level 1
parent institutions already apply most of the prohibitions required by
the proposed rule (except employment termination), if those BDs and IAs
have similar policies as their parent institutions, and the
compensation structure of private institutions is similar to that of
public institutions, the implementation of the proposed with respect to
the prohibition on the acceleration of payments is unlikely to lead to
significant compliance costs. The cost of compliance with the
requirement of the rule will mostly affect the BDs and IAs whose parent
institutions are Level 2 covered institutions or Level 1 covered
institutions that do not currently implement such a prohibition. On the
other hand, if the compensation practices of parent institutions are
significantly different than those at their subsidiaries (e.g., BDs and
IAs do not prohibit acceleration of payments), covered BDs and IAs
could experience significant compliance costs when implementing the
proposed rule. Additionally, since the SEC does not have data on how
many covered IAs have parent institutions, it is also possible that a
significant number of these IAs may be stand-alone companies and
therefore could have higher costs to comply with this specific
requirement of the proposed rule compared to covered IAs and BDs that
are part of reporting parent institutions.
    Lastly, because some BDs and IAs are subsidiaries of private parent
institutions, if there is a significant difference in the compensation
practices of public and private covered institutions such BDs and IAs
could face large compliance costs when applying this rule requirement.
The SEC does not have data for the prohibition of acceleration of
payments at subsidiaries of Level 1 or Level 2 parents, and thus cannot
quantify the impact of the rule on those institutions. The SEC requests
comment on the effects of the prohibition on acceleration of payments
may have on compliance costs for BDs and IAs.
9. Relative Performance Measures
    The proposed rule would prohibit the sole use of relative
performance measures in incentive-based compensation arrangements at
Level 1 and Level 2 covered institutions. Although relative performance
measures are widely used to filter out uncontrollable events that are
outside of management control and can reduce the efficiency of the
compensation arrangement, a peer group could be opportunistically
selected to justify compensation awards at a covered institution. To
the extent that covered persons may influence peer selection,
opportunism in choosing a performance benchmark may translate into
covered persons selectively choosing benchmark firms in order to
increase or justify increases in their compensation awards.
    Evidence on whether such practices take place is mixed. For
example, one study examined the selection of peer firms used as
benchmarks in setting compensation for a wide range of firms and showed
that, on average, chosen peer firms provided higher levels of
compensation to their executives. The study asserts that managers tend
to choose higher paying firms as peers to justify increases in the
level of their own compensation.\445\ The same study also found that
the choice of highly paid peers is more prevalent when the CEO is also
the chair of the board of directors, re-enforcing the argument for
opportunism in peer selection. Another study found that executives
attempt to justify increases in their compensation by choosing
relatively larger firms as their peers since larger firms are likely to
offer higher compensation to their executives.\446\ However, the study
also showed that boards of directors exercise conservative discretion
in using information from benchmark firms when setting compensation
practices. Finally, a third related study \447\ suggests that firms
choose peers with (relatively) highly paid CEOs when their own CEO is
highly talented, a finding that is not consistent with opportunism
regarding the choice of peers in compensation setting. Overall,
empirical studies suggest that opportunism in the peer group selection
may exist, particularly in companies where the CEO may exert influence
over her compensation setting process. By restricting the sole use of
relative performance measures in compensation arrangements, the
proposed rule would curb the ability of covered persons to engage in
such opportunistic behavior, which would benefit covered BDs and IAs.
---------------------------------------------------------------------------

    \445\ See Faulkender, M., Yang, J. 2010. Inside the black box:
The role and composition of compensation peer groups. Journal of
Financial Economics 96, 257-270. The study suggests that companies
appear to select highly paid peers as a benchmark for their CEO's
pay to justify higher CEO compensation. The study also suggests that
such an effect is stronger when governance is weaker: In companies
where the CEO is also the chairman of the board, has longer tenure,
and when directors are busier serving on multiple boards.
    \446\ See Bizjak, J., Lemmon, M., Nguyen, T. 2011. Are all CEOs
above average? An empirical analysis of compensation peer groups and
pay design. Journal of Financial Economics 100, 538-555. The study
suggests that companies use compensation peer groups that are larger
or provide higher pay in order to inflate pay in their own company
and this practice is more prevalent for companies outside of the
S&P500. However, the study also shows that boards exercise
discretion in adjusting compensation due to the peer group effect;
pay increases only close about one-third of the gap between company
CEO and peer group CEO pay.
    \447\ See Albuquerque, A., De Franco, G., Verdi, R. 2013. Peer
Choice in CEO Compensation. Journal of Financial Economics 108, 160-
181. The study examines whether companies that benchmark CEO pay
against highly paid peer CEOs is driven by incentives to increase
CEO pay. Whereas the study suggests that benchmarking pay against
highly paid peer CEOs is driven by opportunism, such practice mostly
represents increased compensation for CEO talent.
---------------------------------------------------------------------------

    As mentioned above, the proposed rule would prohibit the sole use
of relative performance measures in determining compensation at covered
institutions. Constraining the use of relative performance measures in
incentive-based compensation contracts has potential costs. Absolute
firm performance is typically driven by multiple factors and not all of
these factors are under the covered persons' control. If incentive-
based compensation is tied to measures of absolute firm performance,
then at least

a part of incentive-based compensation will be tied to events out of
covered persons' control. This could generate uncertainty about
compensation outcomes for covered persons, reducing the efficiency of
the incentive-based compensation arrangement. Whereas the proposed rule
would not prohibit the use of relative performance measures, if the
proposed limitation regarding the use of performance measures in
determining compensation awards leads to less filtering out of the
uncontrollable risk component of performance, then covered institutions
may increase overall pay to compensate covered persons for bearing
uncontrollable risk.
    The SEC's baseline analysis of current compensation practices
suggests that most Level 1 and Level 2 covered institutions use a mix
of absolute and relative performance measures. If BDs and IAs have
similar policies as their parent institutions, and the compensation
structure of private institutions is similar to that of public
institutions, the SEC does not expect this rule requirement to generate
significant compliance costs for covered institutions. The cost of
compliance with the proposed rule would mostly affect the few BDs and
IAs whose parent institutions do not currently implement such a
requirement. On the other hand, if the compensation practices of parent
institutions are significantly different than those at their
subsidiaries (e.g., they do not use absolute performance measures, or
use mostly absolute measures), covered BDs and IAs could experience
significant compliance costs when implementing the proposed rule. Since
the SEC does not have data on how many covered IAs have parent
institutions, it is also possible that a significant number of these
IAs may be stand-alone companies and therefore could have higher costs
to comply with this specific requirement of the proposed rule compared
to covered IAs and BDs that are part of reporting parent institutions.
The same holds true if the compensation of BDs and IAs is generally
different than that of banking institutions, which most of their parent
institutions are.
    The SEC has attempted to quantify such costs based on the estimates
in Table 14. The SEC also notes that these costs are not necessarily
going to be in addition to the compliance costs discussed above, as
covered institutions may hire a compensation consultant to help them
with several requirements in the proposed rules. These costs could be
lower, however, if the parent institutions of BDs and IAs already
employ compensation consultants and could extend their services to meet
the proposed rule requirements for BDs and IAs. Lastly, because some
BDs and IAs are subsidiaries of private parent institutions, if there
is a significant difference in the compensation practices of public and
private covered institutions such BDs and IAs could face large
compliance costs. The SEC does not have data for the prohibition of the
sole use of relative performance measures at subsidiaries of Level 1 or
Level 2 parents, and thus cannot quantify the impact of the rule on
those institutions. To better assess the effects of this prohibition on
compliance costs for BDs and IAs. The SEC requests detailed comments
below.
10. Volume-Driven Incentive-Based Compensation
    For covered persons at Level 1 and Level 2 covered institutions,
the proposed rule would prohibit incentive-based compensation
arrangements that are based solely on the volume of transactions being
generated without regard to transaction quality or compliance of the
covered person with sound risk management. Such a compensation contract
would provide incentives for employees to maximize the number of
transactions since that outcome would lead to maximizing their
compensation. A compensation contract that solely uses volume as the
performance indicator is likely to provide employees with incentives
for inappropriate risk-taking since employees benefit from one aspect
of performance but do not bear the negative consequences of their
actions--the associated costs and risks incurred to generate revenue/
volume. There is limited academic literature addressing the effect of
volume-driven compensation on employee incentives. A study examined the
behavior of loan officers at a major commercial bank when compensation
switched from a fixed salary structure to a performance-based structure
where the measure of performance was set as loan origination
volume.\448\ The study found a 31 percent increase in loan approvals,
holding other factors related to the probability of loan approvals
constant. The study also found that the 12-month probability of default
in originating loans increased by 27.9 percent. Whereas the study did
not conclude whether the bank was better or worse off due to the
introduction of the compensation scheme, the authors found that
interest rates charged to lower quality loans did not reflect the
increased riskiness of the borrowers. Another related study \449\ finds
that loan officers who are incentivized based on lending volume rather
than on the quality of their loan portfolio originate more loans of
lower average quality. The study also finds that due to the presence of
career concerns or reputational motivations, loan officers with lending
volume incentives do not indiscriminately approve all applications.
Whereas the study examines the effects of volume-driven compensation on
employees that are not likely to be covered by the proposed rule, it
confirms intuition that providing incentives for volume maximization
may lead to behaviors that do not necessarily maximize firm value.
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    \448\ See Agarwal, S., Ben-David, I. 2014. Do Loan Officers'
Incentives Lead to Lax Lending Standards? NBER Working Paper. This
study examines changes in lending practices in one of the largest
U.S. commercial banks when loan officers' compensation structure was
altered from fixed salary to volume-based pay. The study suggests
that following the change in the compensation structure, loan
origination became more aggressive as evident by higher origination
rates, larger loan sizes, and higher default rates. The study
estimates that 10% of the loans under the volume-based compensation
structure were likely to have negative net present value.
    \449\ See Cole, S., Kanz, M., Klapper, L. 2015. Incentivizing
Calculated Risk-Taking: Evidence from an Experiment with Commercial
Bank Loan Officers. Journal of Finance 70, 537-575. The study
examines the effect of different incentive-based compensation
arrangements on loan originators behavior in screening and approving
loans in an Indian commercial bank. In general, the study finds that
the structure of incentive-based arrangements for loan officers
affects their decisions; the performance metric used in compensation
arrangements of loan officers as well as whether pay is deferred
affect loan officers screening and approval incentives and
corresponding decisions.
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    It is unclear to the SEC whether volume-driven incentive-based
compensation arrangements are utilized by IAs and BDs given the nature
of the business conducted by IAs and BDs. Assuming that these
incentive-based compensation arrangements are relevant to IAs and BDs,
restricting the sole use of volume-driven compensation practices may
curb incentives that reward employees of BDs and IAs on only partial
outcomes of their actions; partial in the sense that costs and risks
associated with those actions are not part of the performance
indicators used to determine their compensation. As a consequence, to
the extent that BDs and IAs contribute significantly to the overall
risk profile of their parent institutions, covered persons' incentives
would likely become aligned with the interests of stakeholders,
including taxpayers, since covered persons would bear both the benefits
and the costs from their actions. Likewise, the prohibition on the sole
use of volume-driven compensation practices is also likely to

limit covered persons' incentives for inappropriate risk-taking.
    The effect of this proposed rule on BDs and IAs cannot be
unambiguously determined because of the lack of data on the current use
of volume-driven compensation practices. If BDs and IAs have already
instituted similar policies with respect to senior executive officers
and significant risk-takers, the SEC does not expect this rule
requirement to generate significant compliance costs for covered
institutions. On the other hand, if covered BDs and IAs' compensation
practices with respect to senior executive officers and significant
risk-takers rely exclusively on volume-driven transactions, covered BDs
and IAs could experience significant compliance costs when implementing
the proposed rule. To better assess the effects of this prohibition on
compliance costs for BDs and IAs the SEC requests comments below.
11. Risk Management
    The proposed rule would include specific requirements with regard
to risk management functions to qualify a covered person's incentive-
based compensation arrangement at Level 1 and Level 2 covered
institutions as compatible with the rule. Specifically, the proposed
rule would require that a Level 1 or Level 2 covered institution have a
risk management framework for its incentive-based compensation
arrangement that is independent of any lines of business, includes an
independent compliance program that provides for internal controls,
testing, monitoring, and training, with written policies and procedures
consistent with the proposed rules, and is commensurate with the size
and complexity of a covered institution's operations. Moreover, the
proposed rule would require that covered persons engaged in control
functions be provided with the authority to influence the risk-taking
of the business areas they monitor and be compensated in accordance
with the achievement of performance objectives linked to their control
functions and independent of the performance of the business areas they
monitor. Finally, a Level 1 or Level 2 covered institution would be
required to provide independent monitoring of all incentive-based
compensation plans, events related to forfeiture and downward
adjustment and decisions of forfeiture and downward adjustment reviews,
and compliance of the incentive-based compensation program with the
covered institution's policies and procedures.
    The proposed requirements may strengthen the risk management and
control functions of covered BDs and IAs, which could result in lower
levels of inappropriate risk-taking. Academic literature suggests that
stronger risk controls in bank holding companies resulted in lower risk
exposure, as evident by lower tail-risk and lower fraction of non-
performing loans; and better performance, as evident by better
operating performance and stock return performance, during the
crisis.\450\ This study also shows that the risk management function is
stronger for larger banks, banks with larger derivative trading
operations and banks whose CEOs compensation is more closely tied to
stock volatility. Additionally, the study shows that stronger risk
function, as measured by this study, was associated with better firm
performance only during crisis years, whereas the same relation did not
hold during non-crisis periods. As such, a strong and independent risk
management function can curtail tail risk exposures at banks and
potentially enhance value, particularly during crisis years. Another
study shows that lenders with a relatively powerful risk manager, as
measured by the level of the risk manager's compensation relative to
the top named executives' level of compensation, experienced lower loan
default rates. Thus, the evidence in the study seems to suggest that
powerful risk executives curb risk-taking with respect to loan
origination.\451\
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    \450\ See Ellul, A., Yerramilli, V. 2013. Stronger Risk
Controls, Lower Risk: Evidence from U.S. Bank Holding Companies.
Journal of Finance 68, 1757-1803.
    \451\ See Keys, B., Mukherjee, T., Seru, A., Vig, Vikrant. 2009.
Financial regulation and securitization: Evidence from subprime
loans. Journal of Monetary Economics 56, 700-720.
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    It is also possible that the proposed requirements may not have an
effect on the current level of risk-taking at BDs and IAs. For example,
if risk-taking is driven by the culture of the institution, then
governance characteristics (including risk management functions) may
reflect the choice of control functions that match the inherent risk-
taking appetite in the institution.\452\ A potential downside of
applying a strict risk management control function over covered BDs and
IAs is that it could lead to decreased risk-taking and potential loss
of value for those BDs and IAs that already employ an optimal risk
management function. For such BDs and IAs, the implementation of the
rule requirements with respect to risk management could result in lower
than optimal risk-taking by covered persons.
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    \452\ See Cheng, I., Hong, H., Scheinkman, J. 2015. Yesterday's
Heroes: Compensation and Risk at Financial Firms. Journal of Finance
70, 839-879.
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    Based on the SEC's baseline analysis, it appears that all Level 1
parent institutions and most Level 2 parent institutions (67 percent)
of BDs already have an independent risk management and control function
(e.g., a risk committee) and compensation monitoring function (e.g., a
fully independent compensation committee) \453\ that could apply the
rule requirements. Similarly, all of the Level 1 and Level 2 parent
institutions of IAs have risk committees and substantial portion (80
percent and above) have fully independent compensation committees. The
SEC, however, does not have information on whether risk committees
review and monitor the incentive-based compensation plans. The SEC's
analysis suggests that there are some Level 1 covered institutions (30
percent) and Level 2 covered institutions (20 percent) where CROs
review compensation packages.
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    \453\ A risk committee is ``fully independent'' for purposes of
this discussion if it consists only of directors that are not
employees of the corporation.