Can the Fed set rates for commissions?

In a worrying notice earlier this year, a number of federal agencies introduced new rules for incentive based compensation – but do they actually have the power to do so?

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Earlier this year, the FRB, OCC, FDIC and other Agencies1 published a Notice of Proposed Rulemaking (the “Proposed Rule”)2 on incentive-based compensation arrangements. The comment period expired July 22, 2016, and proposed final rules on this subject are still forthcoming. 

The Proposed Rule includes a vast new set of procedural, substantive and longer-term requirements over employees, officers and directors of financial institutions. In some instances, the Proposed Rule exceeds or conflicts with relatively new requirements that other federal agencies, such as the SEC, have adopted.

This article explores whether the Board of Governors of the Federal Reserve System (the “FRB”) has authority to enforce the rules as proposed with respect to savings and loan holding companies (“SLHCs”) that are operating insurance companies. We conclude that there is a question with respect to the authority of the FRB over these institutions. Therefore, the FRB should reconsider the scope of its Proposed Rule and the inclusion of insurance SLHCs and their non-depository insurance company subsidiaries primarily because (1) the FRB lacks statutory authority to enforce such provisions, (2) inclusion would be contrary to the intent of Congress, and (3) at the very least, inclusion of SLHCs is premature prior to the FRB taking final action with regard to insurance SLHC capital requirements.3
The Proposed Rule carries out Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”).4 Section 956(b) requires the Agencies to “jointly prescribe regulations or guidelines that prohibit any types of incentive-based payment arrangements, or any feature of any such arrangements, that the [Agencies] determine encourages inappropriate risks by covered financial institutions.”5 (emphasis added). The Agencies expressly cite Section 956 in the Proposed Rule as the statutory basis for the proposed rules on incentive compensation.6
Does the FRB have a statutory mandate to enforce incentive compensation rules?
Upon significant review, it is apparent that the FRB lacks a statutory mandate to enforce the incentive compensation rules as proposed because (A) the language of Section 956 of Dodd-Frank, along with its internally referenced statutes (1) excluded such power from OTS (defined below) authority, (2) specifically reserved such power to the State insurance regulators and (3) the FRB implicitly acknowledged the limitation in the Proposed Rule; (B) a contrary interpretation would be in conflict with the McCarran-Ferguson Act; (C) the OCC and FDIC specifically excluded “persons providing insurance”; and (D) regulation by State insurance departments is consistent with the statute.
Section 956 of dodd-frank and section 505 of glba
Of particular note is that the regulatory regime established by Section 956 of Dodd-Frank does not provide that the statute and any regulations issued thereunder shall be enforced by the Agencies that promulgated the regulations.  Rather, Section 956(d) of Dodd-Frank expressly provides that Section 956 of Dodd-Frank and the regulations issued thereunder “shall be enforced under section 505 of the Gramm-Leach-Bliley Act [(“GLBA”)] and, for purposes of such section, a violation of this section or such regulations shall be treated as a violation of subtitle A of title V of such Act.”7 In turn, Section 505(a)(6) of GLBA8 expressly provides that Subtitle A (Disclosure of Nonpublic Information) of Title V (Privacy) and regulations prescribed thereunder are to be enforced as to insurance companies by State insurance authorities, subject to Section 104 of the Act, and not by the Agencies.  It provides:

“[t]his subtitle and the regulations prescribed thereunder shall be enforced by the Federal functional regulators, the State insurance authorities, and the Federal Trade Commission with respect to financial institutions and other persons subject to their jurisdictions under applicable law, as follows: (1) Under section 8 of the Federal Deposit Insurance Act, in the case of - . . . (B) member banks of the Federal Reserve System (other than national banks), branches and agencies of foreign banks (other than Federal branches, Federal agencies, and insured State branches of foreign banks), commercial lending companies owned or controlled by foreign banks, organizations operating under section 25 or 25A of the Federal Reserve Act, and bank holding companies [“BHCs”] and their nonbank subsidiaries (except brokers, dealers, persons providing insurance, investment companies, and investment advisers) by the Board of Governors of the Federal Reserve System; . . . (D) savings associations the deposits of which are insured by the Federal Deposit Insurance Corporation, and any subsidiaries of such savings associations (except brokers, dealers, persons providing insurance, investment companies, and investment advisers), by the Director of the Office of Thrift Supervision… (6) Under State insurance law, in the case of any person engaged in providing insurance, by the applicable State insurance authority of the State in which the person is domiciled, subject to section 104 of this Act . . . .” (emphasis added).

Presumably the Agencies, including the FRB, recognized the need for an exception by including, in the proposed incentive compensation rule, Section ___.13, which expressly provides that “[t]he provisions of this part shall be enforced under section 505 of the Gramm-Leach-Bliley Act and, for purposes of this section, a violation of this part shall be treated as a violation of subtitle A of title V of such Act.” Thus, the Agencies have recognized that, for these institutions, they are not responsible for enforcement.
Exclusion of frb authority over insurance slhcs’ compensation
There is a lack of any statutory basis for FRB enforcement authority in the area of insurance SLHC compensation.  Section 505 of GLBA does not include any enforcement authority against SLHCs—even in the provision providing enforcement authority to the Office of Thrift Supervision (the “OTS”), the regulatory agency with responsibility for supervising SLHCs prior to such authority being transferred to the FRB following passage of Dodd-Frank.  In fact, it is unclear that Congress was in any way concerned about the effect of incentive compensation on the financial soundness9 of SLHCs as the conference report for Dodd-Frank does not address SLHCs at all, but instead targets BHCs in its language.10 Since Section 505 of GLBA does not convey any enforcement authority over SLHCs, even to the OTS, the FRB cannot convincingly conclude that authority to enforce Section 505 of GLBA was transferred to it.  Thus, authority to enforce Section 956 of Dodd-Frank and its implementing regulations as to insurance SLHCs would not rest with the FRB. 
Reservation of enforcement authority to the state insurance regulators 
Section 505 of GLBA explicitly places the authority to bring enforcement actions with the State insurance authority of the State where the company is domiciled, subject to Section 104. Thus, it would appear that only State insurance authorities may enforce Section 505 of GLBA as to insurers and, therefore, only State insurance authorities have the legal authority to enforce Section 956 of Dodd-Frank and any implementing regulations against insurers. Congress’ intent on the issue of enforcement authority has been extremely clear, as such enforcement language, which was originally a part of an earlier bill (the Corporate and Financial Institution Compensation Fairness Act of 2009, which was passed out of the House, but was never addressed in the Senate), was incorporated again when Dodd-Frank was introduced in the House, and although left out of the Senate version of the bill,11 was deemed so crucial when the House and Senate met in conference that it was reinserted.

Reservation of enforcement authority in State insurance commissioners—the primary supervisors of insurance companies that are also SLHCs—precludes the FRB from examining insurance SLHCs for compliance with any final incentive compensation regulation. Enforcement is a natural outgrowth of supervision. Examination is an inherent aspect of supervision and normally serves as the basis of enforcement action. If, as is the case, enforcement authority has been denied to the FRB with respect to insurance SLHCs, then similarly, the authority to examine insurance SLHCs for compliance with any incentive compensation rule would also rest exclusively with State insurance authorities and not with the FRB. The FRB lacks discretionary legal authority to examine or bring enforcement actions separate or apart from actions taken by state regulators. To the extent that the FRB disagrees with an action, or lack thereof, taken by the State insurance commissioners, discretionary authority has been delegated solely to the insurance departments, and the FRB does not have authority to supersede such actions.

There is nothing inconsistent in authorizing the FRB to adopt regulations applicable to insurance SLHCs, but leaving the enforcement authority with State insurance departments. Such an arrangement—that the FRB can make regulations but is not responsible for supervision and enforcement—is consistent with current practice in which the FRB promulgates regulations and enforcement of such regulations is left by Congress to other agencies. For example, Federal Reserve Regulation T (Credit by Brokers and Dealers) imposes margin requirements and was adopted by the FRB, but is enforced by the SEC. 
The FRB has expressed support for its limited authority
The FRB expressly and publicly acknowledged in its July 22, 2011 notice of intent and request for comment12 that Section 505 of GLBA does not apply to SLHCs or their non-depository institutions. Therefore, entirely apart from whether Section 956(d) limits enforcement and examination authority over insurance SLHCs, it may even be concluded that no agency has enforcement authority over any SLHC’s compliance with any final incentive compensation rule.

Consistent with the above interpretation of Section 956(d), FRB Governor Daniel K. Tarullo has recognized, in his address to the National Association of Insurance Commissioners (“NAIC”) International Insurance Forum on May 20, 2016, that the FRB’s oversight role complements the role that insurance regulators play, and while Dodd-Frank broadened the FRB’s statutory mandate, it also preserved functional regulation. Tarullo added that the FRB has no role in regulating the manner in which insurance is provided as that is the province of State insurance regulators.
Conflict with the McCarran-Ferguson act
The McCarran-Ferguson Act largely reserves regulation of the business of insurance to the States. It expressly provides that “[n]o Act of Congress shall be construed to … impair … any law enacted by any State for the purpose of regulating the business of insurance….”13 Section 104(a) of GLBA, incorporated by reference by Section 505 of GLBA, affirms this position and provides in no uncertain terms that “[the McCarran-Ferguson Act] remains the law of the United States.” Section 956 of Dodd-Frank explicitly references Section 505 of GLBA, which has, in turn, deferred enforcement in the case of persons engaged in providing insurance to state insurance regulators and further bolstered that deferral by referencing GLBA Section 104’s intent not to supersede state regulation of the insurance industry. Congress, in enacting Section 956, made a careful and deliberate decision to avoid creating any conflict between Section 956 (and regulations implementing Section 956) and any State law that regulates the business of insurance.
Apparent violation of the requirement to work jointly with the other agencies
Neither the OCC nor the FDIC propose to apply the requirements of the Proposal to “persons providing insurance;” only the FRB does so. Thus, the FRB's action is inconsistent with the statutory directive that the Agencies develop the rule jointly.14 The OCC and the FDIC presumably excluded persons providing insurance because, under the terms of the GLBA, which governs enforcement of the rule, the Prudential Banking Regulators have no power over persons providing insurance. That power rests with state insurance regulators. 
Reserving enforcement authority to the states is consistent with the statute
Reserving the regulation of operating insurance companies to State insurance departments is also consistent with ensuring financial soundness of the insurance industry.15 A primary objective of state regulation of insurance companies is to regulate the industry in a way to monitor institutions and licensed individuals and to correct market failures that would otherwise cause insurers to incur an excessive risk of insolvency.16 Significant state insurance department regulatory resources are employed to monitor market behaviors, compliance, and solvency.17 Each state, the District of Columbia, and the U.S. Territories are responsible for regulating the insurance business within their own jurisdictions, and each maintains its own insurance department operating under the supervision of an elected or appointed commissioner, director or superintendent.  Insurance companies are chartered by individual jurisdictions and receive a license (certificate of authority) to conduct business from each jurisdiction in which the company wishes to underwrite insurance.18 Those licenses may be revoked if insurance commissioners determine that the companies are not operating in a safe and sound manner. Since 1792, insurance companies have been required by the States to limit their activities and investments and to file financial statements.19 State insurance regulators monitor insurance company financial health by requiring extensive financial reporting based on conservative statutory accounting principles that do not permit the inclusion of certain assets in calculating an insurer’s surplus.  That reporting and many other information sources are used to screen for solvency,20 as are on-site examinations. Using these tools, State insurance regulators historically have done an excellent job of limiting risk at insurance companies. Between 1980 and 2010, insurance companies had a lower failure rate (0.40%) than either banks (0.49%) or thrift institutions (2.07%).21
Is inclusion of insurance SLHCS contrary to congressional intent?
In Dodd-Frank, Congress recognized that various exceptions were appropriate for the insurance industry. Insurance companies: (1) are inherently different from banks in their business operations and risk profiles; (2) are supervised and regulated in a different manner than banks; (3) have compensation methods that vary greatly from other types of financial services institutions; and (4) that are forced to apply incentive compensation restrictions as proposed in the Proposed Rule—particularly the discrete insurance companies regulated as Covered Institutions—would be disparately impacted and unfairly harmed in their ability to retain and attract high-quality employees. That disparate impact, over time, could potentially reduce the competitiveness, strength and success of the companies, particularly as compared to other insurance companies that are not covered by such a rule. Congress, quite possibly recognizing these factors, specifically exempted insurance companies. Thus, applying the proposed rule to insurance SLHCs runs contrary to both the enabling legislation and the intent of Congress. Congress’ intent to make exceptions for insurance companies was made explicit in other sections of Dodd-Frank—notably Section 619 (the “Volcker Rule”), which stated that one of the policy goals in implementing the Volcker Rule was to “appropriately accommodate the business of insurance within an insurance company, subject to regulation in accordance with the relevant insurance company investment laws, while protecting the safety and soundness of any banking entity with which the insurance company is affiliated and of the United States financial system . . . .”22 Therefore, the Volcker Rule sought to ensure that the normal operations of insurance companies would be excluded from inappropriate federal oversight and preserves the existing system of State regulation.
Is inclusion of insurance SLHCS appropriate prior to the FRB’s announcement of final capital rules?
It is difficult to see how it would be appropriate for the FRB to propose a rule on how to assess risk in compensation plans for employees in insurance companies based on the risk that such employees pose to the safety and soundness of the holding company or the underlying depository institution at a point in time when the FRB has not yet adopted final rules to set forth the basis on which it will assess risk for the SLHC insurance companies it regulates. On June 3, 2016, the FRB issued an advance notice of proposed rulemaking (“ANPR”) regarding various potential approaches to regulatory capital requirements for depository institution holding companies significantly engaged in insurance activities. Comments were due on that ANPR on September 16, 2016, and eventually the FRB may propose a rule to reflect how it will consider the adequacy of capital of such firms.  At some indefinite later date, the FRB may adopt a final rule and subsequently that rule may become effective, at which time it will become clear what capital levels the FRB will expect such insurance companies to maintain and, by extension, apply portions of the incentive-based compensation rule that rely on regulatory capital.23 Therefore, it is, at the very least, premature to issue rules regulating the compensation of insurance company employees whose conduct theoretically could put the capital of the insurance company at risk.

This is a developing issue and we expect the Agencies to release Final Rules or Proposed Final Rules in the future. Winston & Strawn is monitoring this situation and will provide additional client alerts as needed.
1 The FRB, the Office of the Comptroller of the Currency (the “OCC”), the Federal Deposit Insurance Corporation (the “FDIC”), the National Credit Union Administration (the “NCUA” and in combination with the FRB, OCC, and FDIC, the “Federal Prudential Banking Regulators”), the Securities and Exchange Commission (the “SEC”), and the Federal Housing Finance Agency (the “FHFA”) (each an “Agency” and collectively, the “Agencies”).
2 81 F.R. 37670 pub. avail. June 10, 2016.
3 This article does not examine any potential constitutional issues associated with the Proposed Rule.
4 12 U.S.C. § 5641.
5 12 U.S.C. § 5641(b).
6 81 Fed. Reg. 37672 (Jun. 10, 2016).
7 12 U.S.C. § 5461(d).
8 15 U.S.C. § 6805.
9 Financial soundness being a key determinant as it was the primary motivation for enactment of Dodd-Frank generally, and part of the express intent of Section 956 is to discourage incentivizing inappropriate risk-taking which “could lead to material financial loss to the covered financial institution.”
10 See Report of Committee on Banking, Housing, and Urban Affairs, Conference, 111th Congress, Report 176 (“Section 956. Excessive compensation by holding companies of depository institutions. Section 956 amends Section 5 of the Bank Holding Company Act of 1956 to establish standards prohibiting as an unsafe and unsound practice any compensation plan of a BHC that provides an executive officer, employee, director, or principal shareholder with excessive compensation, fees, or benefits; or could lead to material financial loss to the BHC.  This applies regulatory authority currently applicable to banks to their holding companies.”)
11 Although it should also be noted that the Senate version was significantly shorter, and the omission may have simply been one of oversight. 
12 Continued Application of Regulations to Savings and Loan Holding Companies.  76 F. R. 43953 (July 22, 2011).
13 15 U.S.C. § 1012(b).
14 See Section 956(b) (“the appropriate Federal regulators shall jointly prescribe regulations or guidelines that prohibit any types of incentive-based payment arrangement, or any feature of any such arrangement, that the regulators determine encourages inappropriate risks by covered financial institutions”) and Section 956(e)(2)(G) (“the term “covered financial institution” means—any other financial institution that the appropriate Federal regulators, jointly, by rule, determine should be treated as a covered financial institution for purposes of this section.”) 
15 As noted above, “financial soundness” is a primary element of Dodd-Frank generally, and is specifically highlighted in Section 956.
16 Report of the National Association of Insurance Commissioners (“NAIC”) and the Federal Reserve System Joint Troubled Company Working Subgroup: A Comparison of the Insurance and Banking Regulatory Frameworks for Identifying and Supervising Companies in Weakened Financial Condition (April 19, 2005) at 5.
17 Ibid.
18 Ibid.
19 Ibid. at 6.
20 Ibid. at 11.
21 Comparative Failure Experience in the U.S. and Canadian Life Insurance and Banking Industries From 1980 To 2010 (March 2013) at 33.
22 12 U.S.C. § 1851(b)(1)(F).
23 Such standards would be necessary, for example, should the final definition of “significant risk -taker” continue to integrate a capital exposure test.
This article first appeared on
Christine Edwards,
Partner, Julius Loeser, Of Counsel and Sterling Sears, Associate 
Winston & Strawn LLP
35 W. Wacker Drive
Chicago, IL 60601-9703

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