Financial Services Law

Take Two: Incentive-Based Payment Arrangements Rule Reappears

For a second time, federal banking regulators are seeking comment on a jointly proposed rule that would impose restrictions on incentive-based pay arrangements.

What happened

A similar proposal was released in 2011 but never acted upon. Now, the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), and the Federal Reserve Board, joined by the Securities and Exchange Commission (SEC), the Federal Housing Finance Agency (FHFA), and the National Credit Union Administration (NCUA), are moving forward with a rule to implement Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act that would apply in varying degrees to covered institutions (including banks, bank holding companies, credit unions, broker-dealers and investment advisers) with total assets of $1 billion or more.

Pursuant to the rule, covered institutions would be broken down into three categories based on assets: those with $250 billion and above in Level 1, those with $50 billion to $250 billion in Level 2, and those with $1 billion to $50 billion in Level 3.

All covered institutions would be prohibited from offering any incentive-based compensation arrangements that would "encourage inappropriate risks" by providing a "covered person" with compensation deemed "excessive" or that "could lead to material financial loss" to the covered institution.

The regulators defined "excessive" as amounts paid that are "unreasonable or disproportionate" to the value of services performed by the covered persons, consistent with the compensation standards in Section 39(c) of the Federal Deposit Insurance Act. Covered entities could satisfy the rule's prohibition on incentive-based compensation arrangements that "encourage inappropriate risks that could lead to material financial loss" by ensuring the arrangement appropriately balances risk and reward, is compatible with effective risk management and controls, and is supported by effective governance.

An incentive-based compensation arrangement would not be considered to appropriately balance risk and reward unless it considers financial and nonfinancial measures of performance, is designed to allow nonfinancial measures of performance to override financial measures of performance when appropriate, and is subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and nonfinancial performance.

Boards of directors would be required to oversee and approve incentive-based compensation programs and arrangements, and covered institutions would be required to meet recordkeeping and disclosure requirements to document the structure of the arrangements and to demonstrate compliance with the proposed rule.

Additional requirements would apply to entities that fall within Level 1 and Level 2. This includes deferral, downward adjustment, forfeiture and clawback requirements that would apply to incentive compensation arrangements of senior executive officers and "significant risk-takers" (SRTs).

Senior executive officers would include president, executive chairman, CEO, COO, CFO, chief investment officer, chief legal officer, chief lending officer, chief risk officer, chief compliance officer, chief audit executive, chief credit officer, chief accounting officer and head of any major business line or control function. An individual who is not a senior executive officer would be considered a SRT if either the individual is among the top 5% highest-paid persons for Level 1 institutions or top 2% for Level 2 institutions, or the individual has the ability to commit or expose 0.5% or more of the covered institution's equity capital. In either case, an individual would be a SRT only if at least one-third of his or her compensation is incentive-based.

The deferral provision would require at least 60% of a senior executive officer's qualifying incentive-based compensation and 50% of a SRT's qualifying compensation to be deferred for at least four years for Level 1 institutions, and at least 50% of a senior executive officer's qualifying incentive-based compensation and 40% of a SRT's to be deferred for at least three years for Level 2 institutions. Similar percentages of long-term incentive compensation for such employees would be deferred for at least two years after the end of the performance period for Level 1 institutions and at least one year for Level 2 institutions. Deferred incentive compensation could vest no faster than on a pro rata annual basis and vesting could not accelerate except on death or disability.

Level 1 and Level 2 covered institutions would be required to reduce incentive-based compensation for SRTs and senior executive officers for certain triggering events, such as poor financial performance, inappropriate risk-taking or material risk management or control failure. A "downward adjustment" would reduce compensation not yet awarded for a performance period that already had begun while "forfeiture" would reduce deferred compensation awarded but not yet vested.

The new proposal would require covered institutions in Level 1 and Level 2 to include clawback provisions in incentive compensation arrangements with senior executive officers and SRTs allowing recovery of vested incentive-based compensation if the senior executive officer or SRT engaged in misconduct that resulted in significant financial or reputational harm to the covered institution, fraud, or intentional misrepresentation of information used to determine the compensation. The institution would have seven years to recover the compensation after vesting.

The new proposal also would prohibit covered institutions in Level 1 and Level 2 from allowing hedging against incentive compensation, providing volume-driven incentive compensation, basing incentive compensation solely on peer group performance and exceeding a maximum incentive compensation limit above target.

Comments on the proposal are being accepted through July 22, 2016.

To read the proposed rule, click here.

Why it matters

If adopted—with the earliest effective date likely to be for performance periods beginning in 2019—the proposed rule would have a major impact on the compensation practices of all covered institutions with a higher level of regulation and requirement at the country's largest institutions. "This is perhaps the most important Dodd-Frank rulemaking remaining to be implemented," FDIC Chairman Martin J. Gruenberg said in a statement after the regulators approved the new rule. "Material Loss Reviews of failed institutions issued by the inspectors general for the three federal banking agencies found that, in a number of instances, poor compensation practices were a contributing factor to the institution's failure. When poor compensation practices involve the largest financial institutions, the negative impacts of inappropriate risk-taking can have broader consequences for the financial system."

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CFPB Drags Banks Into Battle Over Payday Lending

Bringing banks into the battle over payday lending, the Consumer Financial Protection Bureau (CFPB) released a report finding that online payday loans "add a steep, hidden cost" to consumers by racking up bank fees.

What happened

The Bureau has had its eye on online payday lending for a while, but its new report focuses on the role of banks in online payday loan payments. Payday lenders often use the Automated Clearing House (ACH) network to deposit loan proceeds directly into borrowers' checking accounts and then collect payment through the same system, the CFPB explained.

Problems arise when a borrower's account lacks sufficient available funds at the time a lender submits an ACH payment request, however. The depository institution has the choice to fulfill the payment request—typically resulting in an overdraft fee—or to deny the request, likely causing the borrower to be charged a non-sufficient funds (NSF) fee as well as the possibility of a late fee, a returned payment fee, or both, by the lender, according to the report.

"Taking out an online payday loan can result in collateral damage to a consumer's bank account," CFPB Director Richard Cordray said in a statement about the report. "Bank penalty fees and account closures are a significant and hidden cost to these products."

Analyzing data on consumer checking accounts obtained from several large depository institutions spanning an 18-month period in 2011 and 2012, the CFPB report found the typical overdraft and NSF fees were $34.

Accounts with one or more loans from at least one of the identified online lenders made payments totaling on average $2,164, the Bureau said, although the data did not permit the agency to distinguish which portion of the payment went to cover fees, interest, or principal. But the same accounts were charged an average of $92 in overdraft and NSF fees by their institutions on payment requests for the payday lenders, according to the report.

Half of all accounts had at least one payment request resulting in an overdraft or failure due to NSF during the observation period, with an average charge of $186 in bank penalties on attempted payment requests from online lenders. Breaking down the $186 figure, the CFPB said on average $97 of the total was charged on payment requests that were not preceded by a failed payment request, with $50 charged when lenders re-presented a payment request after a prior failure, and $39 coming when a lender submitted multiple payment requests on the same day.

During the relevant sample period, the Bureau said more than one-third of the accounts had more than one overdraft and/or failed payment request and charged a mean total of $242 in overdraft and NSF fees on attempted payment requests from lenders.

The report found that subsequent payment requests to the same consumer account are "unlikely" to succeed. The vast majority of first requests for payment are successful (with just a 6% failure rate) but 70% of re-presentments fail, the Bureau said, with subsequent re-presentments even less likely to succeed. Of the successful 94% initial payment requests, 7% succeed based on the depository institution's decision to cover the payment as an overdraft; as the number of attempts increases, so do the odds of the bank covering the payment as an overdraft.

Other findings from the report: Many online lenders submit multiple payment requests on the same day, with 34% of all payment requests occurring on the same day as another request by the same lender. Cordray noted in his remarks that in "one extreme case, we saw a lender that made 11 payment requests on an account in a single day."

The CFPB also noted an increase in account closures. "Depository-initiated account closures are markedly higher for accounts with online payday loan use than for the overall sample," according to the report, 23% compared to 6%, respectively. "Moreover, accounts with failed online loan payment requests experience much higher rates of depository-initiated account closure than accounts with only successful payments." Closures typically occurred within 90 days of the first NSF transaction, the Bureau said.

To read the CFPB's report, "Online Payday Loan Payments," click here.

Why it matters

"Of course, lenders that are owed money are entitled to get paid back," CFPB Director Richard Cordray said in a call about the report. "But we do not want lenders to be abusing their preferential access to people's accounts. Borrowers should not have to bear the unexpected burdens of being hit repeatedly with steep, hidden penalty fees that are tacked on to the costs of their existing loans. Yet today's report shows that this is just what is happening to many consumers." The Bureau expects to publish a rule on payday lending later this spring with the possibility of a cap on the number of unsuccessful attempts in succession by a lender to debit a borrower's checking or savings account. This may further increase banks' attention on payday lending, even if banks are not directly involved in payday lending activities.

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CFPB Takes Action Against Individuals Operating Lead Aggregator

In new lawsuits seeking to hold the individuals behind a company that allegedly violated the Consumer Financial Protection Act of 2010 liable, the Consumer Financial Protection Bureau (CFPB) took action against the cofounders of a lead aggregator that allegedly bought and sold consumer loan applications without properly vetting lead generators and purchasers.

What happened

D and D Marketing, Inc., d/b/a T3Leads, is a California-based company that purchased consumer loan applications from lead generators containing data such as consumers' names, telephone numbers, home and e-mail addresses, references, and employer information.

Dmitry Fomichev and Davit Gasparyan cofounded the company in 2005, serving as the chief executive officers and chief technology officer as well as the chief financial officer and chief marketing officer, respectively. Both individuals helped direct the strategy and business practices of the company from its inception through mid-2014, the CFPB said.

After the company received the applications, it sold them to purchasers, including online small-dollar lenders, data managers, data brokers and remarketing companies, payday or installment lenders, without regard to the representations made by the lead generators to consumers or how the information of consumers would be used, the CFPB alleged. Some of T3Leads' purchasers included lenders that skirted state laws or denied the jurisdiction of United States courts, the Bureau said.

T3Leads—and Fomichev and Gasparyan—violated Dodd-Frank in three ways, the CFPB alleged in its California federal court complaint. First, the company ignored the statements made about lenders to the consumers who provided their information. Lead generators often falsely claimed to match consumers with lenders that offered "reasonable" terms or met certain criteria. Despite knowledge about these misleading statements—and that consumers were trusting T3Leads' selection of lenders—the company disregarded such statements, the Bureau alleged.

Second, the company failed to vet or monitor purchasers of its leads, neglecting to require lenders to verify that they complied with state laws, the CFPB said, and exposed consumers to the possibility that their personal data could be used for illegal purposes.

Finally, the Bureau alleged that T3Leads steered consumers toward unfavorable loans. Lenders that ignore state usury limits or claim immunity from state regulation typically paid higher prices for leads than lenders who followed the law, according to the Bureau, so T3Leads was more likely to sell leads to those entities, despite being aware of their unfavorable terms and conditions.

Fomichev and Gasparyan provided "substantial assistance" to T3Leads, the Bureau alleged, and had "significant responsibility" for establishing the company's policies and practices, with "substantial control" over the company's operations. The complaints against the individual defendants seek monetary and injunctive relief, as well as penalties.

To read the complaint in CFPB v. Fomichev, click here.

To read the complaint in CFPB v. Gasparyan, click here.

Why it matters

The CFPB filed a similar suit against T3Leads last December. Director Richard Cordray called the new suit "a reminder to the middlemen who buy and sell consumer loan applications: if you engage in this type of conduct, you risk the consequences for harming people."

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Bank Fraud Statute Returns to Supreme Court

Does the federal bank fraud statute require proof of an intent to deceive a bank as well as cheat it out of some of its funds?

What happened

The U.S. Supreme Court has agreed to answer this question in Shaw v. United States.

18 U.S.C. Section 1344 provides: "Whoever knowingly executes, or attempts to execute a scheme or artifice (1) to defraud a financial institution; or (2) to obtain any of the moneys, funds, credits, assets, securities, or other property owned by, or under the custody or control of, a financial institution, by means of false or fraudulent pretenses, representations, or promises; shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both."

In 2014, the Supreme Court decided Loughrin v. United States, a case involving the second clause of the bank fraud statute. In a unanimous opinion authored by Justice Elena Kagan, the Justices held that no proof of intent to defraud the particular financial institution is required by the statute and the government must only prove that a defendant intended to obtain bank property "by means of" a false statement.

The new case involves Lawrence Shaw, who operated a scheme to take money from bank accounts belonging to Stanley Hsu, a Taiwanese businessman. Hsu opened a Bank of America account while working in the United States. When he returned to Taiwan, he arranged for the daughter of an employee to collect his mail and forward it to him. Unfortunately for Hsu, the daughter lived with Shaw, who opened Hsu's mail and learned about the bank account.

Shaw used Hsu's information to open a PayPal account that he linked to the Bank of America account. He then added other bank accounts to the PayPal account and began siphoning money from Hsu's Bank of America account into the PayPal account and then out to his own bank accounts. Shaw was able to convince the banks (using a doctored e-mail account, bank statements, and driver's license) to transfer and release over $300,000 of Hsu's money over a five-month period.

Bank of America returned approximately $130,000 to Hsu, covering the fraudulent activity that occurred within 60 days of Hsu's report. PayPal reimbursed the bank for that amount but Hsu lost over $170,000 because of his delay in notifying the banks.

The government charged Shaw with 17 counts of bank fraud in violation of Section 1344(1). At trial, Shaw requested a jury instruction that the government had to prove he not only intended to deceive the bank, but that he also intended to target the bank as a financial victim of the fraud.

A federal district court judge declined to give the requested jury instructions, ruling that the bank fraud statute did not require the bank to be an intended financial victim of the fraud. The jury convicted Shaw on 14 counts of bank fraud. He appealed.

The Ninth Circuit Court of Appeals affirmed the verdict, relying on circuit precedent that it found unaffected by the decision in Loughrin, "and indeed complements Loughrin's holding that Section 1344(1) of the statute does not require any intent to defraud the bank," the panel wrote. "Section 1344(1) does require intent to defraud the bank, but neither clause requires the bank to be the intended financial victim of the fraud."

Shaw's attempt to characterize the difference between the two clauses as involving the intended financial victim of the fraud (i.e., the bearer of the loss) did not persuade the Ninth Circuit. "The statutory language focuses on the intended victim of the deception, not the intended bearer of the loss," the court said. "Section 1344(1) requires the intent to deceive the bank. Section 1344(2) requires false or fraudulent representations to third parties," but neither clause "requires the government to establish the defendant intended the bank to suffer a financial loss."

The panel also disposed of Shaw's argument that because Bank of America did not actually suffer a loss, he could not have intended to defraud the bank. A similar argument was rejected in Loughrin with regard to the second clause of the bank fraud statute, and the Ninth Circuit elected to follow suit for the first clause.

Although the court recognized a split in the circuits on the issue of whether the risk of financial loss to the bank is an element that must be proven by the government under the bank fraud statute's first clause, the panel held fast to its position and refused "to read an additional element into Section 1344(1) that Congress did not include; that does not serve the Congressional purpose; and that could needlessly entangle judges and juries in the intricacies of banking law."

Shaw filed a petition for writ of certiorari presenting the question: "Whether [Section 1344(1)'s] 'scheme to defraud a financial institution' requires proof of a specific intent not only to deceive, but also to cheat, a bank, as nine circuits have held, and as petitioner Lawrence Shaw argued here."

The Justices granted the petition.

To read the Ninth Circuit's decision in United States v. Shaw, click here.

To read Shaw's petition for writ of certiorari, click here.

Why it matters

For the second time in three years, the U.S. Supreme Court will consider the bank fraud statute with the hopes of settling a circuit split. The Ninth Circuit is one of three federal appellate courts that only require an intent to deceive the bank. A majority of circuits, however, take the position that the government must also prove the bank was the intended financial victim of the fraud. Oral argument will be heard next term, sometime between October and June.

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