After a four-year hiatus, some of the more controversial elements of the executive compensation rules mandated by the U.S. Dodd-Frank Act1 are back on the table. This article explores these elements – principally in the context of the investment management industry – and looks to the equivalent rules in Europe for an indication of what might be expected of the final proposals.


Dodd-Frank was a response to the recent global recession, in much the same way that AIFMD2 was in Europe. However, Dodd-Frank is broader in its reach, and affects not only the investment management industry but also the financial sector more generally. Nevertheless, both statutory frameworks are ultimately geared towards the same goal: the implementation of harmonised, sound and effective risk management practices throughout the market.

One element of such risk management practices relates to the compensation of not only the heads and executives of large or listed financial institutions, but also individuals who otherwise perform functions on behalf of market participants that could create or harbour systemic risk – an area that was largely (albeit not entirely) unregulated previously3.

Many elements of the U.S. Rules are already in force (e.g., “say-on-pay” and provisions relating to compensation committees). Others are being introduced piecemeal, in close consultation with industry. The U.S. Rules relating to incentive-based compensation were last proposed in March 2011 (2011 Proposals), but progress stalled after encountering considerable resistance from the financial services industry.

Following recent shareholder activism and renewed political interest (including meetings at the White House), the Federal Reserve announced earlier this year that the U.S. financial regulators (collectively, U.S. Regulators)4 were planning to revisit the issue of incentive-based compensation, although it did not give any specific timeline for the revised proposals. It has been reported that these inter-regulator discussions are now underway.

Although very little has been officially disclosed, based upon the Federal Reserve’s own announcement (as well as sources reportedly close to the negotiations), it appears that current proposals are unlikely to be scaled-back much (if at all) from the 2011 Proposals and may even be enhanced. Parallels can certainly be drawn with the EU Rules and their evolution from draft to final stage, wherein certain concepts were unexpectedly introduced or expanded in spite of industry opposition (e.g., extension of the EU Rules to delegates of in-scope managers).

The bottom line is that change appears to be on its way in the United States and is very likely to affect a large portion of the fund management (and broader financial services) sector – potentially opening up well-established compensation practices to scrutiny by the SEC and other U.S. Regulators.

To Whom and to What do the U.S. Rules Apply?


The U.S. Rules generally apply to a broad range of financial institutions (including most banks, credit unions, broker-dealers, investment companies and investment advisers) as well as, in some cases, non-financial public companies.

The provisions relating specifically to incentive-based compensation are designed to be narrower in scope (covering a slightly shorter list of financial institutions than other elements of the U.S. Rules and implicitly excluding non-financial institutions entirely). However, there is a potentially far-reaching catch-all that enables the U.S. Regulators to impose the compensation (and other) rules in respect of “any other financial institution” they determine should be covered. In any event, most investment advisers are likely to be caught – although there is a general exemption for entities with “total consolidated assets” of less than $1 billion.5


The incentive-based compensation rules apply in respect of any “executive officer, employee, director, or principal shareholder” of a covered financial institution.

Although the U.S. Regulators have proposed criteria for identifying who is an executive officer, director or a principal shareholder6, no definition has been proposed (or is expected) for “employee”. The idea here is that covered institutions should observe and apply the general principles subjectively, bearing in mind that the underlying purpose of the provisions is to address those compensation arrangements that could incentivise inappropriate risk-taking (either because they offer excessive levels of compensation or pose a risk of material financial loss to the firm).

The likely consequence of all of the above is a qualitative test for identifying covered persons – to capture not only all senior personnel, but also any attempts to re-categorise staff (whether by way of change of title or by converting their status to that of an independent contractor).


“Compensation” has been defined in the U.S. Rules as any variable payment or benefit (whether direct or indirect), regardless of the form in which it is paid7. However, certain types of compensation are expressly excluded, namely:

  • basic salary (and similar non-variable payments or benefits tied solely to continued employment);
  • benefits received solely in respect of activities that do not involve risk-taking (e.g., payments for achieving a professional certification or higher level of educational achievement);
  • benefits linked solely to a covered person’s level of fixed compensation and that do not vary based upon performance metrics (e.g., fixed percentage employer contributions into a 401(k) retirement plan or similar); and
  • dividends received or capital appreciation realised on stock or other equity instruments that a covered person owns outright (i.e., not subject to any vesting or deferral conditions).

It is not clear at present how these principles will be applied in the context of investment advisers established as LLPs or LLCs – as was initially the case in the EU, it currently is unclear whether or not fixed drawings by partners or residual (non-variable) profit shares would fall within scope or be considered excluded items.

In any event, these parameters are unlikely to be narrowed much in the final U.S. Rules, which means that most performance-related bonuses (whether paid in cash, in specie or by way of options), carried interest and similar employee profit participation arrangements are likely to be caught by the U.S. Rules.

What are the Requirements of the U.S. Rules?

Section 956 of Dodd-Frank mandates (i) the prohibition of incentive-based compensation arrangements that are either “excessive” or that “could lead to material financial loss” to the relevant institution; and (ii) disclosure of all incentive-based compensation arrangements by covered financial institutions to their governing regulator.

The 2011 Proposals fleshed out these principles as set forth below.

Excessive Compensation

Incentive-based compensation arrangements would be considered excessive where the amounts paid are unreasonable or disproportionate to, among other things, the amount, nature, quality and scope of services performed by the covered person.

In assessing compensation arrangements, the U.S. Regulators will consider the following factors:

  • the combined value of all cash and non-cash benefits provided to the covered person;
  • the compensation history of the covered person and other individuals with comparable expertise at the institution;
  • the financial condition of the institution;
  • compensation practices at comparable institutions (based on such factors as asset size, geographic location and the complexity of the institution’s operations and assets);
  • for post-employment benefits, the projected total cost and benefit to the institution;
  • 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 institution; and
  • any other factors the U.S. Regulators determine to be relevant.

Material Financial Loss

While the 2011 Proposals did not define “material financial loss”, they did specify a sub-set of covered persons in respect of whom material financial loss would be assumed to be a risk, namely:

  • executive officers and other covered persons responsible for oversight of an institution’s firm-wide activities or material business lines;
  • other covered persons whose activities may expose an institution to material financial loss (e.g., traders with large positions relative to that institution’s overall risk-tolerance levels); and
  • groups of covered persons who are subject to the same or similar incentive-based compensation arrangements and who could together expose an institution to material loss (e.g., loan origination professionals who together account for a material portion of that institution’s credit risk).

The 2011 Proposals went on to indicate that the above assumptions may be rebutted in respect of individual persons where it could be demonstrated that the following three conditions are met in respect of their compensation arrangements: (i) there is a balance between risk and financial results (e.g., compensation is subject to deferral, risk adjustment or long-term performance periods); (ii) compatibility with effective controls and risk management; and (iii) strong support of corporate governance.


Each covered financial institution would have to submit an annual report (within 90 days of the end of its fiscal year) to its applicable U.S. Regulator, disclosing the structure of its incentive-based compensation arrangements in a manner sufficient to allow that U.S. Regulator to determine whether the arrangements provide covered persons with excessive compensation or could lead to material financial loss. The report would likely need to contain:

  • a clear narrative description of the components of the institution’s incentive-based compensation arrangements applicable to covered persons;
  • a succinct description of the institution’s policies and procedures governing its incentive-based compensation arrangements for covered persons;
  • any material changes to the institution’s incentive-based compensation arrangements and policies and procedures made since the institution’s last report was submitted;
  • the specific reasons why the institution believes that the structure of its incentive-based compensation plan does not encourage inappropriate risks by the institution; and
  • for larger covered financial institutions (as described below), a succinct description of any specific incentive compensation policies and procedures for the institution’s executive officers and other covered persons whom the board or a board committee determines individually have the ability to expose the institution to possible losses that are substantial in relation to the institution’s size, capital or overall risk tolerance.

Policies and Procedures

To supplement the above prohibitions and reporting requirements, the 2011 Proposals also required covered financial institutions to adopt and maintain policies and procedures that, at a minimum:

  • ensure that risk management, risk oversight and internal control personnel are appropriately involved in designing incentive-based compensation arrangements and in assessing their effectiveness in restraining inappropriate risk-taking;
  • provide for the independent monitoring of incentive-based compensation awards and payments, risks taken and actual risk outcomes with a view to determining whether compensation payments are appropriately reduced to reflect such outcomes or risks taken (as applicable);
  • require that the firm’s governing body receives sufficient data and analysis to enable it to assess whether or not the overall design and performance of the firm’s incentive-based compensation arrangements are consistent with the Section 956 principles;
  • maintain proper documentation (including written compensation policies, names and titles of individuals covered, records of incentive-based payments made and details of persons involved in the approval and monitoring of awards) relating to the establishment, implementation, modification and monitoring of incentive-based compensation arrangements, to enable the applicable U.S. Regulator to determine compliance with Section 956; and
  • if applicable, provide details relating to the deferral of payments (including details of the persons covered by such policies, the risks associated with their functions and provisions for performance-related adjustments) to the applicable U.S. Regulator.

However, the 2011 Proposals went beyond simply defining and supplementing the concepts set out in Section 956. The U.S. Regulators sought to impose two additional requirements (described below) in respect of “larger covered financial institutions” (i.e., those with total consolidated assets of at least $50 billion).

Deferral of Executive Officer Compensation

The most controversial element of these additional requirements was the obligation that such larger covered financial institutions defer at least 50% of the incentive-based compensation payable to an executive officer over a period of at least three years. Furthermore, any such deferred amount would be subject to adjustment in light of actual losses suffered by the institution or other aspects of performance that are realised or become known during the deferral period.

Review and Approval of Certain Non-Executive Compensation

Furthermore, the governing body of a larger covered financial institution would be required to identify those non-executive covered persons who individually have the potential to expose it to losses that are substantial in relation to its size, capital and overall risk tolerance levels and to review and approve each such individual’s incentive-based compensation, ensuring that such arrangements (including the method of payment) effectively balances the reward with the range and time horizon of risks associated with such individual’s activities. Such balancing methods would extend to reducing incentives for inappropriate risk taking.

What is Expected of the Current Proposals?

It was reported that the additional requirements in respect of larger covered financial institutions proved to be the ultimate stumbling block for the 2011 Proposals; the other elements were received with comparatively little resistance.

Consequently, it would be safe to assume that the pending proposals are likely to mirror the 2011 Proposals in scope, defining what is excessive or material loss-risking compensation, specifying reporting requirements and necessitating specific internal policies to ensure ongoing compliance.

However, somewhat surprisingly, it is being reported by sources close to the current discussions that, far from being deterred by their previous lack of success, the U.S. Regulators are not only keeping deferred compensation and related elements firmly on the table but are looking to introduce additional elements that could prove even more controversial. Indeed, as part of its announcement earlier this year, the Federal Reserve hinted that the U.S. Regulators would also be considering triggers for forfeiture and clawback of performance-based awards – concepts that were not proposed previously. However, it was indicated that such sanctions would be reserved for the most serious of cases (i.e., instances where there had been a material risk management error, or in the event of fraud or malfeasance).

Although the industry’s reaction to this has been (understandably) unenthusiastic, it is worth mentioning that even the most controversial elements of the proposals are not novel in the market. Whether or not intentional, the U.S. Regulators’ proposals appear to be increasingly drawing inspiration from the EU Rules. Therefore, pending a release of updated proposals, looking to the equivalent provisions in the EU Rules could prove a helpful indication of the eventual final U.S. Rules.

Looking to Europe

The EU Rules on incentive-based compensation adopt a principles-based approach and rely on domestic regulators, as well as the firms themselves, to determine how these rules are best applied in specific cases. The principles cover a range of topics, including: assessing performance in a multi-year framework, and by reference to a combination of financial and non-financial criteria; prohibiting guaranteed variable remuneration (save in exceptional circumstances, such as the first year of service for a new hire); avoiding severance payments that reward failure; and avoiding conflicts of interest.

Two of the most relevant principles – which provide an interesting comparison with the U.S. Rules in an investment management industry context – call for:

  • deferral of at least 40% of any variable compensation (or 60% where overall remuneration is particularly high) for a minimum period of three to five years; and
  • adjustment of variable remuneration to account for negative financial performance of the investment manager or the funds it manages.

It is worth noting that the principle of deferral is effectively on a par with the equivalent element of the 2011 Proposals, and potentially mandates an even longer timeline than the one that proved so controversial in the United States. However – unlike in the United States – the above-mentioned power to adjust is understood to cover forfeiture and clawback of awards where appropriate.

Assuming that the U.S. Regulators are unlikely to settle for standards that are materially more lenient than those imposed in other jurisdictions, it may well be that the deferral and adjustment provisions in the final U.S. Rules are not much watered-down from those proposed in 2011 – especially since the proposed rules were subject to a relatively generous minimum size threshold (which is not explicitly contained in the EU Rules8).

Incidentally, two additional principles of the EU Rules that do not appear to have made their way into U.S. proposals (but if they were, could prove to be just as controversial as the deferral and clawback elements) are the requirements that:

  • covered firms establish a remuneration committee – to oversee, assess and approve incentive-based compensation arrangements; and
  • at least 50% of total remuneration (whether immediately payable or deferred) take the form of fund units, subject to appropriate retention policies.

Although this appears to go beyond what is proposed in the United States, it is not entirely unfeasible that such requirements could be quietly imposed under the banner of policies and procedures to be implemented by covered institutions. For example, the latest U.S. proposals call for a firm’s governing body (or committee thereof) to assess the design and performance of incentive-based compensation arrangements as compared with Section 956 principles – this is not a far cry from needing to establish a remuneration committee.

However, one of the key principles that applies to the EU Rules – but does not have a clear equivalent in the U.S. Rules – is the concept of proportionality. In encouraging firms and domestic regulators to assess the applicability of relevant principles, the EU Rules provide that the manner and extent of compliance need only be appropriate to a firm’s size and internal organisation, as well as the nature, scope and complexity of its activities. The EU Rules permit a number of the remuneration principles (i.e., deferral, forfeiture/clawback, payments-in-kind, remuneration committee9) to be disapplied entirely – provided this is consistent with the risk profile and strategy of the manager and the funds it manages, and that the manager is able to justify such disapplication. As a result, while the EU Rules do not generally provide any size-based exemptions, in practice the manner in which these rules are applied and enforced is expected to be relatively less burdensome for smaller firms.

It might perhaps be hoped that a similar approach be taken in the final U.S. Rules. Indeed, a concept similar to proportionality was suggested in the 2011 Proposals, which indicated that the policies and procedures to be adopted by covered institutions should be “appropriately tailored to balance risk and reward for an institution of its size, complexity, and business activity, as well as the scope and nature of the covered financial institution’s incentive-based compensation arrangements”. This is uncannily similar to the language in the EU Rules, which may be a good sign.

It is worth noting one additional aspect of the EU Rules – arguably the most controversial – that pertains to the application of these rules to delegates of covered firms. The EU Rules are drafted on a “look through” basis and apply not only to the investment manager but also to any person(s) to whom portfolio or risk management responsibilities are outsourced or delegated10, which arguably goes further than intended by the U.S. Rules. In-scope EU firms are required to ensure either that their delegates are subject to remuneration rules that are “equally as effective” as the EU Rules, or (by contractual arrangement) that the EU Rules are not circumvented by such delegation.

Likely Impact of the U.S. Rules on the Investment Management Industry

In the first instance, some comfort may be taken from the fact that the minimum size thresholds currently on the table for the U.S. Rules are relatively generous, especially as they are presently drafted by reference to firms’ balance sheets (rather than AUM) – this may well provide an effective safe harbour for the vast majority of investment advisers (whose own balance sheets tend to be relatively asset-light).

Separately, it may well be the case that the U.S. Regulators take a relatively sensible approach to the practical application of some of the more stringent elements of the rules. The U.S. Regulators might, for example, follow the lead of the UK Financial Conduct Authority which, recognising that the payment-in-kind principles of the EU Rules would be impractical to apply for certain types of funds (e.g., closed-end funds, funds with high minimum investment thresholds, and private/unregulated funds ineligible for ownership by staff), determined that this principle could be disapplied in such cases.

Finally, the introduction of clawback requirements is unlikely to be revolutionary in the context of investment adviser remuneration structures. Clawback provisions are already a common feature of most carried interest and similar performance-based compensation arrangements, and are typically triggered following a reassessment of long-term fund performance at specific milestones in a fund’s life. Given that recipients have been conditioned to return awards in such circumstances (i.e., where the recipient is not necessarily at fault), requiring that awards be returned where an individual has committed some form of violation may not be a difficult pill to swallow.

Ultimately, if the European model is anything to go by, implementation of the U.S. Rules is unlikely to be as tumultuous to the fund management industry as some might fear.