Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the Securities and Exchange Commission (“SEC”), the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and a number of other government agencies (collectively, “Agencies”) to jointly issue regulations or guidelines (1) prohibiting incentive-based payment arrangements that the Agencies determine encourage inappropriate risks by certain financial institutions by providing excessive compensation or that could lead to material financial loss, and (2) requiring those financial institutions to disclose information concerning incentive-based compensation arrangements to the appropriate federal regulator.
SEC Releases Proposed Rule
The SEC recently released a proposed rule (“Proposed Rule”) with respect to the implementation of incentive-based compensation arrangements for certain “covered financial institutions” (“CFIs”). The Proposed Rule, if adopted, will replace a rule proposed in April 2011 and follows the release of a substantially similar rule by a number of the other Agencies.
Applicability of the Proposed Rule
The Proposed Rule would apply to any CFI, including investment advisers (both registered and unregistered), with average total consolidated assets greater than or equal to $1 billion that offers incentive-based compensation to covered persons. The Proposed Rule defines “covered person” as any executive officer, employee, director or principal shareholder who receives incentive-based compensation at a CFI. The Proposed Rule identifies three categories of CFIs based on average total consolidated assets: (1) Level 1 (greater than or equal to $250 billion); (2) Level 2 (greater than or equal to $50 billion and less than $250 billion); and (3) Level 3 (greater than or equal to $1 billion and less than $50 billion). It is likely that most investment advisers that would be subject to the Proposed Rule would fall into Level 3. Advisers should note, however, that the Proposed Rules allow the Agencies to treat a Level 3 CFI as a Level 1 or Level 2 CFI with respect to some or all of the rules in the event that the Level 3 CFI has at least $10 billion in average total consolidated assets and it is determined that the CFI’s complexity of operations or compensation practices are consistent with those of a Level 1 or Level 2 covered institution, based on the CFI’s activities, complexity of operations, risk profile or compensation practices.
Average total consolidated assets for an investment adviser would be determined by the adviser’s total assets shown on its balance sheet for the entity’s most recent fiscal year end, exclusive of nonproprietary assets (which would include client assets under management, even if such amounts were included on the adviser’s balance sheet). It is currently unclear if assets attributable to employee co-investment vehicles would be excluded from the calculation; however, it would seem reasonable to do so. The Proposed Rule provides that the SEC could, based on the relevant facts and circumstances, combine as a single investment adviser two or more affiliated investment advisers that are separate legal entities but that are operationally integrated. Depending on the circumstances, this would likely result in the consolidation of the assets of an investment adviser with the assets of certain of its affiliated general partner entities (general partner entities often have accrued incentive compensation on their balance sheets which, if required to be included by an investment adviser when calculating its average total consolidated assets, could result in the investment adviser's exceeding the $1 billion threshold).
Requirements for All CFIs
Under the Proposed Rule, all CFIs are prohibited from establishing or maintaining incentive-based compensation arrangements (1) that encourage inappropriate risk by providing covered persons with excessive compensation, fees or benefits, or (2) that could lead to material financial loss to the CFI.
The Proposed Rule provides that compensation, fees and benefits would be considered excessive where amounts paid are unreasonable or disproportionate to the value of the services performed by a covered person. All relevant factors would be taken into consideration in determining if the amounts are excessive, including, without limitation, the combined value of all compensation, fees or benefits provided to a covered person; the compensation history of the covered person and other individuals with comparable expertise at the CFI; compensation practices at comparable CFIs; the financial condition of the CFI 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 CFI.
Encouraging Inappropriate Risks
The Proposed Rule provides that the incentive-based compensation arrangement would be considered to encourage inappropriate risks that could lead to material financial loss to the CFI unless the arrangement appropriately balanced risk and reward, were compatible with effective risk management and controls, and were supported by effective governance. A compensation arrangement would not be considered to appropriately balance risk and reward unless (1) it included financial and nonfinancial measures of the covered person’s performance; (2) were designed in such a manner that it would allow, where appropriate, nonfinancial measures of performance to override financial measures of performance; and (3) amounts awarded were subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and nonfinancial performance.
Approval of Board of Directors
Under the Proposed Rule, the board of directors (or a committee thereof) of a CFI would be required to conduct oversight of the CFI’s incentive-based compensation program; approve incentive-based compensation arrangements for senior executive officers, including amounts of awards and, at the time of vesting, payouts under such arrangements; and approve material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers.
Under the Proposed Rule, CFIs would be required to create and maintain records documenting the structure of incentive-based compensation arrangements. The records, which must be provided to the applicable Agency upon request, must be maintained for at least seven years. The Proposed Rule would require that the records include, at a minimum, copies of all incentive-based compensation plans, a list 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.
Additional Requirements for Level 1 and Level 2 Entities
The Proposed Rule includes more detailed disclosure and record-keeping requirements for Level 1 and Level 2 entities and would require that incentive-based compensation arrangements for certain covered persons at such entities include deferral of incentive-based compensation, risk of downward adjustment and forfeiture of any incentive-based compensation, and the establishment of clawback provisions in incentive-based compensation arrangements to appropriately balance risk and reward.
Comments to the Proposed Rule must be received by July 22, 2016.
The compliance date of the Proposed Rule would be no later than the first day of the first calendar quarter that begins at least 540 days after a final rule is published in the Federal Register. Incentive-based compensation arrangements with a performance period that begins prior to the compliance date will not be subject to the Proposed Rule.