On March 2, 2011, the SEC proposed a rule that would require SEC-regulated brokers, dealers and investment advisers with $1 billion or more in assets to disclose the structure of their incentive-based compensation practices so regulators can determine whether such compensation is excessive or could lead to material financial loss to the firm and would prohibit those institutions from maintaining any type of incentive-based compensation arrangements that regulators determine encourage inappropriate risks by providing excessive compensation or that could lead to material financial loss to the institution.

The proposed rule contains the following three elements:

  • Disclosures About Incentive-Based Compensation Arrangements. A covered financial institution would be required to file annually with the appropriate federal regulators, a report describing the institution's incentive-based compensation arrangements, including a narrative description of their components, a succinct description of the institution's policies and procedures governing such arrangements and a statement of specific reasons as to why the institution believes the structure of such arrangements will help prevent it from suffering a material financial loss or does not provide covered persons with excessive compensation.
  • Prohibition on Encouraging Inappropriate Risk. A covered financial institution would be prohibited from establishing or maintaining an incentive-based compensation arrangement that encourages inappropriate risks by providing covered persons – executive officers, employees, directors or principal shareholders –with excessive compensation or that can lead to material financial loss. The proposal states that incentive-based compensation arrangements would be deemed to encourage inappropriate risks unless the incentive-based compensation arrangement meets certain standards. In assessing these arrangements, regulators will consider, among other things, the combined value of all benefits provided to the covered person; compensation history of the covered person and other individuals with comparable expertise; the financial condition of the institution; for post-employment benefits, the projected total cost and benefit to the financial institution; and any connection between the individual and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the covered financial institution.

The proposed rule lays out more specific requirements for executive officers and certain other designated individuals at financial institutions with $50 billion or more in total consolidated assets, requiring these firms to defer for three years, at least 50% of any incentive-based compensation for executive officers and award the compensation no faster than on a pro-rata basis. Any incentive-based compensation payments must be adjusted for losses incurred by the covered financial institution after the compensation was initially awarded. This proposed rule will also apply to other employees that may have the ability to impact the risk profile of the financial institution and that may expose the institution to risk of significant loss. Under the proposed rule, the board of directors or a committee of the board of directors would be charged with identifying the covered persons, other than executive officers, who individually have the ability to expose the firm to possible losses that are substantial in relation to the institution's size, capital or overall risk tolerance. This could include for example, a trader with large position limits relative to the institution's overall risk tolerance. Once the board indentifies such covered person, the board or the committee would need to approve the incentive-based compensation arrangement for each such person.

  • Policies and Procedures. A covered financial institution would be barred from establishing an incentive-based compensation arrangement unless the arrangement has been adopted under policies and procedures developed and maintained by the institution and approved by its board. The proposed rule recognizes the diversity of the institutions covered by the rule and explicitly states that the policies and procedures should be commensurate with the size and complexity of the organization as well as the scope and nature of its use of its incentive-based compensation.

The SEC will be working with the Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, the Federal Housing Finance Agency and the National Credit Union Administration to jointly write the rules or guidelines. The proposed rules will be substantially similar from agency to agency, but are expected to contain technical differences to account for the different entities that the various agencies regulate. Although the SEC has approved the proposed rule release, each agency must individually review and approve the proposed rule for public comment before the proposal is published in the Federal Register. Once published in the Federal Register, the public will be given 45 days to comment.