On March 2 the Securities and Exchange Commission (the “SEC”) announced a proposed rule (the “Proposed Rule”) that would require “covered financial institutions,” including certain investment advisers and broker-dealers, to disclose the structure of their incentive-based compensation practices to the SEC and prohibit these entities from maintaining compensation arrangements that encourage inappropriate risks.

The Proposed Rule is part of an inter-agency parallel rulemaking project mandated by Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Some of the other agencies involved include the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the Federal Deposit Insurance Corporation. Each relevant agency will be issuing a rule that is substantially similar to the Proposed Rule. Once all of the relevant agencies approve their versions of the rule, a consolidated document will be jointly published in the Federal Register, followed by a 45-day comment period.

The details of the Proposed Rule discussed herein are taken from the FDIC version of the rule, available at http://www.fdic.gov/news/board/2011rule2.pdf.

Which Broker-Dealers and Investment Advisers are “Covered Financial Institutions”?

An entity would be a “covered financial institution” subject to the Proposed Rule if it has total consolidated assets of $1 billion or more and is either a broker-dealer registered under Section 15 of the Securities Exchange Act of 1934 (the “Exchange Act”) or an investment adviser as defined in Section 202(a)(11) of the Investment Advisers Act of 1940 (regardless of whether registered or required to be registered under that Act). For brokers or dealers, asset size would be determined by the total consolidated assets reported in the firm’s most recent year-end audited Consolidated Statement of Financial Condition filed pursuant to Rule 17a-5 under the Exchange Act. For investment advisers, asset size would be determined by the adviser’s total assets shown on the balance sheet for the adviser’s most recent fiscal year end. Importantly, for investment advisers, the $1 billion threshold is not based on assets under management absent client assets being consolidated on the adviser’s own balance sheet.

What Basic Rules Apply to Covered Financial Institutions Generally?

In general, the Proposed Rule’s requirements for covered financial institutions fall into three categories:

  1. Reporting.A covered financial institution that is a broker-dealer or investment adviser would be required to submit an annual report to the SEC that describes the structure of the institution’s incentive-based compensation arrangements for its executive officers, employees, directors and principal shareholders (“covered persons”). Individualized data is not required. The report would have to meet certain minimum requirements, including, for example, a “succinct description” of the institution’s incentive-based compensation arrangements applicable to covered persons and the institution’s compensation policies and procedures governing those incentive-based compensation arrangements. Under the Proposed Rule, “incentive-based compensation” is defined broadly to mean any variable compensation that serves as an incentive for performance.
  1. Prohibited Pay Practices:
  • A covered financial institution would be prohibited from establishing or maintaining any incentive-based compensation arrangements that encourage inappropriate risks by providing covered persons with excessive compensation or compensation that could lead to a material financial loss to the institution. Compensation would be excessive for this purpose when the amounts paid are unreasonable or disproportionate to the services performed, taking into consideration a number of factors listed in the Proposed Rule.
  • In general, all incentive-based compensation arrangements for covered persons would have to balance risk and financial rewards, be compatible with effective controls and risk management, and be supported by strong corporate governance, including oversight by the covered financial institution’s board of directors or similar governing body.
  1. Required Policies and Procedures. Any incentive-based compensation arrangement for covered persons would have to be adopted pursuant to policies and procedures developed and maintained by the covered financial institution’s board or similar governing body. The Proposed Rule contains a number of minimum standards for these policies and procedures that are intended to help ensure compliance.

What Special Rules Apply to Covered Financial Institutions with $50 Billion or More in Total Consolidated Assets?

Special rules apply to covered financial institutions with $50 billion or more in total consolidated assets. Specifically:

  1. Executive Officer Deferrals. Executive officers would be required to have at least 50% of their annual incentive-based compensation deferred for no less than three years, with the release of deferred amounts no faster than pro rata over the minimum deferral period. Deferred amounts would have to be subject to adjustment to reflect actual losses or other aspects of performance that are realized or become better known during the deferral period. “Executive officers” for this purpose would include anyone who holds the title or performs the function of one or more of the following positions: president, chief executive officer, executive chairman, chief operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer, or head of a major business line.
  1. Employees Presenting Particular Loss Exposure. The Proposed Rule would require the covered financial institution’s board to identify those covered persons (other than executive officers) who 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. The institution’s board would have to specifically approve the incentive-based compensation of these covered persons after having determined that the arrangement (and the method of paying compensation under the arrangement) effectively balances the financial rewards to the employee with the range and time horizon of risks associated with the employee’s activities.

Separately, the annual reports filed by these larger financial institutions would be required to provide additional succinct descriptions of the institution’s incentive-compensation policies specific to the covered persons and executive officers specified above.

Anti-Abuse Rule

Finally, the Proposed Rule contains an anti-abuse provision that would prohibit a covered financial institution from evading the Proposed Rule’s restrictions by indirectly doing anything that would be unlawful to do directly.