SEC Adopts Proposed Rules on Incentive-based Compensation for Large Broker-Dealers and Investment Advisors
The SEC has adopted proposed rules on incentive-based compensation applicable to broker-dealers and investment advisors that have more than $1 billion in assets. The rules are being jointly approved by, and subject to the separate approval of, the SEC and the Office of the Comptroller of the Currency, Treasury; Board of Governors of the Federal Reserve System; Federal Deposit Insurance Corporation; Office of Thrift Supervision, Treasury; National Credit Union Administration; and the Federal Housing Finance Agency.
As Broc Romanek of thecorporatecounsel.net first pointed out on Twitter, the proposed rules are stamped “draft,” presumably because they have not yet been approved by all of the regulators. To our knowledge, none of the other regulators have seen fit to send such a signal, such as the FDIC.
We were hoping that the SEC action would provide some more details on how the proposal would be implemented, such as the separate release proposed by the National Credit Union Administration. That is not the case, so important details such as how all of this will be reported to the SEC are not yet known.
We also think that with these rules, being a member of the compensation committee of a large bank, with perhaps a large broker dealer operation and maybe a large investment advisory arm, has become a full time job. It looks like duplicate rules and reporting will be applied to each separately regulated entity, and each business has its own risks inherent in its compensation programs.
Details on this one-size-fits-all regulated entities proposal follow.
Covered Broker Dealers and Investment Advisers
“Covered financial institutions” under the proposed rule include broker dealers and SEC registered investment advisers that have more than $1 billion in assets. For brokers or dealers registered with the SEC, 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 Securities Exchange Act of 1934. 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. The proposed method of calculation for investment advisers is consistent with the SEC’s recent proposal that each investment adviser filing Form ADV Part 1A indicate whether the adviser had $1 billion or more in “assets,” defined as the total assets shown on the balance sheet for the adviser’s most recent fiscal year end.
Only incentive-based compensation paid to “covered persons” would be subject to the requirements of the proposed rule. A “covered person” would be any executive officer, employee, director, or principal shareholder of a covered financial institution. No specific categories of employees are excluded from the scope of the proposed rule, although it is the underlying purpose of the rulemaking to address those incentive-based compensation arrangements for covered persons or groups of covered persons that encourage inappropriate risk because they provide excessive compensation or pose a risk of material financial loss to a covered financial institution.
Incentive-Based Compensation Arrangement
Consistent with Section 956 of the Dodd-Frank Act, the proposed rule would apply only to incentive-based compensation arrangements. The proposed rule defines “incentive-based compensation” to mean any variable compensation that serves as an incentive for performance. The definition is broad and principles-based to address the objectives of Section 956 in a manner that provides for flexibility as forms of compensation evolve. The form of payment, whether it is cash, an equity award, or other property, does not affect whether compensation meets the definition of “incentive-based compensation.”
There are types of compensation that would not fall within the scope of this definition. Generally, compensation that is awarded solely for, and the payment of which is solely tied to, continued employment (e.g., salary) would not be considered incentive-based compensation. Similarly, a compensation arrangement that provides rewards solely for activities or behaviors that do not involve risk-taking (for example, payments solely for achieving or maintaining a professional certification or higher level of educational achievement) would not be considered incentive-based compensation under the proposal. In addition, the proposing agencies do not envision that this definition would include compensation arrangements that are determined based solely on the employee’s level of fixed compensation and do not vary based on one or more performance metrics (e.g., employer contributions to a 401(k) retirement savings plan computed based on a fixed percentage of an employee’s salary). The proposed definition also would not include dividends paid and appreciation realized on stock or other equity instruments that are owned outright by a covered person. However, stock or other equity instruments awarded to a covered employee under a contract, arrangement, plan or benefit would not be considered owned outright while subject to any vesting or deferral arrangement (irrespective of whether such deferral is mandatory).
Reporting of Incentive Based Compensation
Section 956(a)(1) of the Dodd-Frank Act requires that a covered financial institution submit an annual report to its appropriate Federal regulator disclosing the structure of its incentive-based compensation arrangements that is sufficient to determine whether the incentive-based compensation structure provides covered employees with excessive compensation, fees, or benefits, or could lead to material financial loss to the covered financial institution. In order to fulfill this requirement, the proposed rule would establish the general rule that a covered financial institution must submit a report annually to its appropriate regulator or supervisor in a format specified by its appropriate Federal regulator that describes the structure of the covered financial institution’s incentive-based compensation arrangements for covered persons. The report must contain:
- A clear narrative description of the components of the covered financial institution’s incentive-based compensation arrangements applicable to covered persons and specifying the types of covered persons to which they apply;
- A succinct description of the covered financial institution’s policies and procedures governing its incentive-based compensation arrangements;
- For larger covered financial institutions, a succinct description of any specific incentive compensation policies and procedures for the institution’s executive officers, and other covered persons who the board or a committee thereof determines under the proposed rule 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;
- Any material changes to the covered financial institution’s incentive-based compensation arrangements and policies and procedures made since the covered financial institution’s last report was submitted; and
- The specific reasons the covered financial institution believes the structure of its incentive-based compensation plan does not provide covered persons incentives to engage in behavior that is likely to cause the covered financial institution to suffer a material financial loss and does not provide covered persons with excessive compensation.
The proposed rule would implement Section 956(b) of the Dodd-Frank Act by prohibiting a covered financial institution from having incentive-based compensation arrangements that may encourage inappropriate risks (i) by providing excessive compensation or (ii) that could lead to a material financial loss. The proposed rule would establish a general rule that a covered financial institution may not establish or maintain any incentive-based compensation arrangement, or any feature of any such arrangement, that encourages a covered person to expose the institution to inappropriate risks by providing that person with excessive compensation. Specifically, under the proposed rule, compensation for a covered person would be considered excessive when amounts paid are unreasonable or disproportionate to, among other things, the amount, nature, quality, and scope of services performed by the covered person. In making such a determination, the proposing agencies will consider:
- 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 covered financial institution;
- The financial condition of the covered financial institution;
- Comparable compensation practices at comparable institutions, based upon 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 covered financial institution;
- 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; and
- Any other factors the regulating agency determines to be relevant.
Section 956(b)(2) of the Dodd-Frank Act requires the proposing agencies to adopt regulations or guidelines that prohibit a covered financial institution from establishing or maintaining any incentive-based compensation arrangement, or any feature of such an arrangement, that encourages a covered person to expose the institution to inappropriate risks that could lead to a material financial loss at the covered financial institution.
This prohibition will apply only to those incentive-based compensation arrangements for individual covered persons, or groups of covered persons, whose activities may expose the covered financial institution to a material financial loss. Such covered persons include:
- Executive officers and other covered persons who are responsible for oversight of the covered financial institution’s firm-wide activities or material business lines;
- Other individual covered persons, including non-executive employees, whose activities may expose the covered financial institution to a material financial loss (e.g., traders with large position limits relative to the covered financial institution’s overall risk tolerance); and
- Groups of covered persons who are subject to the same or similar incentive-based compensation arrangements and who, in the aggregate, could expose the covered financial institution to a material financial loss, even if no individual covered person in the group could expose the covered financial institution to a material financial loss (e.g., loan officers who, as a group, originate loans that account for a material amount of the covered financial institution’s credit risk).
Larger Covered Financial Institutions
Deferral Arrangements Required for Executive Officers.
The proposed rule would establish a deferral requirement for larger covered financial institutions (i.e., generally those with $50 billion or more in total consolidated assets). At these covered financial institutions, at least 50 percent of the incentive-based compensation of an “executive officer” (as previously defined), would have to be deferred over a period of at least three years. The proposed rule also requires that deferred amounts paid be adjusted for actual losses or other measures or aspects or performance that are realized or become better known during the deferral period.
If a covered financial institution is required to use deferral, the proposed rule provides some flexibility in administering its specific deferral program. A covered financial institution may decide to release (or allow vesting of) the full deferred amount in a lump-sum only at the conclusion of the deferral period; alternatively, the institution may release the deferred amounts (or allow vesting) in equal increments, pro rata, for each year of the deferral period.
Special Review and Approval Requirement for Other Designated Individuals
Other individuals at a larger covered financial institution, beyond the institution’s executive officers, may 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. In order to help ensure that the incentive compensation arrangements for these individuals are appropriately balanced, and do not encourage the individual to expose the institution to risks that could pose a risk of material financial loss to the covered financial institution, the proposed rule would require that, at a larger covered financial institution, the board of directors, or a committee thereof, identify those covered persons (other than executive officers) that 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. The proposal notes that these covered persons may include, for example, traders with large position limits relative to the institution’s overall risk tolerance and other individuals that have the authority to place at risk a substantial part of the capital of the covered financial institution. In addition, the proposed rule would require that the board of directors, or a committee thereof, of the institution approve the incentive-based compensation arrangement for such individuals, and maintain documentation of such approval.
Under the proposal, the board (or committee) of a larger covered financial institution may not approve the incentive-based compensation arrangement for an individual identified by the board (or committee) unless the board (or committee) determines that the arrangement, including the method of paying compensation under the arrangement, effectively balances the financial rewards to the employee and the range and time horizon of risks associated with the employee’s activities.
Policies and Procedures
The proposing agencies believe that the incentive-based compensation practices of covered financial institutions should be supported by policies and procedures, appropriate to the size and complexity of the covered financial institution, to foster transparency of each covered financial institution’s incentive-based compensation practices and to promote compliance and accountability regarding the practices that the agencies propose to prohibit. Accordingly, the proposed rule would require covered financial institutions to have policies and procedures governing the award of incentive-based compensation as a way to help ensure the full implementation of the prohibitions in the proposed rule.
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Contact Steve Quinlivan for more information.