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SEC Proposes Rule That Would Require Certain Investment Advisers, Broker-Dealers and Other Financial Institutions to Disclose Incentive Compensation Arrangements to Government

March 3, 2011

On March 2, 2011, the United States Securities and Exchange Commission, on a split vote, proposed a new rule (the “Proposed Rule”) requiring the disclosure of incentive-based compensation arrangements at certain financial institutions with total assets of $1 billion or more, including broker-dealers and investment advisers registered with the SEC. 

The Proposed Rule is being implemented pursuant to Section 956 of the Dodd-Frank Act which requires the SEC to develop regulations or guidelines, jointly with “appropriate federal regulators,”1 on incentive-based compensation arrangements at “covered financial institutions.”2 Although the Proposed Rule will only apply to financial institutions with total assets of $1 billion or more, it is not yet clear how assets will be calculated for purposes of determining this $1 billion threshold. Last November, the SEC proposed revisions to Part IA of Form ADV that would require investment advisers to indicate whether they had $1 billion or more in assets.3 The proposed amendments specified that “the amount of assets would be the adviser’s total assets determined in the same manner as the amount of ‘total assets’ is determined on the adviser’s balance sheet for its most recent fiscal year end.” The SEC has yet to take further action on these proposed amendments.

In her opening remarks to the Commission, SEC Chairman Schapiro remarked that she was “interested in commenters’ views on how assets would be calculated for purposes of determining whether institutions fall within either component of the proposal…and how the proposal might affect the broad array of financial firms covered by Section 956, including broker-dealers and advisers — most particularly private fund advisers, given how they often structure their compensation.” 

The Proposed Rule is substantially similar to the rules proposed by other federal regulators having jurisdiction over “covered financial institutions” and will be published in the Federal Register once all of the federal agencies involved in the rulemaking process approve their final proposed incentive-based compensation rules. Following such publication, the public will then be given 45 days to submit comments to the SEC on the Proposed Rule. 

The Proposed Rule:

  • requires broker-dealers and investment advisers registered with the SEC that have total assets of $1 billion or more to (i) file reports annually with the SEC on any incentive-based compensation arrangements entered into by the firm and (ii) develop policies and procedures that ensure and monitor compliance with the requirements related to incentive-based compensation;
  • prohibits incentive-based compensation arrangements that encourage inappropriate risk-taking by providing excessive compensation or that could lead to material financial loss to the firm; and
  • imposes new requirements on financial institutions with $50 billion or more in assets, including deferral of incentive-based compensation of executive officers and approval of compensation for people whose job functions give them the ability to expose the firm to a substantial amount of risk.

A brief summary of each of the material elements of the Proposed Rule, as set forth in the SEC Press Release relating to the Proposed Rule, is set forth below:

Disclosures Relating to Incentive-Based Compensation Arrangements

 

Under the Proposed Rule, broker-dealers and investment advisers registered with the SEC that have total assets of $1 billion or more will be required to file an annual report with the SEC relating to the firm’s incentive-based compensation arrangements, including:

  • a narrative discussion of the components of its incentive-based compensation arrangements;
  • a brief discussion of the policies and procedures covering the firm’s incentive-based compensation arrangements; and
  • a discussion as to why the firm believes the structure of its incentive-based compensation arrangements will help prevent it from suffering a material loss or does not provide excessive compensation, fees or benefits to “covered persons.”4

Prohibitions on Encouraging Inappropriate Risks in General

The Proposed Rule will prohibit broker-dealers and investment advisers registered with the SEC that have total assets of $1 billion or more “from establishing or maintaining any incentive-based compensation arrangements that encourage inappropriate risks by providing excessive compensation, fees or benefits to ‘covered persons,’ or that could lead to material financial loss.” Accordingly, incentive-based compensation arrangements will be measured against certain standards set forth in previously enacted legislation and crafted, in part, by bank regulators in 2010.

Prohibitions for Larger Financial Institutions

The Proposed Rule would also create more specific requirements for financial institutions with more than $50 billion or more in total consolidated assets. Financial institutions that meet this threshold will be required to:

  • defer for three years at least 50% of any incentive-based compensation for executive officers and award such compensation no faster than on a pro-rata basis; and
  • adjust, or “claw-back,” any such compensation payments for losses incurred by the firm after the date on which such compensation was initially awarded.

The board of directors, or a committee thereof, will be responsible for (i) identifying additional “covered persons” and certain other designated personnel “that 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” and (ii) approving the incentive-based compensation arrangement for each such person.

Establishing Policies and Procedures Addressing Incentive-Based Compensation Arrangements

Under the Proposed Rule, a firm would not be permitted to establish or implement an incentive-based compensation arrangement unless such arrangement is adopted pursuant to policies and procedures developed and maintained to ensure and monitor compliance with the rule and is approved by the firm’s board of directors. The Proposed Rule notes the policies and procedures should be tailored to the size and complexity of the firm as well as the nature and scope of its incentive-based compensation arrangements.

We will continue to monitor this proposal as it develops.

 

Please direct any questions to any of the listed lawyers or to any other Bingham lawyer with whom you ordinarily work on related matters.

Amy Kroll, Partner, Broker-Dealer Group
amy.kroll@bingham.com, 202.373.6118

David Boch, Partner, Broker-Dealer Group
david.boch@bingham.com, 617.951.8485

L. Kevin Sheridan Jr., Partner, Investment Management
kevin.sheridan@bingham.com, 212.705.7738 

Stephen C. Tirrell, Partner, Investment Management
stephen.tirrell@bingham.com, 617.951.8833

Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area
roger.joseph@bingham.com, 617.951.8247

Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area
edwin.smith@bingham.com, 617.951.8615

Tim Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area
timothy.burke@bingham.com, 617.951.8620

Authored by: Stephen C. Tirrell

Endnotes

1The term ‘‘appropriate federal regulator’’ means the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Board of Directors of the Federal Deposit Insurance Corporation, the Director of the Office of Thrift Supervision, the National Credit Union Administration Board, the Securities and Exchange Commission, and the Federal Housing Finance Agency.
2 The term “covered financial institution” means (a) a depository institution or depository institution holding company, as such terms are defined in section 3 of the Federal Deposit Insurance Act; (b) a broker-dealer registered under section 15 of the Securities Exchange Act of 1934; (c) a credit union, as described in section 19(b)(1)(A)(iv) of the Federal Reserve Act; (d) an investment adviser, as such term is defined in section 202(a)(11) of the Investment Advisers Act of 1940; (e) the Federal National Mortgage Association; (f) the Federal Home Loan Mortgage Corporation; and (g) any other financial institution that the appropriate federal regulators, jointly, by rule, determine should be treated as a covered financial institution for purposes of Section 956.
3 See “Rules Implementing Amendments to the Investment Advisers Act of 1940,” available at http://www.sec.gov/rules/proposed/2010/ia-3110.pdf.
4Section 956 of the Dodd-Frank Act defines “covered persons” to include a covered financial institution’s executive officers, employees, directors and principal shareholders.
5The Federal Reserve, the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the Federal Deposit Insurance Corporation jointly issued “Guidance on Sound Incentive Compensation Policies,” available at http://www.federalreserve.gov/newsevents/default.htm.

Circular 230 Disclosure: Internal Revenue Service regulations provide that, for the purpose of avoiding certain penalties under the Internal Revenue Code, taxpayers may rely only on opinions of counsel that meet specific requirements set forth in the regulations, including a requirement that such opinions contain extensive factual and legal discussion and analysis. Any tax advice that may be contained herein does not constitute an opinion that meets the requirements of the regulations. Any such tax advice therefore cannot be used, and was not intended or written to be used, for the purpose of avoiding any federal tax penalties that the Internal Revenue Service may attempt to impose.

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