There is a new joint federal rule in the works for all financial institutions. This will lump together banks, credit unions, broker-dealers and investment advisers. If you have more than $1 billion in assets under management, you need to pay attention to this rule.
Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires federal regulators to
“prescribe regulations or guidelines to require each covered financial institution to disclose to the appropriate Federal regulator the structures of all incentive-based compensation arrangements offered by such covered financial institutions sufficient to determine whether the compensation structure:
(A) provides an executive officer, employee, director, or principal shareholder of the bank holding company with covered financial institution with excessive compensation, fees, or benefits; or
(B) could lead to material financial loss to the covered financial institution.”
The proposed rule is tied to the proposed method of calculation for the investment advisers and private fund managers released in November 2010. Unfortunately, the Form ADV in that proposed rule has not yet been finalized, so we don’t know exactly how that assets under management will be calculated. Assuming there are not big changes to the new Form ADV, if your fund assets plus uncalled capital commitments are in excess of $1 billion, then you are a “covered financial institution.
If you are a “covered financial institution” then you must submit a new report to the SEC. In that report you will need to describe the structure of your incentive-based compensation arrangements and whether they provide for excessive compensation or could lead to to material financial loss. This report must include the following:
- 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 covered persons
- If the covered financial institution has total consolidated assets of $50 billion or more, an additional succinct description of incentive-based compensation policies and procedures specific to the covered financial institution’s:
(i) Executive officers; and
(ii) Other covered persons who the board of directors, or a committee thereof, of the covered financial institution has identified and determined under §248.205(b)(3)(ii) of subpart C of this part individually have the ability to expose the covered financial institution to possible losses that are substantial in relation to the covered financial 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 submitted under paragraph (a) of this section; and
- The specific reasons why the covered financial institution believes the structure of its incentive-based compensation plan does not encourage inappropriate risks by the covered financial institution by providing covered persons with:
(i) Excessive compensation; or
(ii) Incentive-based compensation that could lead to a material financial loss to the covered financial institution.
“Covered person” means any executive officer, employee, director, or principal shareholder of a covered financial institution. (So, everyone.)
According to the SEC’s Office of Risk, Strategy and Financial Innovation there are about 132 broker-dealers with assets of $1billion or more and 18 with assets in excess of $50 billions. Since investment advisers do not currently report their assets so the SEC lacks hard numbers. They estimated that about 70 investment advisers meet the $1 billion asset threshold and only about 10 would be large enough to get hit by the proposed bonus retention rules. (see page 70 of the proposed draft (.pdf).)
I assume that the investment adviser counts do not take into account the thousands of hedge fund, private equity fund and real estate fund managers who will be registering with the SEC in the next few months.
The rule will not require a report on the actual compensation. But it does try to limit incentive-based compensation that is “unreasonable or disproportionate to the services performed.”
For private equity funds, this should just be a paperwork issue and not a substantive issue. Since private equity funds pay most of their performance based on the final realization of assets in the fund, there are generally few short-term incentives. Private equity fund managers get their incentive pay when their investors get paid.
Nevertheless, this rule will be a headache for registered private fund managers.
The rule has not yet been officially published by the SEC. They are waiting for the other federal regulators to formally approve the draft.
- Proposed Draft – This release was approved by the Commission on March 2, 2011, but it has not yet been
approved by all of the other agencies listed in the release. When all the agencies have taken
final action on this release, it will be published in the Federal Register and this release will be
replaced by the Federal Register version.
- SEC, in Split Vote, Backs Bonus Curbs on Brokers, Hedge Funds by Jessica Holzer in the Wall Street Journal
- Incentive Compensation Limitations and Disclosures for Private Fund Managers – prior post in Compliance Building