Incentive Compensation Limitations and Disclosures for Private Fund Managers

At the Wednesday March 2 Open Meeting, the Securities and Exchange Commission voted to approve a new rule that would affect incentive compensation paid to employees of investment advisers and broker-dealers. Commissioners Casey and Paredes voted against proposing the rule as drafted. The other three voted to move the proposed rule into the comment period.

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.”

A “covered financial institution” includes investment advisers (as defined under section 202(a)(11) of the Investment Advisers Act), a broker-dealer registered under section 15 of the Securities Exchange Act of 1934, as well as banks, credit unions, FNMA, FHLMC and others designated by regulators, with assets of $1 billion of more.

If you are a private fund manager and have assets of $1 billion or more under management, then this rule would affect you. As drafted the rule applies if you are an investment adviser, regardless of whether you are registered with the SEC as an investment adviser.

Some real estate fund managers are still looking for exemptions for registering with the SEC or registering with the state based on the securities calculation, or by taking the position that they are not a “private fund” under the SEC’s definition. The choice of registration would not affect the applicability of this proposed rule.

This is a joint rulemaking so there needs to be some consistency across financial institutions. A draft of the proposal was published by the FDIC (pdf).

Only incentive-based compensation paid to “covered persons” would be subject to the requirements of this Proposed Rule. A “covered person” would be any executive officer, employee, director, or principal shareholder of a covered financial institution.

The proposed rule defines “incentive-based compensation” to mean any variable compensation that serves as an incentive for performance. It excludes fixed salary.

The first requirement is that a covered financial institution must submit an annual report “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.” The report must contain:

(1) 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;

(2) A succinct description of the covered financial institution’s policies and procedures governing its incentive-based compensation arrangements;

(3) 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 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;

(4) 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

(5) 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.

Under the SEC proposal, there would be a mandatory deferral of incentive compensation for employees of large financial institutions (over $50 billion). At least 50% of the incentive compensation must be paid over three years. It sounded like this deferral requirement was the point most disliked by the two dissenting commissioners.

This is a fairly ugly rule for private equity funds and real estate funds. Incentive compensation is usually paid upon the realization of the assets.

Under Dodd-Frank, the rule is required to be in place 9 months after enactment. That would mean an April 21, 2011 deadline.

Greater Boston Real Estate CCO Forum

Are you running a real estate fund and wondering what do about registering with the Securities and Exchange Commission? Are you near Boston?

If your answers are yes and yes, join a group of CCOs who are getting together on an informal basis to discuss the issues. Our next meeting is Thursday, March 3 at noon in downtown Boston.

Send a message to me at [email protected] and I will give you more information.

Is Madoff a Sociopath?

The New York magazine interview with Bernie Madoff has finally been published.  Steve Fishman spoke with Madoff on the phone (collect calls from Madoff’s prison) for several hours.

And so, sitting alone with his therapist, in the prison khakis he irons himself, he seeks reassurance. “Everybody on the outside kept claiming I was a sociopath,” Madoff told her one day. “I asked her, ‘Am I a sociopath?’ ” He waited expectantly, his eyelids squeezing open and shut, that famous tic. “She said, ‘You’re absolutely not a sociopath. You have morals. You have remorse.’ ” Madoff paused as he related this. His voice settled. He said to me, “I am a good person.”

There aren’t many who would agree.

According the the interview, Madoff was already a wealthy man before he starting stealing from his clients and lying about their investments.

In the early days, Madoff mostly employed technical and fairly low-risk arbitrage techniques built around his market-making business. “I always had a good feel for the direction of the market because of the order flow I was seeing,” he said. In the eighties, he said, he produced consistent returns of 15 to 20 percent, and he insists he did it legally.

To me it sounds a bit like he was taking advantage of his trading business to help out his investment advisory business. Madoff had long been suspected of front-running trades to make money for his advisory business.

In the interview, he claims that the fraud started after the crash of 1987. Clients pulled out capital and he was forced to unwind long-term hedges on unfavorable terms. Then his trading scheme was no longer working because the market lacked the volatility needed for his arbitrage. And because trading spreads were narrowing because of the rise of electronic exchanges.

In the interview, Madoff displays some of the classic criminological behaviors of a fraudster.

He blames his victims: “Madoff says that he waved red flags, issued caveats that should have been obvious to even an unsophisticated investor.”

He denies his victims: “Everyone was greedy,” he continues. “I just went along. It’s not an excuse.” “Look, none of my clients, even if they lost every penny they put in there, can plead poverty.” In the tapes he claims that very few of the early investors will have lost their invested capital.

He condemns his condemners: “The whole new regulatory reform is a joke. The whole government is a Ponzi scheme.”

He claims everyone else is doing it: “It’s unbelievable, Goldman … no one has any criminal convictions.”

I think Madoff’s prison therapist told him the wrong answer. Or Madoff lied to Fishman about the therapist response.

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