(Article from Registered Funds Alert, September 2016)
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In June 2016, the SEC and several other regulatory agencies published a revised rule proposal (the “Proposed Rule”) on incentive-based compensation for covered financial institutions, which are those institutions with total consolidated assets (i.e., balance sheet assets) of at least $1 billion and includes asset managers. The Proposed Rule, which is mandated by Section 956 of the Dodd-Frank Act, calls for prohibitions on incentive-based compensation arrangements, or any feature of any such arrangements, that encourage inappropriate risks that could jeopardize the stability of the financial institution.
Under the Proposed Rule, an incentive-based compensation arrangement would be considered to encourage inappropriate risks that could lead to material financial loss to the covered financial institution unless the arrangement: (i) appropriately balances risk and reward; (ii) is compatible with effective risk management and controls; and (iii) is supported by effective governance. A compensation arrangement would not be considered to appropriately balance risk and reward unless: (i) it includes financial and nonfinancial measures of the covered person’s performance; (ii) is designed in such a manner that it would allow, where appropriate, nonfinancial measures of performance to override financial measures of performance; and (iii) amounts awarded are subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and nonfinancial performance. For example, under the Proposed Rule a bonus structure that rewards covered employees for significant gains but offers no disincentives for significant losses would be potentially problematic because it does not appropriately balance risk and reward.
The Proposed Rule divides covered institutions by average total consolidated assets:
| Level 1 | ≥ $250 billion |
| Level 2 | ≥ $50 billion and
< $250 billion |
| Level 3 | ≥ $1 billion and
< $50 billion |
The sprawling 706-page proposal contains significant revisions from the initial 2011 proposal for regulation of incentive-based compensation, some of which have been well received. But several fund industry representatives submitted comment letters that argue the Proposed Rule is still too broad and captures certain investment advisers unnecessarily.
With respect to revisions that were embraced by the asset management industry, the Investment Company Institute (“ICI”), among others, commended the SEC for clarifying that investment advisers should include only proprietary assets in the calculation of consolidated assets and exclude non-proprietary assets, such as client assets under management, regardless of whether they appear on an investment adviser’s balance sheet. This distinction was not clear in the 2011 proposal. Since the aim of the Proposed Rule is to curtail systemic risk that may be threatened if the financial institution becomes unsound, it is only the advisers’ assets that are relevant, and not those of their clients.
Other portions of the Proposed Rule were met with more criticism. Possibly the most criticized component of the rule is its tiered system for classifying covered institutions based on size.
The Proposed Rule imposes increasingly detailed disclosure and record-keeping requirements for Level 1 and Level 2 entities and would require that incentive-based compensation arrangements for certain covered persons at such entities include additional features, such as clawback provisions, to appropriately balance risk and reward. These more stringent requirements affect two categories of individuals: “senior executives” and “significant risk-takers.” At Level 2 institutions, “significant risk-takers” are those employees who derive at least one-third of their annual compensation from incentive-based metrics and fall among the top 2% of earners. At Level 1 institutions, however, such conditions apply to the top 5%. If an investment adviser were to be deemed to be a Level 1 or Level 2 institution, these requirements would likely impact key personnel, such as portfolio managers.
Notably, an investment adviser that is a subsidiary of a banking institution could have its level dictated by the level that applies to the top-tier holding company. Several comment letters critical of the proposal argue that this inflexible leveling system unfairly puts advisers who are affiliated with larger parent banks at a significant recruiting disadvantage relative to their standalone peers, and does so without regard to how they might actually operate. If viewed on the basis of their own assets, most fund advisers subject to the rules would be Level 3; but those that happened to be under the umbrella of a larger bank would face stricter requirements solely because of that affiliation. Wells Fargo submitted a comment letter arguing that the result of the Proposed Rule would be that its asset manager subsidiaries will be forced to abide by tight Level 1 restrictions, while many of its subsidiaries’ peers will only have to comply with Level 3 restrictions despite being “much larger and hav[ing] higher risk profiles.”
The ICI’s letter also argues that the rigid application based on size tiers does not properly account for the reality that many asset managers operate completely independent of their parent financial institutions. A potential fix put forth by the ICI would be to add an escape valve by which the SEC would have the discretion to treat a Level 1 or 2 institution as a Level 3 if it determines that the adviser’s activities, complexity of operations, risk profile and compensation practices are consistent with those of a Level 3 adviser. This would allow for independent determinations in cases where the applicants believe circumstances warrant a different classification.
Comments on the proposal were due on July 22, 2016. Because of the multiagency basis on which these rules were proposed and will assumedly be adopted, it is unclear when these rules will be adopted, if at all, and the extent to which the SEC will have flexibility to apply the rules to asset managers in a manner appropriate to the asset management industry, as compared to the financial institutions that are the primary target of the rules.