The SEC recently released a proposed rule pursuant to Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) with respect to the implementation of incentive-based compensation arrangements for certain covered institutions. The SEC is the last federal regulator to promulgate rules under Section 956. The SEC proposal places strict focus on creating a culture of accountability at financial services firms in the aftermath of the 2008 financial collapse that gave rise to Dodd-Frank. The proposal attempts to rein in undue risk taking by clamping down on incentive-based compensation and emphasizing risk control management. To date, the National Credit Union Administration, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Federal Housing Financing Agency and the Board of Governors of the Federal Reserve System have all promulgated rules under the requirements of Section 956 of Dodd-Frank.
The SEC has issued these proposed rules, in accordance with Section 956 of Dodd Frank, which requires the aforementioned federal regulators to jointly issue regulations or guidelines (1) prohibiting incentive-based payment arrangements that the federal regulators determine encourage inappropriate risks by certain financial institutions by providing excessive compensation or that could lead to material financial loss; and (2) requiring those financial institutions to disclose information concerning incentive-based compensation arrangements to the appropriate federal regulator. Additionally, the proposed rules would require all covered institutions, regardless of size, to implement additional record keeping and compliance procedures to help stop excessive compensation that could result in inappropriate risk taking.
Incentive-based compensation is any variable compensation, fees or benefits that serves as an incentive or reward for performance. Compensation, fees or benefits that are awarded solely for, and the payment of which is solely tied to, continued employment would not be incentive-based compensation.
The proposed SEC rule applies to United States broker-dealers and investment advisers and creates three tiers of regulation based on asset size, which would be determined using regulatory reports filed by such institution. Generally, the prosed rule will capture any broker-dealer or investment adviser that has total consolidated assets of greater than or equal to $1 billion and less than $50 billion (a “Level 3 Institution”). However, the requirements under the proposed rule become increasingly onerous for broker-dealers and investment advisers with total consolidated assets greater than or equal to $50 billion and less than $250 billion (a “Level 2 Institution”) and are most stringent for those entities with total consolidated assets of greater than $250 billion or more (a “Level 1 Institution”).
The proposed rule applies to “covered persons” such as any executive officer, employee, director, or principal shareholder who receives incentive-based compensation. The most notable requirements under the proposed rule apply to "senior executive officers" or "significant risk-takers." Senior executives include, among others, the CEO, CFO and COO. Significant risk-takers generally include individuals who are not "senior executive officers" but may still expose a Level 1 or Level 2 institution to material financial loss. To qualify as a covered person, a significant risk-taker must receive at least 1/3 of his/her total compensation as incentive based compensation and meet either the "relative-compensation test" or "exposure test." The "relative-compensation test" covers those employees in the top 5% of the highest compensated employees for Level 1 institutions and the top 2% for Level 2 institutions. The exposure test covers any person who may commit or expose 0.5% or more of the capital of the broker-dealer or investment adviser.
With respect to Level 1 Institutions, at least 60% of the incentive-based compensation for senior executive officers (50% for the significant risk-takers), must be deferred for at least four years and at least 60% (50% for significant risk-takers) of compensation awarded under a long term incentive plan ("LTIP") must be deferred at least two years, in each case beyond the end of the performance period.
With respect to Level 2 Institutions, at least 50% of the incentive-based compensation for senior executive officers (40% for the significant risk-takers), must be deferred for at least three years and at least 50% (40% for significant risk-takers) of compensation awarded under an LTIP must be deferred at least one year, in each case beyond the end of the performance period.
A Level 3 Institution is not subject to the same minimum required deferrals as a Level 1 or Level 2 Institution.
In addition, for both Level 1 and Level 2 covered institutions, all incentive-based compensation awarded to senior executive officers and significant risk-takers must be subject to clawback for at least seven years from the vesting date. Level 3 Institutions are not subject to the clawback requirement.
If adopted as proposed, advisers and broker-dealers would need to comply no later than the beginning of the first calendar quarter that begins at least 540 days after the final rule is published in the Federal Register. Whether a broker-dealer or investment adviser is a Level 1, Level 2 or Level 3 Institution on the compliance date would be determined based on the average total consolidated assets as of the beginning of the first calendar quarter that begins after a final rule is published in the Federal Register.
The SEC is accepting comments on the proposed rule until July 22, 2016.
Interested parties may find a copy of the proposed rule here.