On May 16, 2016, six federal agencies issued a joint release inviting public comment on a proposed rule to prohibit or condition certain incentive-based compensation arrangements. This proposed rule was mandated by section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and is a revision of the proposed rule the agencies previously published in the Federal Register on April 14, 2011.
As one of the six agencies, the U.S. Securities and Exchange Commission (SEC), is seeking to apply the rule to covered institutions with average total consolidated assets greater than or equal to $1 billion that offer incentive-based compensation to covered persons. By its terms, the definition of “covered financial institution” in section 956 of Dodd-Frank includes any institution that meets the definition of “investment adviser” under the Investment Advisers Act of 1940, as amended (the Advisers Act), regardless of whether the institution is registered, or exempted or prohibited from registration, as an investment adviser under the Advisers Act.
In order to invoke coverage of the proposed rule, an investment adviser must, at a minimum, meet the definition of a “covered institution”, which is defined as a regulated institution with average total consolidated assets greater than or equal to $1 billion. For a covered institution that is an investment adviser, average total consolidated assets would be determined by the investment adviser’s total assets (exclusive of non-proprietary assets) shown on the balance sheet for the adviser’s most recent fiscal year end. Significantly, the SEC clarified in the proposed rule that investment advisers should include only proprietary assets in the calculation—that is, non-proprietary assets, such as client assets under management would not be included, regardless of whether they appear on an investment adviser’s balance sheet.
In the release, the SEC estimated that out of 11,702 investment advisers registered with the SEC, or reporting to the SEC as exempt reporting advisers, 669 investment advisers (5.7% of registered RIAs and reporting ERAs) had total assets of at least $1 billion as of December 31, 2014. The SEC stated it used 2014 data in its analysis because this was the most recent year for which compensation data is available.
Should an investment adviser meet the definition of a “covered institution” by virtue of having average total consolidated assets of $1 billion or more, it would be designated as a Level 3 Covered Institution. Investment advisers reaching $50 billion and $250 billion in fiscal year-end balance sheet assets would be designated as Level 2 and Level 1 Covered Institutions, respectively.
Generally, the compliance and reporting requirements applicable to Level 3 Covered Institutions would be limited to a prohibition against establishing or maintaining any type of incentive-based compensation arrangement, or any feature of any such arrangement, that encourages inappropriate risks by the covered institution: (i) by providing a covered person with excessive compensation, fees, or benefits; or (ii) that could lead to material financial loss to the covered institution. A Level 3 Covered Institution would also be required to create annually and maintain for a period of at least seven years records that document the structure of all its incentive-based compensation arrangements and demonstrate compliance with the rule. At a minimum, the records must include copies of (i) all incentive-based compensation plans, (ii) a record of who is subject to each plan, and (iii) a description of how the incentive-based compensation program is compatible with effective risk management and controls. Under the proposed rule, Level 3 Covered Institutions would not be required to report the actual amount of compensation, fees, or benefits of individual covered persons as part of the disclosure and recordkeeping requirements.
Comments submitted to the agencies on the joint proposed rule must be received by July 22, 2016. Investment advisers meeting the definition of a covered institution would be required to be in compliance with an enacted final rule on the date of the beginning of the first calendar quarter that begins at least 540 days after the final rule is published in the Federal Register. Incentive-based compensation plans with performance periods that are in effect prior to the compliance date will not be subject to the regulations.