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Implementing the Dodd-Frank Act’s Incentive-Based Compensation Prohibition

March 3, 2011

Photo by iChaz. Some rights reserved.

On March 2nd, the SEC voted to propose jointly with other federal financial regulatory agencies rules implementing the Dodd-Frank Act’s prohibition against incentive-based compensation arrangements that encourage inappropriate risk taking by “covered financial institutions” and are deemed to be excessive, or that may lead to material losses.

Who is Affected

“Covered financial institutions” include the following institutions that have $1 billion or more in assets: depository institutions or holding companies; SEC-registered broker-dealers; investment advisers; and any other financial institution that federal regulators jointly determine should be treated as such. Heightened standards apply to institutions with $50 billion or more in total consolidated assets. For these larger institutions, at least 50 percent of incentive-based payments must be deferred for a minimum of three years for designated executives. The boards of these larger institutions must also identify employees who may expose the institution to substantial risk, and must determine that the incentive compensation for these employees appropriately balances risk and rewards according to enumerated standards.

What is Excessive

Compensation would be considered excessive when amounts paid are unreasonable or disproportionate to the amount, nature, quality, and scope of services performed by the covered person. In evaluating whether compensation is excessive, the agencies would consider the individual’s expertise; the financial condition of the covered financial institution; industry practice; and any link to malfeasance.

Larger Institutions

Addressing the compensation practices of larger firms, the proposed rule emphasizes the role of risk management and compliance personnel, ultimately holding the board responsible for oversight.

What Must be Disclosed

Under the Act, a covered financial institution must disclose the structure of its incentive-based compensation arrangements in sufficient detail to allow regulators to determine whether the structure provides “excessive compensation, fees, or benefits” or “could lead to material financial loss.” While actual compensation need not be disclosed, the volume of information provided will vary with the size and complexity of the institution, as well as the scope and nature of its compensation arrangements.

What Happens Next

SEC Chairman Mary L. Schapiro is particularly interested in commenters’ views on how assets would be calculated for purposes of determining whether institutions fall within the $1 billion or $50 billion supervisory category; how the proposal might affect the compensation structure of private fund advisers; and the proposal’s potential impact on broker-dealer and investment adviser business models. The proposal is a joint rulemaking by the Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, Federal Reserve Board, Office of Thrift Supervision, National Credit Union Administration, SEC, and the Federal Housing Finance Agency, who must each independently approve the proposed rule before it is published in the Federal Register. The proposed rule will be substantially similar from agency to agency, but will contain technical differences to account for the different entities that the federal agencies regulate. While the FDIC voted on February 7, 2011 to propose the rule, it is unclear as to when the other agencies will vote. View the proposed rule, as prepared by the FDIC, here.

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