SEC Proposes Wall Street Bonus Disclosure Rules

by Glen Shapiro, LawAndTax-News.com, Washington

07 March 2011

The United States Securities and Exchange Commission (SEC) has proposed a rule that would require brokers, dealers and investment advisers with USD1bn or more in assets, to disclose the structure of their incentive-based compensation practices, and prohibit them from maintaining compensation arrangements that encourage inappropriate risks.

The proposed rule stems from a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act which requires the SEC and several other agencies to jointly write rules and guidelines in this regard. “Our staff has worked closely with other federal regulators and the proposal reflects a series of carefully considered compromises,” said SEC Chairman Mary L. Schapiro.

The SEC’s proposed rules would require each financial institution to produce an annual report related to incentive-based compensation that they would file annually with SEC; prohibit incentive-based compensation arrangements that encourage inappropriate risk-taking by providing excessive compensation, or that could lead to material financial loss to the firm; and require them to develop policies and procedures that ensure and monitor compliance with requirements related to incentive-based compensation.

Under the proposed rule, for example, incentive-based compensation arrangements would be deemed to encourage inappropriate risks unless the incentive-based compensation arrangements meet certain standards, which are drawn from standards established in prior legislation and from guidance published by bank regulators last July.

The rule also lays out more specific requirements for executive officers and certain other designated individuals at financial institutions with USD50bn or more in total consolidated assets. For executive officers at these larger firms, the proposed rule would require the firms to defer, for three years, at least 50% of any incentive-based compensation for executive officers - and award such compensation no faster than on a pro rata basis.

It is recognized that some employees of a firm other than the executive officers - for example, a trader with large position limits relative to the institution’s overall risk tolerance - may have the ability to impact the risk profile of the covered financial institution. Accordingly, at larger covered financial institutions, the proposed rule would set forth additional requirements for employees exposing such institution to risk of significant loss.

It was said that the proposed rule recognizes the diversity of institutions covered by the rule and explicitly states that the policies and procedures should be commensurate with the size and complexity of the organization.

There have, however, been some doubts expressed on the effect the proposed rule could have on the business of the covered financial institutions; particularly the largest of them. Shapiro, in her introductory remarks, said that she looked forward “to receiving public comment on the proposed rules and specifically on how the practices contemplated by the proposed rule compare to existing conventions.”

“In particular,” she added, “I am interested in commenters’ views on how assets would be calculated for purposes of determining whether institutions fall within either component of the proposal. I am also very interested in their views on how the proposal might affect the broad array of financial firms covered, including broker-dealers and advisers - most particularly private fund advisers - given how they often structure their compensation; and the proposal’s potential impact on broker, dealer and investment adviser business models and the variety of services they provide to investors. This is an area where we want to be very attuned to unintended consequences.”

In addition, the SEC has proposed rule amendments to remove references to credit ratings in certain rules and forms under the Investment Company Act of 1940, particularly in relation to money market funds. “The focus of these efforts is to eliminate over-reliance on credit ratings by both regulators and investors, and encourage an independent assessment of creditworthiness,” said Schapiro.

Credit ratings are often considered by investors when they evaluate whether to purchase securities. The Dodd-Frank Wall Street Reform and Consumer Protection Act requires every federal agency to review rules that use credit ratings as an assessment of creditworthiness, and replace those credit-rating references with other appropriate standards.

Under the SEC’s proposal, a rating would no longer be a required element in determining which securities are permissible investments for a money market fund. A security would instead be an eligible investment for a money market fund if the fund’s board, or its delegate, determines that the security presents minimal credit risks.

As under the current rule, funds would have to invest at least 97% of their assets in securities that the board has determined are issued by an issuer that has the highest capacity to meet its short-term financial obligations. This latter standard is intended to be consistent with the highest credit rating category.

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