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New Incentive-Based Comp Rules Murky For Financial Advisors

On Wednesday, the SEC proposed open-ended rules aimed at reigning in incentive comp. The rules, which stem from Section 956 of the Dodd-Frank Act, would prohibit incentive-based compensation arrangements that encourage “inappropriate” risk-taking or could lead to “material financial loss” at broker-dealers and investment advisers with $1 billion or more of assets.

On Wednesday, the SEC proposed new rules aimed at reigning in incentive comp. The rules, which stem from Section 956 of the Dodd-Frank Act, would prohibit incentive-based compensation arrangements that encourage “inappropriate” risk-taking or could lead to “material financial loss” at broker-dealers and investment advisers with $1 billion or more of assets.

The prohibition applies to basically everyone who works at or is affiliated with such firms: executive officers, employees, directors, or principal shareholders. It is not clear, however, what this all means for financial advisors and brokers, some of whom get incentive pay in the form of recruiting bonuses that reward them for increasing assets and/or production, as well as what’s often called differential comp (higher comissions for recommending certain products to clients than for recommending others).

The SEC could decide that either or both of these practices encourage inappropriate risk-taking. But it's unlikely the regulator would claim such practices could result in material financial loss for firms, said Andy Tasnady, compensation consultant at Tasnady & Associates in New York.

“How do you determine what is excessive? Each of these individual advisors is bringing in more money than they’re costing, so who’s to determine whether it’s excessive? I’d be surprised if they try to go after the monthly regular compensation plans of financial advisors,” said Tasnady. “And I don’t think having a sales person or broker paid bonuses could lead to material financial loss, because they’re just taking positions, not trading on the firm’s behalf.”

The proposed rules would also require all firms with over $1 billion in assets to file annual reports on incentive-based compensation with the SEC and to develop policies and procedures to help them comply with incentive-based comp requirements.

In addition, firms with over $50 billion in assets would have to defer incentive-based comp for executive officers, and get approval for compensation to individuals whose jobs might expose the firm to great risk.

The rules leave a lot of room for interpretation, said Tasnady. “It’s not bad having directional guidelines on things that should be done, but it leaves a lot open,” says Tasnday. “This is more outcome oriented. Having that kind of thing isn't bad. It depends on how detailed they get. It’s almost like this is a threat guideline. There are few numeric or policy specifics. The more conservative firms might just try to be as careful as possible and look at their policies and stay out of the screen or attention of the regulators. Others might say, 'We don’t know what this means; we’ll just keep doing what we’re doing.' I expect a variety of reactions from all kinds of firms.”

Digging Into The Details

In its rule proposal, the SEC recommended defining “inappropriate” risk-taking as anything that fails to meet the standards “established in prior legislation,” as well as standards “set in guidance published by bank regulators last July.”

SEC spokesman John Nester said the legislation in question is Section 39 of the Federal Deposit Insurance Act, while the guidance mentioned (75 FR 36395) was actually released in the Federal Register on June 25. Both the legislation and guidance leave the definition of “excessive” risk-taking or “excessive” compensation vague, and there is no mention of the term “financial advisor.”

The Federal Deposit Insurance legislation cited in the proposed rules says that standards that define “excessive compensation” should consider whether the individual being paid has committed fraud, breach of trust or fiduciary duty, or insider abuse. But it also gives the regulator the leeway to consider other “relevant” factors, as well as “other standards relating to compensation, fees, and benefits as the agency determines to be appropriate.”

In addition, the Federal Register guidance proposes that incentive compensation arrangements at financial firms should: Provide employees incentives that appropriately balance risk and reward; be compatible with effective controls and risk-management; and be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.

Meanwhile, according to the SEC's rule proposal, annual reports on incentive compensation would need to include (but not be limited to):

  • A narrative description of the components of the firm’s incentive-based compensation arrangements.
  • A succinct description of the firm’s policies and procedures governing its incentive-based compensation arrangements.
  • A statement of the specific reasons as to why the firm believes the structure of its incentive-based compensation arrangement will help prevent it from suffering a material financial loss or does not provide covered persons with excessive compensation.

Under the proposed rule, all new incentive-based compensation arrangements will need to be written into policies and procedures and approved by a firm’s board of directors.

Comments on the proposal are due within the next 45 days. “In particular, 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,” SEC Chairman Mary Schapiro said at an Open Meeting held today. “I am also very interested in their views on how the proposal might affect the broad array of financial firms covered by Section 956, 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.”

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