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AALU INSIGHTS

Proposed Sec Rule Targets Compensation That Encourages Risk

On March 30, the SEC and six other federal financial regulators jointly released their proposed rules, required under the Dodd- Frank Act, for incentive-based compensation arrangements at certain financial institutions. Other agencies involved in the joint rule-making process include the OCC, the FED, the FDIC, the OTS, the NCUA and the FHFA. The proposed rules are similar from agency to agency but vary somewhat due to the different entities being regulated.

These seven agencies requested public comments on the proposed rules within 45 days of their publication in the Federal Register. This article summarizes, in the three sections below, the elements of the proposed rules that would apply to brokers, dealers or investment advisors with assets of at least $1 billion and to other financial institutions these agencies regulate.

The proposed rules are part of in a series of efforts by government agencies over the past couple of years to regulate the executive compensation pay practices of certain companies. The proposed rules recognize the significant advantages of deferred compensation in aligning the long-term interests of the shareholders with those of the executives and in making compensation more sensitive to risk.

1: Annual Disclosures About Incentive-based Compensation

Each covered financial institution would be required to file a report with its federal regulator that includes:

• 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 arrangements will help prevent it from suffering a material financial loss or does not provide covered persons with excessive compensation.

The required disclosures do not include the actual compensation of particular individuals.

"Incentive-based compensation" is defined broadly to include any variable compensation that serves as an incentive for performance, but does not include compensation that is tied solely to continued employment or activities that do not involve risk-taking.

2: Prohibition on Encouraging Inappropriate Risk

The proposed rules apply to executive officers, employees and directors or principal shareholders – "covered persons" – at a covered financial institution and would prohibit an incentivebased compensation arrangement that encourages inappropriate risks by providing covered persons with excessive compensation or could lead to material financial loss. Incentive-based compensation would be excessive when amounts paid are unreasonable or disproportionate to the amount, nature, quality and scope of services performed considering a wide array of factors laid out in the proposed rules.

The proposal states that incentivebased compensation arrangements would be deemed not to encourage inappropriate risk if they meet the following standards, which are drawn from standards established in prior legislation and from guidance published by bank regulators in July 2010. The arrangement:

• Balances risk and financial rewards (for example, using deferral of payments, risk adjustment of awards, reduced sensitivity to short-term performance, or longer performance periods).

• Is compatible with effective controls and risk management.

• Is supported by strong corporate governance.

3: Establishing Policies and Procedures

A covered financial institution would be barred from establishing an incentive- based compensation arrangement unless the arrangement has been adopted under policies and procedures developed and maintained by the institution and approved by its board of directors. The proposed rules recognize the diversity of institutions covered by the rules and explicitly state that the policies and procedures should commensurate with the size and complexity of the organization as well as with the scope and nature of its use of incentive-based compensation.

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