SEC aims to curb broker, adviser comp that promotes excess risk taking

Firms with $1B in assets under management would be subject to the proposed rule; ‘unintended consequences'?

Mar 2, 2011 @ 3:56 pm

By Mark Schoeff Jr.

Large investment advisers and broker-dealers would have to end compensation programs that foster excessive risk taking under a rule proposed on Wednesday by the Securities and Exchange Commission.

The agency voted 3-2 to release the initial compensation rule, which would require advisory firms and broker-dealers with more than $1 billion in assets to disclose to the SEC their incentive-based compensation schemes.

Regulators could prohibit a plan if they find it “encourages inappropriate risks” or could lead to substantial financial losses by offering “excessive compensation,” according to an SEC fact sheet.

Financial institutions with more than $50 billion in assets would have to defer for at least three years 50% of incentive-based pay for executives. In addition, the firm's board would have to approve incentive arrangements for other employees, such as high-profile traders, who could expose the firm to substantial losses.

The SEC is among several federal agencies — including the Federal Deposit Insurance Corp., the Federal Reserve and the Office of the Comptroller of the Currency — that must write compensation regulations under a provision of the Dodd-Frank financial reform law designed to curb reckless financial decisions that could harm investors and potentially destabilize markets.

The SEC and the FDIC have proposed a similar compensation rule.

Once all of the collaborating regulators approve their proposed rules, it will be published in the Federal Register and open for a 45-day public comment period. Later, the financial agencies will promulgate a final rule.

SEC Chairman Mary Schapiro said she wants feedback on how assets under management would be calculated to determine whether a firm must comply with the compensation requirements.

She also is eager to assess the impact the compensation rule might have on the investment advice sector — particularly on private-fund advisers and on broker-dealer and investment adviser business models.

“This is an area where we want to be very attuned to unintended consequences,” Ms. Schapiro said in her prepared opening statement.

The proposal should come as no surprise to financial professionals, according to Scott Olsen, a principal at PwC, the accounting giant. The trend toward compensation controls began in the banking sector and has been expanding into other areas of the industry, such as asset management.

“The general approach used by most regulators has been principles-based, not overly prescriptive or one-size-fits-all,” Mr. Olsen said. “It's meant more to align risk and compensation outcomes rather than eliminate risk. The question is, ‘How do you do that in a way that is fair across organizations?'”

Two methods be considered to achieve better risk-reward balance would be to spread incentives out along a longer timeline and to implement more risk adjustment. The latter occurs, for instance, when two traders attain the same volume of commissions — but the one who does so by jeopardizing less of the firm's capital gets a larger reward.

Many firms are following compensation practices that would be approved under the new regulatory regime, according to Mr. Olsen.

“We're already observing a directional change in the industry,” he said.

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