Last week, you probably caught the rush of news about SEC commissioners finally releasing a proposal that would allow shareholders to compare top executives’ pay with company performance.
For private equity execs, it was interesting news from a bystander perspective, but Section 953 of the Dodd-Frank Act has never been a major source of interest (privately held firms are exempt from the rule).
What is interesting though is that the commission is delivering on its promise to tackle executive pay issues under the leadership of Mary Jo White. While Section 953 has a limited impact on the industry, still on regulators’ to-do list is Section 956, which is something that can strike GPs’ wallets. And from what regulatory lawyers tell us, the rule is being given renewed attention by the SEC and its sister federal regulators.
What Section 956 does is prevent firms from offering key decision-makers so much incentive-based compensation that it distorts their risk appetite – a rule designed to stop the type of risky betting that observers pin as one of the underlying causes of the global banking meltdown.
The SEC and its sister agencies first tried fleshing out the bones of Section 956 in 2011, but were criticized for taking a one-size-fits-all approach to the various pay models used in finance, ultimately leading them to shelve the proposal until now. At the time, the private equity industry was among the rule’s critics, arguing that the carry model – in which a performance bonus is only paid out after investors first receive a negotiated preferred return – already provides all the protection against the inappropriate risk-taking and compensation abuses that Section 956 strives to prevent.
If regulators disagree, GPs may have to review and possibly restructure partners’ compensation arrangements – a timely and costly exercise. Aside from an annual reporting requirement describing the firm’s compensation policies and procedures, GPs would also have to consider a number of factors in determining if carry and other pay arrangements are “excessive,” two of which being the combined value of all cash and non-cash benefits provided to a covered person and how that compensation stacks up to other individuals with “comparable expertise.”
What’s unclear is if regulators will, say, interpret a huge sum of cash awarded to a junior-level partner as excessive, which is a more real possibility under the carry model compared to an investment banker of similar age and experience collecting an annual bonus. Also unclear is to whom the rule will apply. Based on a firm’s internal accounting structure, and whether they must consolidate fund assets at the management level, it could apply differently to two firms of similar size and shape.
In our May issue, we give the subject a more in-depth look as part of a special report on compliance. There’s a lot on CCOs’ plates these days. What they’re hoping is that strict Section 956 requirements won’t be added to the pile this year.