Section 956 of the Dodd-Frank Act is a rule that caused immediate heartburn when it was enacted in 2010, but has not been given much consideration since by private fund managers.
The rule, a key element of the landmark financial reform bill, strives to limit the amount of risk taken by bankers, chief executives and other financial types who are paid handsomely when speculative investments go right. Specifically, the section prohibits financial institutions from offering key decision makers so much incentive-based compensation that it would distort the amount of risk others would reasonably find acceptable.
For private equity and other illiquid asset classes operating under the standard “2 and 20” model, it was seen as a confusing piece of regulation – primarily written with bankers in mind – that would either have a massive impact on their pay structures or virtually none at all. Five years later, the industry may finally get its answer.
No easy solution
It was in the spring of 2011 that seven federal regulators, including the Securities and Exchange Commission (SEC), first fleshed out the bones of Section 956. Despite the vast range of compensation structures used to pay finance professionals, the joint proposal took a one-size-fits-all approach, leading to immediate resistance from various trade bodies and industry associations – private equity included.
The amount of response and pushback was so severe that regulators eventually shelved the proposal, allowing other Dodd-Frank mandates to take precedent. It’s tough for seven regulators to agree on anything, let alone something touchy like compensation arrangements, but sources close to the process say the federal agencies have picked up the ball again, and may even issue a new proposal by end of year.
The hope is that things will be different this time around, and that the SEC will, at best, offer private equity firms an exemption from the entire section (for reasons offered below) or at the very least tweak the rules so they make sense (at a practical level) for carry and fee arrangements.
In a response letter to the 2011 proposal, the Private Equity Growth Capital Council (PEGCC) laid out the case for exemption, writing that “the structure of compensation and earnings opportunities in place at private equity firms, derived from the nature of the private equity firm business model itself, already provides all the protection against the inappropriate risk-taking and compensation abuses that Section 956 of the Dodd-Frank Act strives to prevent.”
The question now is: will regulators agree? If so, the firm’s compliance team can breathe a giant sigh of relief. If not, CCOs may have to review and possibly restructure partners’ compensation arrangements – a timely and costly exercise.
Confusing application
Section 956 has a few key provisions, each of which is hazy in the private equity universe, making it difficult to determine which way regulators will go.
One is a requirement to file an annual report with the SEC, or whoever the appropriate regulator is, describing the firm’s policies and procedures around incentive-based compensation (and explaining why they don’t encourage too much risk-taking). To save smaller firms from costly reporting burdens, only GPs with at least $1 billion or more in assets are required to file. But a simple AUM calculation isn’t always possible in the private equity sector, and could unfairly net mid-sized GPs who consolidate fund assets on their firms’ balance sheets.
Moreover, the US Financial Accounting Standards Board is considering changes that may force more GPs to consolidate assets at the firm-level if they don’t grant investors’ adequate removal rights, and so retain a certain level of control over the fund.
Two very similar funds could be in or out of the rule’s scope based on their internal structures and accounting practices, “which seems an unfair way to go about rulemaking,” comments Debevoise & Plimpton partner Elizabeth Pagel Serebransky, an executive compensation and securities group specialist.
The second item is the actual ban on pay structures that distort incentives. It’s here private equity feels it can make a strong case that its default pay model – the standard “2 and 20” arrangement – is already in compliance with the rule’s objective. In its letter, the PEGCC noted that GPs are only awarded a performance bonus (carried interest) after investors first receive a negotiated preferred return. And a “clawback mechanism” on carry ensures GPs are never paid too much should the fund later turn sour.
Regulators will use a number of factors to determine 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 annual bonuses.
The industry sees the nominal figure of compensation as a moot point.
“Particularly, we believe that the proposed rules should clarify that compensation will be deemed excessive based on its promotion of inappropriate risk-taking or its ability to lead to a material financial loss to the covered financial institution, rather than based on the dollar amount of the awards,” the PEGCC wrote in its letter.
Room for hope
If US regulators are anything like their counterparts in Europe, there’s a chance they’ll appreciate the industry’s reasoning. In 2013, the European Securities and Markets Authority issued technical guidance for pay provisions under the Alternative Investment Fund Managers Directive (AIFMD) that clarified certain GPs will not need to defer carry payouts – as is required for other types of variable remuneration under the directive. But a number of technical questions still linger, leading EU-based firms to try and guess what the directive means in certain areas related to pay.
For instance, a difficult challenge for regulators may be carry allocation rights that are worth zero at the time of grant. Somewhat similar to AIFMD, Section 956 requires supersized firms (managing $50 billion or more) to defer at least 50 percent of the annual incentive-based compensation of executive officers for at least three years. For the handful of private equity and real estate shops that may have to comply with this provision, it’s unclear how the percentages work when carry rights haven’t materialized into dollars in hand. Debevoise & Plimpton international counsel Sally Gibson says a similar requirement contained in the AIFMD has yet to answer this question.
After a rule proposal is released for comment, regulators normally take the feedback into consideration and issue a final rule. But given the level of controversy Section 956 has generated, and the appreciation regulators may now have for all the different pay structures utilized in finance, the SEC and its sister agencies may feel inclined to issue a follow-up proposal before letting the ink dry. The firm’s compliance team will be praying that they do.
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