{"id":1797,"date":"2011-11-27T21:50:49","date_gmt":"2011-11-28T01:50:49","guid":{"rendered":"http:\/\/journals.law.harvard.edu\/hblr\/?p=1797"},"modified":"2016-07-04T21:55:12","modified_gmt":"2016-07-05T01:55:12","slug":"limiting-private-equity-comp","status":"publish","type":"post","link":"https:\/\/journals.law.harvard.edu\/hblr\/limiting-private-equity-comp\/","title":{"rendered":"Proposed SEC Rules Could Limit Carried Interest and Incentive Compensation Paid by Private Equity Firms"},"content":{"rendered":"

Download PDF<\/a><\/span><\/p>\n

Elizabeth Pagel Serebransky, Michael P. Harrell, Jonathan F. Lewis <\/span>and Charity Brunson Wyatt<\/span>*<\/a><\/p>\n

On April 14, 2011, the Securities and Exchange Commission (\u201cSEC\u201d) and several other federal agencies jointly published proposed rules aimed at governing incentive compensation practices at a broad range of banks and other financial institutions, including private equity firms.<\/span>[1]<\/sup><\/sup><\/a> The proposed rules were intended in part to address situations where employees at financial firms were perceived to have exposed their institutions to long-term risks in exchange for near-term fees to the institutions (and large near-term bonuses to the employees), leading to excessive risk taking and even, possibly, the risk of adverse impacts on the financial system should those institutions find themselves in material distress.<\/span>[2]<\/sup><\/sup><\/a><\/p>\n

The proposed rules implement Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the \u201cDodd-Frank Act\u201d),<\/span>[3]<\/sup><\/sup><\/a> which prohibits certain incentive compensation arrangements that encourage inappropriate risks through excessive compensation or compensation that could lead to material financial loss. The SEC\u2019s version of the proposed rules, approved by the SEC Commissioners in a 3-2 vote,<\/span>[4]<\/sup><\/sup><\/a> covers both registered and unregistered investment advisers (including private equity firms) having $1 billion or more of consolidated assets (\u201cIAs\u201d).<\/span>[5]<\/sup><\/sup><\/a> Unless the scope of the proposed rules is narrowed in response to public comment, the new incentive compensation rules (other than the deferral provisions of the rules, which would apply only to very large IAs) could apply to a significant number of private equity firms. <\/span><\/p>\n

During the public comment period, which closed on May 31, 2011, the SEC received extensive comments on the proposed rules, including in regard to their application to private equity firms.<\/span>[6]<\/sup><\/sup><\/a> The SEC is conducting meetings with certain individuals and entities that submitted comments to discuss those comments and get answers to any follow up questions that the SEC may have.<\/span>[7]<\/sup><\/sup><\/a> Although the Dodd-Frank Act required that the incentive compensation rules be adopted by the end of April 2011, the SEC currently plans to adopt final rules between January and June of 2012<\/span><\/p>\n

 <\/p>\n

Scope and Impact of the Proposed Rules<\/span><\/strong><\/p>\n

The SEC\u2019s version of the proposed rules limits compensation practices at covered IAs, as follows:<\/span><\/p>\n

Prohibitions.<\/em> Each IA is prohibited from establishing or maintaining incentive-based compensation arrangements for \u201ccovered persons\u201d that encourage inappropriate risk by providing (1) excessive compensation or (2) compensation that could lead to a material financial loss by the IA.[8]<\/sup><\/sup><\/a> A \u201ccovered person\u201d means any executive officer, employee, director or principal shareholder (i.e.<\/em>, a 10% or greater owner).[9]<\/sup><\/sup><\/a> <\/span><\/p>\n

The proposed rules specify six factors to consider when determining whether compensation is excessive.<\/span>[10]<\/sup><\/sup><\/a> The factor most relevant to private equity firms is whether compensation arrangements are in line with industry practice. A private equity firm that has industry-standard compensation arrangements\u2014a 20% carry allocated among investment professionals, and salaries and bonuses paid out of its 1.5% to 2.0% management fees\u2014could take the position that its compensation arrangements are consistent with industry practice and, therefore, should not be deemed excessive. Under the rules as currently written, however, industry practice is only one of the factors that may be considered in determining whether compensation is excessive, leaving regulators considerable leeway to second-guess a private equity firm\u2019s decisions concerning compensation arrangements. Other factors include the combined value of all cash and non-cash benefits provided to a covered person, the covered person\u2019s compensation history, and the financial condition of the covered financial institution.<\/span><\/p>\n

Reporting.<\/em> Each IA must submit a brief annual report to the SEC describing the structure of its incentive-based compensation arrangements but is not required to disclose the compensation of particular individuals. [11]<\/sup><\/sup><\/a> The annual report must describe the policies and procedures governing such arrangements and explain why the IA believes that those arrangements comply with the prohibitions against compensation that is excessive or that could lead to material financial loss by the IA. <\/span><\/p>\n

Three-Year Deferral of Incentive-Based Compensation by Very Large IAs.<\/em> IAs having $50 billion or more in \u201cconsolidated assets\u201d must defer at least 50% of the annual \u201cincentive-based compensation\u201d for executive officers (including the chief investment officer and chief legal officer) for a minimum of three years.[12]<\/sup><\/sup><\/a> During the deferral period, the deferred amount must be adjusted (down) for (poor) performance.[13]<\/sup><\/sup><\/a> This deferral requirement appears to apply to annual bonuses paid to employees of the IA, but does not appear to apply to carried interest arrangements, since carried interest distributions should not be considered \u201cannual\u201d compensation.<\/span><\/p>\n

Definition of Consolidated Assets.<\/em> \u201cConsolidated assets\u201d means the IA\u2019s \u201ctotal assets\u201d as reflected on the balance sheet for the IA\u2019s most recent fiscal year end.[14]<\/sup><\/sup><\/a> Under GAAP as currently in effect, certain IAs, including private equity firms, are required to consolidate their affiliated funds if the limited partners of those funds do not have the right to remove the funds\u2019 general partner(s) without cause by a vote of a majority in interest (or less). <\/span><\/p>\n

Only a very small number of private equity firms are likely to have balance sheets showing total assets of $50 billion or more (the trigger for the deferral requirement) in the near term. However, a private equity firm that is required to consolidate third-party managed assets could become subject to the proposed rules as such third-party managed assets rise in value, absent (1) a change in the GAAP consolidation rules, which are under discussion, or (2) a change in the SEC\u2019s proposed rules, such as a change to make clear that for purposes of these rules, consolidated assets are deemed to include only the proprietary assets of the firm (even if GAAP requires that certain third-party managed assets be consolidated). Such proprietary assets would include the firm\u2019s investments in funds (and portfolio companies) that the firm manages, and exclude assets that the firm manages for third-party investors. <\/span><\/p>\n

Definition of Incentive-Based Compensation.<\/em> \u201cIncentive-based compensation\u201d means \u201cany variable compensation that serves as an incentive for performance.\u201d[15]<\/sup><\/sup><\/a> The deferral requirement for larger IAs applies only to \u201cannual\u201d incentive-based compensation. Therefore the deferral requirements appear not to apply to private equity carried interest arrangements (since they should not constitute annual compensation), even if those arrangements are subject to vesting, as is typical. (Vested equity, including partnership interests that are already fully vested, also is not considered incentive-based compensation under the proposed rules.) <\/span><\/p>\n

Policies and Procedures.<\/em> Each IA must develop and maintain specified policies and procedures governing incentive-based compensation that are consistent with the restrictions of Section 956 of the Dodd-Frank Act.[16]<\/sup><\/sup><\/a> In addition, each IA with $50 billion or more in total consolidated assets must have in place a process for the board of directors (or a committee thereof) to review and approve incentive-based compensation for covered persons who individually have the ability to expose the IA to losses that are substantial in relation to the IA\u2019s size, capital or overall risk tolerance.[17]<\/sup><\/sup><\/a><\/span><\/p>\n

 <\/p>\n

Public Comment<\/strong><\/span><\/p>\n

The SEC specifically requested public comment on various aspects of the proposed rules, including on:<\/span><\/p>\n