US House passes comp regulation bill(3)

Today the US House of Representatives voted to pass bill that will give the SEC and the Federal Reserve the power to regulate compensation at financial institutions with more than $1 billion in assets.

On Friday the House of Representatives voted 237-185 to pass a bill that could give US regulators the power to force private equity and venture capital funds, among other financial institutions, to disclose the structure of incentive compensation including management fees, transaction fees and carried interest. After its August recess, the US Senate will vote on the bill, and if approved President Barack Obama could sign the bill into law.

“The Corporate and Financial Institution Compensation Fairness Act” is mainly intended to give shareholders a “say on pay” for executives at public companies. But it would also give those regulators the power to set rules prohibiting certain structures that could “threaten the safety and soundness of covered financial institutions or could have serious adverse effects on economic conditions or financial stability”. The rules would not require that firms disclose individuals’ compensation, however.

The bill would give the Securities and Exchange Commission and the Federal Reserve the power to regulate incentive compensation at banks, credit unions, registered broker dealers, and investment advisors with assets of at least $1 billion. The final category includes private equity, hedge, and venture capital funds, whether they are registered investment advisors or not.

As currently written, the $1 billion figure refers to the firm’s assets, not the firm’s assets under management, says Ropes & Gray partner Dan Evans, which would exclude almost all private equity firms, since the firms themselves do not hold large amounts of capital. But he said it’s likely that the bill’s authors do in fact intend to target assets under management, and the text of the bill will eventually be revised.

The law is intended to give regulators enough information to analyse the extent to which incentive structures encourage undue risk-taking. Traditionally, private equity compensation arrangements have not been seen as encouraging excessive risk-taking because of its long-term nature. Regulators probably will not view private equity compensation structures as presenting a systemic risk to the financial markets, Evans said.

“It would certainly seem to a reasonable observer that it would be a stretch to conclude that these compensation structures incent people to take undue risks,” Evans said.

He adds that the portions of the bill that deal with public companies focus on ensuring that shareholders are aware of incentive compensation structures and have the chance to vote on them. “In the fund world the equivalent of shareholders – the investors – know exactly what these compensation structures are because it’s critical to the fundraising process. It’s negotiated and completely understood, and all of these sophisticated investors have invested knowing what these compensation structures are.”

But in recent weeks some critics have pointed out that carried interest, when not properly structured, can have the effect of incenting managers to take on too much risk, especially through the application of leverage.

“It’s certainly something that they need to think about,” said Evans. “I guess you could say that if you’re going to get compensated if you make money for the limited partners, but you aren’t going to lose money if you lose money for them, then you’ll be incented to take risks. The question is does it provide incentive to take undue risk. If you take undue risk and you lose a lot of money, you won’t get another fund.”

It’s important to note that the SEC already routinely asserts its authority to review compensation of registered investment advisers, said Evans, so the new bill won’t be an “earth shattering” change if passed. The rule making element is new however.

The full text of the bill can be read here: (http://www.house.gov/apps/list/press/financialsvcs_dem/3269_as_amended_by_committee.pdf)