August 19, 2016 - August 19, 2016 – In light of significant losses suffered during the financial crisis, the Dodd-Frank Act mandated that the regulators issue rules prohibiting incentive based compensation that encouraged “inappropriate” risk-taking.  While banks have long been in the spotlight, large investment advisers also are subject to the rules. Below, we recap the recently reproposed rule on “Incentive-Based Compensation Arrangements and discuss the LSTA’s response. In brief, the LSTA made two arguments. First, the rule should only look at proprietary assets. Second, investment advisers that are subsidiaries of large covered institutions generally should be regulated based on their own asset size, and not the asset size of the parent.    

Here are the details. The rule divides the universe of institutions into four categories. First, there are advisers with proprietary assets of less than $1 billion, which would not be subject to the incentive comp rule. Second, there are advisers with proprietary assets of $1-50 billion (Level 3 institutions) that would be subject to reporting and principles-based rules. Proposed rules around the next two categories (Level 1 and Level 2) get more prescriptive, including requirements such as deferral of incentive based comp, forfeiture and downward adjustment provisions, and comp clawback rules, limitations on maximum performance comp, and more.  Level 2 comprises institutions with $50-250 billion in proprietary assets, and their covered subsidiaries. Level 1 comprises institutions with more than $250 billion in proprietary assets, and their covered subsidiaries. 

The proposed rule clarified that the asset size would be assessed on proprietary assets and not client assets under management (either on or off the adviser’s balance sheet). The LSTA strongly agreed with this position; we further noted that basing the rule on AUM had the potential of forcing advisers to rapidly swing between categories based on client fund flows or accounting rule changes. 

Second, the LSTA argued against the rule’s proposal that investment advisers that are subsidiaries of larger covered depository institutions be considered the same level as their larger parent institution. For instance, instead of being subject to principles-based rules, a Level 3 investment adviser that is a subsidiary of a Level 1 depository institution would be subject to Level 1 rules, including deferrals, forfeiture and downward adjustments, clawbacks and specific limits on maximum performance based compensation, among others. We supported the ICI’s proposal that any inclusion of a smaller manager in rules affecting its larger parent should be driven by the level of integration between the manager and its parent. 

The letter is available here

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