InDepth Analysis

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InDepth: New FSA Regulations Address Risks from Compensation Practices

by Ron Diel on August 14, 2009

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Summary: Detailed analysis of new FSA rules designed to prevent UK financial services firms from adopting remuneration programs that could encourage key staff to take excessive risks; includes a comparison to US proposals. A briefer entry is available here.

Earlier this week, the FSA provided a workable example of rules that address the risks that can result from poorly structured remuneration programs at financial firms.  Given the uncertain and politically charged debate now underway in the US, this example deserves our attention.  The new FSA rules also highlight the importance of acting quickly enough to affect the upcoming 2010 compensation year – something that will be difficult here where pending legislation provides regulators with a nine-month period to in effect assess the need for action.

By already putting its requirements into effect, the FSA pulled ahead of its counterparts in the US.  The changes go into practice quickly to address the 2010 compensation cycle: firms must adopt remuneration policy statements reflecting the new principles, have them approved by board compensation committees, file them with the FSA by the end of October, and put them into practice by January 1st.  The rules also provide guidance on addressing pre-existing contracts like the questions being raised concerning Andrew Hall’s employment agreement with Citibank.

To act quickly, the FSA focused specifically on the risks created by badly structured compensation agreements, rather than getting caught up in a debate about popular outrage over perceived excesses as has happened in US.  In balancing its reform efforts, the FSA noted that “inappropriate remuneration policies, practices and procedures were a contributory factor rather than a dominant factor behind the market crisis.”  As such, the UK code provides an interesting example of regulations more in tune with traditional financial regulation – mandating formal policies and procedures, internal oversight roles, and specific practices – than the US approach, summarized in another posting on this site, which attempts to limit risk by ceding more compensation authority to shareholders and regulators.

In its newsletter, the FSA describes the intent of the code as getting boards and firms to adopt compensation incentives that more strongly promote good risk management practices:

The aim of the Remuneration Code is to ensure that firms have risk focused remuneration policies, which are consistent with and promote effective risk management and do not expose them to excessive risk.

In keeping with the results focus at the heart of policy-based regulation, the provision anticipates efforts to engineer around any rules-based limits, extending coverage to “all aspects of remuneration that could have a bearing on effective risk management including wages, bonus, long term-incentive plans, options, hiring bonuses, severance packages and pension arrangements.”

Content of the FSA Rules

Structurally, the code modifies existing provisions to require firms to have board-level compensation committees and adopt written compensation policies and procedures.  The procedures must include performance appraisal processes and must allow for the risk and compliance areas to have “significant input” if they are concerned that a decision could encourage risky behavior or include a potential conflict of interest.  The code also extends the definition of regulated business risk to include risks arising from remuneration policies.

The code amends the Senior Management Arrangements, Systems and Controls Sourcebook to include a series of new principles to be applied when setting remuneration for individuals who could significantly impact the performance or risk exposure of the firm.  Under these principles, their compensation should:

  • Be based on risk-adjusted profits not revenues
  • Reflect long term profits, potentially through the use of moving averages, deferred payouts, or risk adjustments
  • Be significantly affected by an individual’s non-financial performance, including adherence with the firm’s risk and compliance policies
  • Tie bonus levels to individual, division, business unit, and firm performance (their emphasis)
  • Include vesting periods and dependencies on future firm performance for deferred bonuses
  • Include a base component sufficient to allow the firm to choose not to pay a bonus in a given year
  • Be set using appropriate, accurate management reports for the relevant areas of the business

Beyond these principles, the code calls for two specific compensation practices: first, guaranteed bonuses should be limited to the first year of employment, and second, payment of at least two-thirds of any senior employee bonuses should be spread over a three-year period.  Special considerations also apply to determining compensation of risk and compliance staff whose compensation is expected to be adequate to attract the required talent but “significantly” less variable or performance based than other positions.

Firms unable to comply with the new provisions because of existing obligations will not be considered in violation provided they amend such obligations to be compliant at the earliest opportunity prior to the end of March 2010.  Firms unable to do so by that date must take reasonable steps to amend or terminate the obligations at the earliest opportunity (and in no case later than the end of December 2010) and must adopt specific, effective procedures to manage any risks raised by such obligations while they remain in effect.

Comparison with Proposed US Regulations

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InDepth: Regulating The Rating Agencies

by Ron Diel on July 31, 2009

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Summary: Detailed analysis of the Treasury’s proposal to require Credit Rating Agencies to register with the SEC and implement enhanced compliance organizations, practices and disclosures.  Includes analysis of the actions the SEC is directed to take to implement the proposal.  A briefer entry is available here.

Last week the Department of the Treasury proposed legislation to strengthen regulatory oversight of national credit rating agencies, one of the groups that has been pointed to as contributing to the current financial crisis. The proposal would amend Section 15E of the 34 Act to require agencies to (1) register with the SEC as “nationally recognized statistical rating organizations” (NRSROs), (2) create internal compliance organizations under a CCO, (3) implement written policies, procedures and codes of ethics, (4) include increased risk-related disclosures in ratings reports, and (5) file annual regulatory reports, including compliance certifications.  The proposal also requires the SEC to create an office dedicated to overseeing NRSROs and to adopt rules to change industry business practices thought to compromise the efficacy of the rating practice, as well as to detail the rules required to implement the Act.

This legislation builds upon the Credit Rating Agency Reform Act of 2006 and its associated regulations, which provided for optional registration and were themselves extensions of earlier Commission efforts to increase the reliability of the ratings process through a series of no action letters.  The approach taken in the proposal to improve the conduct of the NRSROs mirrors regulatory provisions adopted over the past several years to tighten the governance and compliance environments in regulated broker/dealers, investment advisers and investment companies, including the development of written policies and procedures, the adoption of codes of ethics, the designation of Chief Compliance Officers, and the institution of systems of internal controls.  The specific concerns targeted in the proposal also reflect the increased focus that governance experts, like Professor Coffee at Columbia, have placed on dealing with conflicts of interest between the “gatekeepers” like the auditors and rating agencies and their clients, as the basis for structuring statutory and regulatory requirements.

On August 5th Professor Coffee testified before the Senate Committee on Banking, Housing and Urban Affairs concerning this proposal. In his opening statement, a clip from which is included at left, Professor Coffee points to two shortfalls in the Treasury proposal relative to legislation proposed in April by Senator Reed, which he believes would make the measure ineffective in remedying the problems it targets. First, the proposal fails to address the lack of due diligence reviews by the agencies of the inputs used in their models. Second, rating agencies don’t face the same risks of potential legal liability that motivates most other gatekeepers to adopt rigorous measures to verify the accuracy of their work products.

Concern with the reliability of credit ratings has been voiced by a number of firms and organizations in the investment industry, especially by those managing money market funds which are required to apply NRSRO ratings when selecting certain investments.  In April representatives from some of the leading investment firms, the industry groups, the NRSROs, and academia participated in an SEC roundtable on this issue.  While much of the discussion called either for a more dramatic restructuring of the industry at one extreme, or for much less change than the proposal includes at the other, depending mostly on the affiliation of the participant, there was clear agreement that change is required because the markets have lost confidence in the ratings being issued.  In his statement, Richard Baker (the President and CEO of the Managed Funds Association) noted the concerns of the alternative investment industry, described the agencies as playing a fiduciary role,  and called for regulators to require increased disclosure, greater transparency, and some form of accountability.

NRSRO Requirements

The Act directs the SEC to promulgate rules specifying how NRSROs are to manage conflicts that arise from business relationships, affiliations or board overlaps with the issuers they rate, from any affiliations among their staff and the issuers or underwriters of rated securities, and from any any other sources of conflict they identify.  Based on these rules, each NRSRO will be required to establish and enforce compliant written policies and procedures, reasonably tailored to their activities to identify, address and disclose conflicts of interest involving the agency or its staff, and to strengthen their governance procedures for managing such conflicts as may arise.

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Geithner and Obama

InDepth: The Private Fund Investment Advisers Registration Act of 2009

by Ron Diel on July 16, 2009

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Summary: Analyzes the Administration’s proposal to require registration with the SEC, added record-keeping, and filing of annual reports concerning investment practices and clients; includes an analysis of the potential impact of giving the SEC broad power to define terms (including ‘client’) in the Act. A briefer entry is available here.

On Wednesday July 15, the Administration released its widely-expected proposal to require most hedge fund advisers, and most other managers of pools of private equity, to register under the Advisers Act.

The proposal would immediately eliminate the exemption from Advisers Act registration for most hedge fund advisers to the extent of requiring them to register for purposes of imposing record keeping and reporting requirements.   A second consequence of the proposal, which is likely to have the larger long-term impact, is to clarify the power of the SEC to interpret the terms of the Advisers Act, including the term ‘client’, in effect granting the Commission the power to broadly eliminate the Advisers Act exemption, a power which the court found lacking in Goldstein vs. S.E.C..

Immediate Impact

The stated intent of the proposal is to require such record-keeping and reporting as the SEC deems necessary or appropriate: (1) in the general public interest, (2) for the protection of investors, or (3) for assessment of systemic risk.

Like the Commission’s overturned 2004 regulations that required hedge fund advisers to register, the proposed statutory language addresses advisers to ‘private funds’, where a private fund is defined as an investment fund that would be subject to the 40 Act but for the provisions of 3(c)(1) or 3(c)(7), which of course are the provisions relied on by funds exempt from registration under that Act.

Under the proposal, the SEC is authorized to require advisers to private funds to keep records of AUM, use of leverage, counterparty credit exposure, trading and investment positions, and trading practices – along with any other information the Commission determines to be necessary.  The Commission is given the power to determine the mandated record retention period and examination protocols.

By including position, trading and trade practice data, the reporting requirement will encompass much of the the core strategic information now closely held by the advisers.  The SEC is directed to treat the collected information as confidential, subject to the requirement to make it available to the FRB as required to identify those advisers which could pose a systemic risk (who would be designated Tier 1 FHCs).  The Commission also is required to provide confidential treatment to such information to the extent that it is included in its findings and reports, provided that it must disclose such information to the FRB and to such other government agencies and SROs as may require the information.

The proposal would also require advisers to provide added information to investors, prospects, counter parties and creditors in the form of such reports and information as the Commission may prescribe.

Finally, the amendment would explicitly strike the Section 210(c) provision of the Act that limited the Commission’s ability to require an adviser “to disclose the identity, investments, or affairs of any client.”  This again opens their access to strategically sensitive information.

Longer-Term Impact

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InDepth: The Impact of Registration – Broadly

by Ron Diel on July 7, 2009

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Summary: Based on statements by the Administration and the SEC, analyzes potential consequences of requiring hedge funds and other managers of private funds to register with the SEC.  The analysis notes that proposal largely defers the details so that the impact will depend on the interpretations and enforcement that the SEC adopts after the legislation is passed.

Given the administration’s proposed foundation for Financial Regulatory Reform, the presence of multiple bills in Congress, and the vocal acquiescence of the hedge fund industry itself, it appears certain that most hedge fund advisers will be required to register under the Advisers Act by year-end.  The prospects are sketchier, but comments from Mary Schapiro at the SEC and some of the legislative momentum indicate that the funds themselves may be required to register under the 40 Act.  Hedge Fund registration of either sort obviously isn’t an end in itself, however – the response of the industry and any cost/benefit assessments will depend on what is to follow registration.

For example, registration could be a precursor to having the regulators / SROs increase their oversight of individual hedge fund activity.  For the more visible recent problems like Madoff and Stanford Financial, however, the primary problem seems to have been gaps in the effectiveness of the oversight performed in its ability to achieve the twin goals of protecting investors from abuses and protecting the system from catastrophic risks.

The secondary problem has been the high compliance cost imposed on registered entities to achieve these limited benefits, as documented in SIFMA’s study of the Costs of Compliance in the securities industry. The recent scandals clearly undercut many assumptions underlying the asserted value of the hedge fund regulation already in place.

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