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Proposed Rule under Dodd-Frank Addressing Incentive-Based Compensation Arrangements For Financial Firms

by James E. Earle Esq. and Mark D. Perlow Esq.


On March 30, 2011, seven federal financial regulators (each, an "Agency," and collectively, the "Agencies") published a proposed rule (the "Proposed Rule") that would implement Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act").

Section 956 of the Act requires the Agencies to issue joint regulations that prohibit "covered financial institutions" from entering into incentive-based compensation arrangements that encourage inappropriate risks, either because they provide certain covered persons of the covered financial institutions with excessive compensation, or because they could lead to material financial loss to the covered financial institution. Under Section 956, the regulations must also require covered financial institutions to disclose the structures of their incentive-based compensation arrangements in a manner sufficient to determine whether the foregoing prohibitions are being properly implemented.

Section 956 defines "covered financial institutions" to include a broad range of financial institutions, including investment advisers and registered broker-dealers that have $1 billion or more in total consolidated assets (as opposed to assets under management). Section 956 also requires the Agencies to ensure that their proposed regulations (i) are comparable to the safety and soundness standards applicable to insured depository institutions under Section 39 of the Federal Deposit Insurance Act (the "FDIA") and (ii) take into consideration the compensation standards described in FDIA Section 39(c).

While many banking institutions have recently been subjected to guidance on sound incentive compensation policies adopted by certain Federal banking agencies (the "Banking Agency Guidance"), 3 Section 956 applies, and the Proposed Rule would apply, to a broader range of financial institutions. The Proposed Rule, however, will supplement, not replace, other rules on compensation practices (including the Banking Agency Guidance).

A forty-five day comment period will commence after the Proposed Rule is published in the Federal Register, which should occur shortly after March 30. Following the comment period, the Agencies will adopt a final rule which is expected to become effective six months after its publication in the Federal Register. This could mean an effective date for final rule sometime in late 2011 or early 2012.

The scope of the Proposed Rule is potentially very broad. The Agencies collectively estimate that there are over 1,600 covered financial institutions that will be subject to the Proposed Rule. Among those, the SEC estimates that the Proposed Rule could cover up to 200 broker-dealers and investment advisers. Moreover, the Proposed Rule generally follows a principles-based approach to rulemaking and includes a number of critical undefined terms. Much of the actual impact will therefore depend on how each Agency chooses to enforce its rules.

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James E. Earle is a partner in the Charlotte office of K&L Gates. A significant portion of Mr. Earle's practice involves counseling publicly traded companies and other complex employers on matters related to executive compensation. Clients include financial services companies, hedge funds, large national retailers, manufacturers and service-companies with global operations.

Mark D. Perlow
is a partner in the San Francisco office of K&L Gates. His practice focuses on investment management and securities law. He regularly represents mutual funds, hedge fund managers, investment advisers, fund boards of directors, and broker-dealers on a variety of regulatory and transactional matters.