The federal government should not dictate the pay of investment advisers, but the Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173, signed into law by President Barack Obama on July 21, takes a step in that direction.
The new law gives authority to the Securities and Exchange Commission and other federal regulators to oversee incentive-based compensation structures of investment advisers and broker-dealers.
It requires them to “prescribe regulations or guidelines that “prohibit any types of incentive-based payment arrangement, or any feature of any such arrangement, that the regulators determine encourages inappropriate risks by covered financial institutions — (1) by providing an executive officer, employee, director or principal shareholder of the covered financial institution with excessive compensation, fees or benefits; or (2) that could lead to material financial loss to the covered financial institution.”
Under the act, the regulatory oversight would be jointly conducted by the SEC, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Board of Directors of the Federal Deposit Insurance Corp., the Director of the Office of Thrift Supervision, the National Credit Union Administration Board and the Federal Housing Finance Agency.
The SEC and the other federal regulators have to write rules to administer the new law, whose compensation oversight provisions go into effect in April.
The Dodd-Frank act, originally conceived to try to prevent another financial market meltdown, became the most sweeping financial regulatory overhaul since the 1930s era, and injected federal oversight into areas where there were no obvious problems.
The new authority to regulate incentive compensation apparently is aimed at hedge funds and venture capital and private equity funds, which now have to register with the SEC. But they might trip up ordinary investment advisers, both institutional and retail.
Investment advisers, or managers of alternative funds, didn't cause the financial market meltdown. That investment advisers have been lumped together with commercial and investment banks, hedge funds, mortgage bankers and brokers, and derivatives traders shows how little understanding of the investment world the Congress has.
The Dodd-Frank act's impact on executive compensation at publicly traded companies has received much attention. One particular point of focus has been a provision requiring companies to have an advisory say-on-pay vote at least every three years, allowing shareholders a non-binding comment on executive compensation. But the act doesn't dictate executive compensation, set parameters or even require shareholder approval of pay. Shareholder activists never sought federal control over executive compensation. They recognize how it would be jeopardize corporate performance to have a federal regulator set incentives, benchmarks and hurdles.
But with money managers, the new law heads in that direction by giving regulators control over their incentive-compensation practices.
Incentive-based pay is widely used by money managers, just as it is by other companies and institutions, including public retirement systems. Properly structured, it is designed to motivate individuals to meet or exceed objectives, usually all aimed to promote the advantage of clients. Clients know the incentive structures, and they set appropriate risk limitations and compliance guidelines.
Not only are compensation practices policed by clients — who reject pay practices that don't produce an alignment of fiduciary interest in producing superior risk-adjusted performance — they also are policed by competitors seeking to offer better terms to the clients.
For example, in spring, the $10 billion Illinois State Board of Investment, Chicago, punished one real estate advisory firm, CB Richard Ellis, by declining to make a planned additional $100 million commitment because it could not reach an agreement on restructuring the compensation arrangement with Troy Jenkins, portfolio manager.
Townsend Group, the board's real estate consultant, had recommended the change in compensation terms to better align the interests of the manager and fund.
Besides the fact that the section of the law dealing with investment adviser compensation is intrusive and unnecessary, there are significant problems with it.
First, it is incredibly vague. What are “inappropriate risks”? They are not defined. How can any investment advisory firm know when its incentive compensation scheme will pass muster given such a vague statement? What is “excessive compensation”? That is also not defined. What is a “material financial loss to the institution”? Again, material loss is not defined.
Second, the act does not apply to institutions that have “assets of less than $1 billion.” Which assets? The firm's own assets, or assets under management? The law does not specify.
But investment advisers and their clients should lobby Congress to exclude this compensation oversight provision. In the interim, they also should take advantage of any opportunity to influence rulemaking on the provision by the SEC and the other regulators, especially in public comments.