SEC Attempting to Correct Incentives for Risk-taking that Underlie Executive Compensation Structures

The SEC recently proposed a rule that would require greater disclosure of performance-based compensation structures for broker-dealers and investment advisers at companies that manage greater than $1 billion in assets. In addition, the rule would enable SEC regulators to prohibit compensation schemes that it believes promote inappropriate risk-taking and regulators may even require partial deferral of incentive-based compensation for up to three years (for companies managing greater than $50 billion in assets).

This rule is just one of many that the SEC, in collaboration with various other regulatory agencies, has been empowered to implement under the Dodd-Frank Act in order to correct incentive structures which many believe contributed to the recent financial collapse. Many financial institutions (and non-financial institutions, for that matter) pay their employees and executives based on their individual, as well as on the company’s, performance in a given period of time. These compensation structures enable firms to overcome various principal-agent problems that may otherwise exist between shareholders and company executives (as well as between company executives and lower-level employees). The problem with this scheme is that it incentivizes individuals to take risks, particularly risks that pay off in the short term, as the employees stand to benefit tremendously if the risks pay off and yet are not faced with the prospect of personally losing the money that is invested if the risks don’t pay off. The result of this incentive structure is that broker-dealers and investment advisors may end of taking excessive risks, in pursuit of the high yields that fuel their own personal compensation.

Before this rule was even proposed by the SEC, numerous companies had already begun to alter their employees’ compensation structures in response to public pressure. In order to continue recruiting the top talent on the market, many companies have simply increased base salaries and decreased (or even eliminated) performance-based salary/bonuses.

The new regulation proposed by the SEC was notably preceded by a rule that was passed just a few months ago, which empowers stockholders to execute non-binding votes on the salaries awarded to company executives (a.k.a. “say-on-pay” see previous post: