Corporate and Financial Institution Compensation Fairness Act of 2009 Threatens Unprecedented Regulation of Hedge Fund Performance Fees

On July 31, 2009, the U.S. House of Representatives passed the Corporate and Financial Institution Compensation Fairness Act of 2009 (Act).  The Act consists of two components.  The first component is a “say-on-pay” provision that would, among other things, provide for a separate, non-binding shareholder vote on executive compensation and “golden parachutes” at public companies.  The second component – and the more interesting (and potentially game changing) one for hedge fund managers – provides for “enhanced compensation structure reporting” requirements that would apply to “covered financial institutions” (CFIs), a term that would include, among others, hedge fund managers.  The enhanced compensation structure reporting requirements would require “appropriate Federal regulators” jointly to prescribe, no later than nine months after the date of enactment of the Act, regulations requiring disclosures that would enable the regulators to determine whether a CFI’s incentive compensation (1) “is aligned with sound risk management,” (2) “is structured to account for the time horizon of risk” and (3) meets such other criteria as the regulators may determine to be appropriate to reduce unreasonable incentives for employees of CFIs to take undue risks that could threaten the safety and soundness of the CFI or could have serious adverse effects on economic conditions or financial stability.  The Act also contains a “rule of construction” providing that nothing in the Act shall be construed as requiring the reporting of actual compensation of individuals, and exempts CFIs “with assets of less than” $1 billion.  The hedge fund community has been taken aback by the capacious and ambiguous drafting, and the profound ramifications that the Act, if passed in its current form, could have for hedge fund compensation arrangements.  Read literally, the Act would give regulators unprecedented discretion to substantively regulate the performance-based fees charged by hedge fund managers – one of the bedrocks of the hedge fund business model (albeit a bedrock that is shifting in its precise shape and scope).  The Act still remains to be passed by the Senate, and presented to the President, and even if it becomes law in something like its current form, the undefined terms in the Act likely would assume some specificity through implementing regulations.  As it stands, however, the Act represents a significant government intervention into an area heretofore considered the exclusive province of private agreements.  We discuss the likely effect of the Act on performance fees, base salaries and assets under management; application of the $1 billion exclusion; likely construction of the phrase “sound risk management” and who will construe it; whether the Act will require calculation of performance fees based on performance over a number of years; and what may constitute “inappropriate risks.”

To read the full article

Continue reading your article with a HFLR subscription.