New Executive Compensation and Governance Requirements in Financial Reform Legislation
Financial Services Reform Alert
by
James E. Earle
. July 7, 2010
K&L Gates published this alert prior to July 21, 2010, the date on which President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. However, this alert discusses the final version of the bill that would eventually be signed into law.
Introduction
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”), while delayed as the Senate leadership searches for votes, is almost certain nevertheless to be enacted in mid-July 2010. While the Act’s primary purpose is to broadly reform the regulation of the financial services industry, within the massive text of the Act lurk new requirements that may impact executive compensation and corporate governance practices at most public companies, not just banks. This alert highlights these key executive compensation and governance changes.
In many cases, the Act directs the Securities and Exchange Commission (“SEC”) to implement the Act’s requirements by adopting rules or directing the national securities exchanges or associations (the “securities exchanges”) to adopt rules. The Act also authorizes the SEC or securities exchanges to exempt certain companies, such as smaller issuers, from some of the Act’s requirements.
Key Executive Compensation Changes
1. Say-on-Pay
Section 951 of the Act includes two new requirements for public companies to obtain non-binding shareholder approval on executive compensation matters (frequently referred to as “say-on-pay” votes).
First, shareholders must be given a vote on compensation to the company’s named executive officers as disclosed in the executive compensation sections of the annual proxy statement. These disclosures include the Compensation Discussion and Analysis, Summary Compensation Table and various supporting compensation tables and disclosures. Companies must hold this shareholder vote at least once every three years. The shareholders separately determine whether the vote must be obtained on a cycle of every one, two or three years. The shareholders must have a chance to separately vote on the approval cycle at least once every six years.
Second, the so-called “golden parachute” say-on-pay rule requires companies to give shareholders a non-binding vote in connection with shareholder approval of certain mergers, acquisitions or dispositions over compensation to named executive officers based on or relating to the transaction. The compensation arrangements, including potential or contingent payments and the aggregate amount that may be paid to each officer, must be clearly disclosed in the proxy statement or other materials for the shareholder vote on the transaction. The shareholder vote on the compensation arrangements must be separate from the shareholder vote on the transaction. A transaction-related shareholder vote is not required, however, for an arrangement that was subject to a shareholder vote at an annual meeting under the first say-on-pay requirement described above.
Shareholder votes under these requirements are not binding on the company. The Act also makes clear that the shareholder votes do not change or add fiduciary duties for the board and do not limit the ability of shareholders to submit proposals on executive compensation matters. Both requirements first apply to shareholder meetings occurring more than six months after enactment. This means that these requirements will apply for many companies for the first time in the spring 2011 proxy season, assuming a July 2010 enactment. One open question for the SEC to answer in its rulemaking is whether preliminary proxy statements will need to be filed because of the say-on-pay vote requirement.
Say-on-pay shareholder votes have become more common in the U.S. over the last several years. Banks that received financial assistance under the Troubled Asset Relief Program (“TARP”) were required to hold a say-on-pay vote. Dozens of other businesses across various industries have voluntarily included a shareholder vote on executive compensation. While three companies have failed to garner majority support in their say-on-pay votes during the 2010 proxy season, shareholders have, in most cases, shown high levels of support for the disclosed executive compensation.
In addition, one of the main purposes of say-on-pay votes is to encourage better dialogue between companies and their key shareholders on executive compensation matters. To avoid an embarrassing (although non-binding) “no” vote, companies should focus on the quality of their executive compensation disclosures and proactively reach out to key shareholders in order to discuss any concerns about the company’s executive compensation programs.
The Act does not specify the exact form of shareholder resolution to be voted on. Companies should consider alternative formulations for the resolution in order to best obtain meaningful information from the vote and to best facilitate dialogue with shareholders. In addition, many shareholders may look to voting recommendations from proxy advisory firms, such as RiskMetrics and Glass Lewis. As a result, the influence of these proxy advisory firms may further expand. Public companies may need to closely follow the say-on-pay voting policies developed by these firms. For 2010, RiskMetrics has recommended votes against approximately 17% of say-on-pay voting proposals, including TARP companies, most often citing “disconnects” in pay-for-performance.
2. Compensation Committee Independence
Section 952 of the Act requires that most public companies have compensation committees comprised exclusively of “independent” directors. The definition of “independence” for this purpose is to be developed by the securities exchanges, but at a minimum must take into account (i) consulting, advisory or other fees received by the director other than for service on the board and (ii) whether the director is an “affiliate” of the company or its subsidiaries. The Act requires the securities exchanges to publish rules regarding these requirements within 360 days after enactment.
The formulation of the independence standard under the Act mirrors the independence standard that applies to audit committee members under Section 301 of the Sarbanes-Oxley Act. The extent to which this requirement imposes a greater independence standard than current listing rules will depend on how the securities exchanges develop the rules.
One issue to monitor will be whether significant share ownership could potentially disqualify a director from service on the compensation committee under the new requirement. There will likely continue to be separate standards for determining whether compensation committee members are “non-employee directors” for purposes of Section 16 under the Securities Exchange Act or “outside directors” under Section 162(m) of the Internal Revenue Code.
3. Independence of Compensation Consultants and Other Advisers
Section 952 of the Act also addresses Congress’s concerns about the independence of compensation consultants, legal counsel and other advisers to the compensation committee. While the Act does not mandate use of independent compensation consultants or other advisers, it does require the compensation committee to consider factors that could affect the independence of the consultant/adviser. These factors include (i) other services provided by the consultant’s/adviser’s firm, (ii) the amount of fees received by the consultant’s/adviser’s firm from the company relative to the firm’s total revenues, (iii) the consultant’s/adviser’s firm’s policies to limit conflicts of interest, (iv) business or personal relationships between the consultant/adviser and any member of the compensation committee, and (v) share ownership by the consultant/adviser.
The compensation committee retains full authority to engage and oversee its own compensation consultants and other advisers, and the company must provide sufficient resources for the committee to pay those consultants/advisers. The Act clarifies that the compensation committee need not follow the advice of its consultants/advisers, nor does the retention of consultants/advisers relieve the compensation committee from the requirement to exercise its own judgment in fulfilling its duties.
The company must disclose in its annual proxy statement whether the compensation committee has retained a compensation consultant, whether the work of the compensation consultant raises any conflict of interest concerns, and if so, how those concerns have been addressed. This disclosure requirement does not apply to other advisers.
The Act directs rules to be published regarding these requirements within 360 days after enactment. The Act also commissions a study and report by the SEC on the use of compensation consultants, to be submitted to Congress within two years after enactment.
Proxy statement rules already require disclosure regarding the use of compensation consultants, including the identity of the consultant, the types of services provided, and if other non-compensation services are also provided, details on those other services. The disclosures required under the Act do not appear any more comprehensive. Nevertheless, over the last several years there has been considerable pressure on compensation consulting firms retained by compensation committees not to provide broader services to the company, and some management consulting firms have divested or spun off their compensation consulting units in order to avoid such potential conflicts. The Act will continue and increase this pressure.
There has generally not been as much emphasis on compensation committees retaining independent legal counsel, but it is not clear how the Act might impact the delivery of legal services to compensation committees.
4. Additional Executive Compensation Disclosures
Section 953 of the Act imposes two new disclosure requirements regarding executive compensation. First, under what is styled as “disclosure of pay versus performance,” the Act requires the SEC to establish rules regarding “clear disclosures” of executive compensation, including the relationship between amounts actually paid and the company’s financial performance, taking into account stock prices and dividends. The Act states that this disclosure may be provided graphically.
Second, the Act requires disclosure of the ratio of the CEO’s total annual compensation compared to the median total annual compensation of all employees other than the CEO. “Total annual compensation” for this purpose means the total compensation amount reported in the Summary Compensation Table. The Act does not specify a date by which the SEC must adopt these rules.
It is unclear exactly what additional disclosures will be required under the first rule. The current proxy disclosure rules require clear, plain English disclosures regarding the executive compensation policies and, particularly in the case of performance-based compensation, payment outcomes. The reference to a “graphic” disclosure may suggest disclosures similar to the “performance graph” that was previously required to be included in annual proxy statements.
The second new rule raises potentially significant practical challenges. Determining the Summary Compensation Table total compensation amounts for a limited group of executive officers often presents difficulties, especially in identifying and quantifying perks, above-market earnings on deferred compensation, and changes in the present value of pension benefits. How these amounts can be determined for all employees in order to derive a median value may be extremely difficult for many companies. One can only hope that SEC rules will provide clear guidance and rules of convenience to reduce the potential burdens of this rule.
5. Enhanced Clawbacks
Section 954 of the Act requires companies to adopt and implement policies that will require recovery of prior incentive compensation awards (including stock options) that were based on financial information later restated due to the company’s material non-compliance with any financial reporting requirements under the securities laws. These are often referred to as “clawback” policies. The clawback will apply to incentive compensation awarded to any current or former executive officers within three years before the date of the triggering financial restatement. No misconduct on the part of the executive officer will be required.
The Act requires the SEC to direct the securities exchanges to prohibit the listing of any companies that do not meet this requirement. The Act, however, does not specify a date by which the SEC or the securities exchanges must adopt rules regarding this requirement.
This new rule significantly expands on the Sarbanes-Oxley Act’s clawback, which applies only to the CEO and CFO, has only a one-year lookback, and requires misconduct. However, the new rule is in some ways less expansive than the clawback requirement applicable to banks that received financial assistance under TARP. In particular, the TARP clawback could be triggered without regard to whether a financial restatement was required.
For option awards, it is unclear if the clawback would apply only or primarily to (i) options granted based on erroneous financial results, (ii) performance-based options that vest and become exercisable based on such financial results, or (iii) any in-the-money option that is exercised during the prior three-year period regardless of when it was granted or how it became vested. Another uncertainty is how the clawback rules will deal with incentive compensation that is based on a number of factors in addition to financial performance.
One of the biggest legal challenges for any clawback policy is establishing an enforceable right against compensation previously paid. Companies will need to consider how to most effectively incorporate this new clawback requirement into incentive compensation awards. Given the three-year lookback, depending on how the rules are developed, the clawback requirement might attach to individuals who were not executive officers at the time the incentive compensation was awarded.
6. Disclosure of Hedging Policies
Section 955 of the Act requires disclosure as to whether directors or employees of the company are permitted to hedge against stock price drops with respect to equity compensation awards. The Act does not specify a time by which the SEC must adopt rules regarding this disclosure. Although some companies have adopted anti-hedging policies for executives and directors, the requirement under the Act more broadly refers to all employees.
7. Excessive Compensation at “Covered Financial Institutions”
Section 956 of the Act potentially creates new regulatory limits on compensation at “covered financial institutions.” For this purpose, a “covered financial institution” means any of the following entities that has $1 billion or more in assets — a depository institution, a holding company for a depository institution, a broker-dealer registered under the Securities Exchange Act, a credit union, an investment advisor under the Investment Advisers Act or any other financial institution that the applicable regulators determine should be covered. (Fannie Mae and Freddie Mac also are covered.) Unlike the other executive compensation provisions in the Act, the covered financial institutions subject to this rule include both public and private companies.
The applicable regulators (which include the Federal Reserve, FDIC, OCC, SEC and others) have nine months after enactment to establish rules by which covered financial institutions must disclose to their applicable regulator all incentive compensation plans (i.e., not solely executive officer plans). This disclosure is intended to allow the applicable regulator to determine whether the covered financial institution’s incentive plans encourage “inappropriate risks” (i) through providing “excessive compensation, fees or benefits” to its executive officers, employees, directors or principal shareholder or (ii) that could lead to a material financial loss for the covered financial institution. The rules also will directly prohibit such “excessive compensation, fees or benefits.” The Act cross-references certain provisions of the Federal Deposit Insurance Act regarding the intended meaning of “excessive” compensation.
It is not clear how the various regulators will coordinate their rulemaking or how expansive they will be in defining “excessive” compensation. Even the executive compensation limits under TARP did not impose substantive caps on compensation. It is worth noting that the Federal Reserve, FDIC, OCC and OTS recently issued their Guidance on Sound Incentive Compensation Policies (“the Guidance”). The Guidance largely focuses on key principles for ensuring that incentive compensation plans at financial institutions appropriately balance risks with financial performance and compensation rewards. Perhaps the Guidance will inform the rulemaking for this new “excessive compensation” requirement under the Act, especially given the Act’s focus on mitigating against “inappropriate risks.”
Key Governance Changes
1. Broker Non-Votes
Section 957 of the Act prohibits discretionary voting by brokers on shares they do not beneficially own on the following matters — (i) election of directors, (ii) executive compensation matters, and (iii) any other “significant matter” as determined by the SEC. Presumably, the executive compensation matters include the new say-on-pay shareholder votes under Section 951 of the Act. Section 957 of the Act does not prohibit a broker from voting shares if they received voting instructions from the beneficial owner. This new requirement will codify the NYSE rules approved by the SEC in 2009 that preclude discretionary broker votes on director elections, and it will potentially broaden those rules as applied to executive compensation matters.
2. Proxy Access
Section 971 of the Act authorizes (but does not require) the SEC to adopt rules allowing shareholders to nominate candidates for directors, using the company’s proxy statement. There were substantial debates in Congress over whether the Act should include requirements on the level or duration of shareholder ownership. However, due to powerful opposition from shareholder activist groups, these eligibility requirements, if any, were left up to the discretion of the SEC.
Proxy access has been a controversial subject for a number of years. Last summer, the SEC published proposed new rules that would have provided shareholders with an ability to nominate directors through the company’s proxy statement. The SEC expressed a view that this proxy access could make boards more responsive and accountable to shareholder interests.
The SEC proposal included requests for comments on numerous issues, such as – (i) should proxy access be triggered only in case of certain events (such as a management-nominated director receiving a certain percentage of “no” or “withhold” votes), (ii) should proxy access not be required for companies that have adopted a “majority vote” requirement in uncontested elections, (iii) what ownership levels and holding periods should be required before a shareholder could nominate a director candidate through the company’s proxy statement, (iv) should the rules mandate proxy access to shareholders at all companies or simply allow shareholders to propose bylaw changes that would provide for proxy access on a company-by-company basis, (v) should a company be allowed to “opt out” of proxy access if approved by its shareholders, and (vi) how should federal proxy access rules coordinate with potentially conflicting state corporate law requirements?
The SEC received over 500 comment letters on its proposal, expressing a wide range of views on the questions presented. Given the complexity of the issue and the divergence of views, the SEC has not yet adopted a final rule. Indeed, some of the commentary suggested that the SEC lacked authority to adopt proxy access rules, which arguably infringe on internal corporate affairs that are ordinarily the province of state corporate law. It is likely, though, that the authority provided by the Act will spur the SEC to action. It remains to be seen how the SEC will answer the many open questions about proxy access, including the establishment of any shareholder eligibility requirements. The answers to these questions could have potentially profound effects on the director nomination and election process for public companies.
3. Disclosures Regarding CEO/Chairman Leadership Structure
Section 972 of the Act directs the SEC to issue rules requiring disclosure in the annual proxy statement as to why the company either has one person serving in the Chairman/CEO positions or separate people in those roles. The SEC proxy disclosure rules revised last December include a requirement to discuss the rationale for the company’s selected leadership structure. The Act seems to simply codify this requirement and does not appear to add any additional disclosure requirements on this issue.
Conclusion
Much detail for these new executive compensation and governance requirements will come from SEC, securities exchanges or other regulators to be developed over the coming months. Companies will need to monitor closely these developments and potentially consider commenting on proposed rules, if a comment period is made available.
Contacts:
James E. Earle, +1.704.331.7530,
jim.earle@klgates.com
This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.