Thursday, March 3, 2011
KEY GOVERNANCE AND EXECUTIVE COMPENSATION PROVISIONS IN THE DODD-FRANK BILL
On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”). While the Act is focused primarily on overhauling the U.S. financial regulatory system, the Act contains several provisions that will have a major impact on public companies. This Client Alert briefly summarizes the key corporate governance and executive compensation provisions that apply to U.S. public companies and provides several considerations for the 2011 proxy season.
Proxy Access: The Act provides the SEC with explicit authority to adopt rules requiring public companies to include director nominees submitted by shareholders in the public company’s proxy solicitation materials. This is the most controversial corporate governance provision in the Act and was designed to counter prior arguments that the SEC did not have the authority to mandate shareholder access. It is expected that the SEC will adopt final proxy access rules before the 2011 proxy season. Our expectation is that proxy access rules will lead to an increase in contested elections at future annual meetings.
Once the SEC adopts final proxy access rules (the SEC proposed rules in June 2009), public companies may need to amend their bylaws and other governance policies in response to the rules. Additionally, while the Act does not set forth any stock ownership mandates for access rights, we nevertheless recommend that public companies examine their existing shareholder bases in light of the percentage ownership thresholds in the SEC’s most recent rule proposal to determine whether there are any shareholders (or potential groups of shareholders) that may exceed the applicable thresholds and are likely to pursue the new nomination system.
Say-On-Pay: Beginning with the first annual meeting of shareholders that occurs more than six months after the Act’s enactment, each public company must provide shareholders at least once every three years with a non binding advisory vote to approve the compensation of the company’s named executive officers (as disclosed in the CD&A section and compensation tables of the proxy statement). Additionally, once every six years, each public company must provide shareholders with a non binding advisory vote to determine whether the say-on-pay vote should occur once every one, two or three years.
Public companies, in consultation with their outside counsel and compensation consultants, will need to prepare these proposals for annual meetings occurring during the 2011 proxy season. While these votes are non-binding, companies nevertheless will want to tell shareholders a compelling story about their compensation programs, in particular explaining the relationship between compensation policies and the performance of the company, when drafting say-on-pay proposals for the 2011 proxy season. Additionally, compensation committees will need to be particularly mindful of common shareholder concerns when structuring and setting executive compensation. Subject to compliance with Regulation FD, companies may also want to proactively discuss executive compensation issues with significant shareholders before the 2011 say-on-pay vote in time to address any concerns that might result in a negative vote. If majority approval is not obtained at the annual meeting, companies may want to follow up with significant shareholders to understand and appropriately respond to objections.
Compensation Clawbacks: The Act requires the SEC to direct the stock exchanges to prohibit the listing of any public company that fails to adopt a claw-back policy for recouping incentive based compensation (including stock options) from current and former executive officers in the event of an accounting restatement due to the company’s material noncompliance with financial reporting requirements. The provisions of the Act are further-reaching than the claw-back requirements under the Sarbanes Oxley Act, in that they cover any current or former executive (while SOX covers only the CEO and CFO), have a longer look-back period (3 years, versus 12 months under SOX) and do not require misconduct. The Act also mandates that the SEC require each listed company to have a policy providing for disclosure of its policy on incentive-based compensation that is based on financial information required to be reported under the securities laws.
In addition to adopting a policy addressing these topics, listed companies may need to review their incentive based compensation plans for potential amendment once the SEC adopts final rules. The Act does not set a deadline for the SEC’s implementation of these requirements.
Compensation Committee Independence and Oversight: The Act requires the SEC to adopt rules, within 360 days after the date of the Act’s enactment, directing the stock exchanges to prohibit the listing of companies lacking a completely independent compensation committee. For purposes of the Act, independence is to be determined under a more stringent definition, one that is similar to the definition that is currently imposed on audit committee members (which prohibits members from accepting any consulting, advisory or other compensatory fees from the company and prohibits members from being an affiliate of the company or any of its subsidiaries). In addition, the compensation committee must have sole discretion to retain a compensation consultant, independent legal counsel and other advisors and will be directly responsible for the selection, compensation and oversight of such advisors. Compensation committees may only select advisors after taking into account a number of factors that could affect their independence.
The SEC’s rules, once adopted, could have a significant impact on the composition of compensation committees. Public companies will need to re-evaluate the independence of their compensation committee members under the new independence standards, as well as assess the independence of advisors to the compensation committee. Public company boards will also need to review their compensation committee charters for necessary changes, including procedures for retaining and engaging advisors.
Shareholder Approval of Golden Parachutes: Any proxy statement for a shareholder meeting occurring more than six months after enactment of the Act that solicits approval of a change-in-control transaction (an acquisition, merger, consolidation or sale of all or substantially all of a public company’s assets) must include additional disclosures and a separate non-binding shareholder vote on any golden parachute compensation to be paid to named executive officers. However, under the Act, a shareholder vote on parachute payments is not required if the parachute agreements or understandings have already been subject to a say-on-pay vote.
It is unclear whether shareholder votes on parachutes will have an impact on the approval of change-in-control transactions. We expect the SEC to provide guidance on the interpretation of several unclear terms and the application of this provision.
Disclosure of Pay Versus Performance and Internal Pay Equity: The SEC must adopt rules requiring public companies to include information in their proxy statements detailing the relationship between executive compensation actually paid and the company’s financial performance, taking into account any change in stock value, dividends and any distributions. In addition, the SEC must amend its rules to require companies to disclose (i) the median annual compensation for all employees (except the CEO), (ii) the total annual compensation of the CEO and (iii) the ratio of the two.
Public companies will need to prepare these disclosures for the proxy statement once the SEC amends its disclosure rules, for which no deadline has been set; however, companies will nevertheless want to address the pay versus performance topic voluntarily in their say-on-pay proposals that will appear in proxy statements during the 2011 proxy season. Additionally, unless the SEC adopts rules simplifying the calculation of compensation of employees for purposes of the internal pay equity analysis and disclosure (which may need to be calculated in the same manner and with all of the components as for the CEO in the Summary Compensation Table), this calculation is likely to be burdensome for many public companies.
Discretionary Voting by Brokers: The Act requires stock exchanges to prohibit their member brokers from voting shares held in street name with respect to director elections, executive compensation or “any other significant matter” as determined under SEC rules, unless the beneficial owner of the shares provides the broker with specific voting instructions. This provision codifies and expands the scope of NYSE Rule 452, which the NYSE voluntarily amended in 2009 in order to eliminate broker discretionary authority to vote in uncontested director elections.
The expansion of the prohibition on discretionary broker voting will likely have a significant impact on the new advisory say-on-pay and say-on-parachute votes, discussed above, and it remains to be seen whether the SEC will eliminate discretionary voting for any other matters. We expect that public companies will need to engage in more active proxy solicitation efforts generally in response to this provision of the Act.
Disclosure of Chairman and CEO Positions: The SEC is required to adopt rules within six months of enactment of the Act requiring public companies to disclose whether they have separated or combined the positions of CEO and chairman of the board. Most public companies already provide this disclosure under existing SEC rules (which require discussion of the company’s leadership structure), so it is unlikely that additional disclosure will be necessary under the Act for most public companies.
Disclosure Regarding Compensation Consultant and Conflict: One year after enactment of the Act, public companies must disclose whether the compensation committee has retained a compensation consultant and whether the consultant’s services have raised any conflict of interest, and, if so, the nature of the conflict and how the conflict is being addressed. Compensation committees will need to evaluate the relationship between the company and the compensation consultant, including reviewing all work being performed by their compensation consultants for the company, to see whether there are any disclosable conflicts of interest.
Disclosure of Employee and Director Hedging: The SEC must adopt rules requiring proxy statement disclosure of whether any director or employee is permitted to purchase financial instruments (e.g., prepaid variable forwards, equity swaps, collars, etc.) to hedge against any decrease in the value of the company’s equity securities, whether received as compensation or otherwise directly or indirectly held. Companies will need to review their insider trading policies and consider whether any revisions to the policies are warranted to deal with this disclosable issue.
Disclosure of Investor Votes on Executive Compensation and Golden Parachutes: Institutional investment managers required to file a Form 13F with the SEC (beneficial ownership of $100 million or more of exchange-traded shares) must report at least annually how they voted with regard to say-on-pay and say-on-parachute proposals. Presumably, this reporting will occur on Schedule 13F, although this is not specified in the provision. Public companies that are required to file Forms 13F will need to monitor guidance from the SEC on how it expects investment managers to comply with this mandate prior to filing their next Form 13F.
What Public Companies Should Do Now
While many provisions of the Act require the SEC to implement rules that will be proposed and adopted over the next year, we believe that most of the corporate governance and executive compensation disclosure requirements will be effective for the 2011 proxy season. Additionally, while companies will not be able to finalize all of their plans to comply with the Act until the SEC adopts new rules, companies should begin to assess and consider adjustments in their governance practices that will ultimately be required, including confirming the independence of compensation committee members and consultants and devising or amending claw-back policies. Also, companies which have not previously had a say-on-pay advisory vote should begin to consider plans for managing shareholder relations and review their compensation disclosures. Finally, it is expected that the SEC will make certain exemptions available for smaller reporting companies where the Act directs the SEC to take company size into consideration. This Client Advisory is only a brief summary of the principal governance and executive compensation provisions of the Act that apply to U.S. public companies and is qualified by reference to more complete (and far longer) descriptions and analyses that are publicly available and the text of the Act itself.
This Alert is for information purposes only, is general in nature and should not be construed as legal advice. This information is not intended to create, and receipt of it does not constitute a lawyer-client relationship. For further information or an explanation about the matters discussed in this Alert, please contact any of the following attorneys in our Securities Regulation & Corporate Finance Practice Group.