When enacted, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act"), passed by the House of Representatives and the Senate and expected to be signed into law by President Obama shortly, will impose new executive compensation and corporate governance requirements on public companies and public and, in some cases, private financial institutions. Some of these requirements codify standards already imposed by the national securities exchanges on listed companies. Others will change the structure of compensation programs, increase proxy disclosure and empower shareholders of public companies in general and financial institutions in particular. Most will be in effect for the 2011 proxy season.
What You Need to Know - And Do - Now
The Act is intended to give public company shareholders a greater voice in executive compensation and impose regulatory scrutiny on a broader range of public and private financial services companies through the following requirements:
New Powers for Public Company Shareholders:
- A nonbinding shareholder say-on-pay vote at least once every three years.
- A nonbinding shareholder vote on golden parachutes in change of control transactions, separate from the vote approving the transaction.
- Shareholder access to issuer proxy materials for the purpose of nominating director candidates.
- Prohibition against broker voting of securities without instruction from the beneficial owner in the election of directors.
New Public Company Governance and Accountability Standards
- Independence standards for compensation committee and selection procedures for committee advisors.
- Clawback requirements for incentive compensation paid on the basis of erroneous performance data, regardless of culpability.
New Investor Disclosure Requirements
- Disclosure of the relationship of executive compensation to total shareholder return in proxy materials.
- Disclosure of the ratio of chief executive officer pay to the median compensation of other employees in securities law filings such as prospectuses, annual reports and proxy statements.
- Disclosure of an issuer's policy on separation of the roles of chairman and chief executive officer.
- Disclosure of employee and director hedging policies in proxy materials.
- Disclosure of institutional investors' say-on-pay votes.
- Disclosure regarding compensation consultants' conflicts of interest.
Special Provisions for Public and, in Some Cases, Private Financial Institutions:
- Increased regulation of executive compensation structures at financial institutions with more than $1 billion in assets.
- Mandatory board-level risk committees for financial companies.
- Expanded regulatory power to recover compensation from executives and directors of systemically significant failing financial companies.
Congress left the implementation of many of these new requirements, including exemptions from some or all of the requirements, to future rulemaking by the Securities and Exchange Commission (the "SEC") or other federal regulators. Affected companies will want to assess the likely effects of the Act on their operations and investor disclosure practices, and monitor regulatory developments.
New Powers for Public Company Shareholders
- Non-Binding Say-on-Pay. The Act requires public companies with securities registered under the Securities Exchange Act of 1934, as amended (the "Exchange Act") to give their shareholders a "say-on-pay" by including a separate, non-binding proposal allowing shareholders to vote on the compensation of executive officers.
While many of the specifics of what must be included in a "say-on-pay" proposal will be left to SEC rulemaking, the Act requires that shareholders vote on matters disclosed under Item 402 of Regulation S-K, which includes, among other things, the Summary Compensation Table and the calculation of golden parachute payouts in the event of a change in control of an issuer.
The Act requires that say-on-pay proposals must be voted on by shareholders at least once every three years, beginning with the first meeting of shareholders that will occur more than six months after the date on which the Act is signed into law by the President. Thus, for example, if the Act were to be signed by President Obama shortly as expected, the say-on-pay votes would be required for the 2011 annual shareholder meetings or such other shareholder meetings for which the SEC proxy rules require executive compensation disclosure, unless such meetings were held in early January 2011 or earlier.
Public companies must also give their shareholders the right to choose to hold say-on-pay votes more frequently. At the first annual or other meeting of shareholders to occur at least six months after the date on which the Act is signed into law by the President, and every six years thereafter, shareholders must be given the opportunity to vote to determine whether a say-on-pay vote will occur every one, two or three years.
Under the Act, a shareholder say-on-pay vote is not binding on the issuer and is not to be construed as overriding any decision of the company or its board of directors, creating or implying any change to applicable fiduciary duties, creating or implying any additional fiduciary duties, or restricting or limiting shareholders' ability to make other executive compensation proposals for inclusion in the issuer's proxy solicitation materials. Despite their non-binding nature, say-on-pay votes will increase communication between corporate directors and investors on executive pay policies and facilitate investor influence in this area.
- Shareholder Vote on Golden Parachutes. The Act requires every proxy statement seeking a shareholder vote to approve an acquisition, merger, consolidation or proposed sale of all or substantially all of a reporting company's assets to include a to-be-prescribed form of disclosure regarding any agreements or understandings with any named executive officer of the seller concerning any type of compensation (whether present, deferred or contingent) that is based on or otherwise relates to the transaction and the aggregate total of such compensation.
The proxy statement must also include a separate shareholder resolution to approve such arrangements, understandings or compensation as disclosed, unless they have been the subject of a prior annual, biennial or triennial say-on-pay vote. The extent to which a regular say-on-pay vote will, in practice, eliminate the need to a separate vote in a specific transaction is unclear.
The requirement to have a separate vote on golden parachute and similar arrangements is effective for shareholder meetings occurring more than six months after the President signs the Act and thus may impact transactions recently announced or currently in negotiation if the shareholder meeting for any such transaction will be held after mid-January 2011 (assuming the Act is signed into law shortly as expected).
Similar to triennial say-on-pay proposals, the Act provides that a shareholder vote on golden parachutes is not binding on the issuer and is not to be construed as overriding any decision of the issuer or its board of directors, creating or implying any change to applicable fiduciary duties, creating or implying any additional fiduciary duties or restricting or limiting shareholders' ability to make other executive compensation proposals for inclusion in the issuer's proxy solicitation materials.
The Act expressly permits the SEC, by rule or order, to exempt an issuer or class of issuers from the requirement to include say-on-pay and golden parachute votes in certain proxy statements and directs the SEC to take into account whether these requirements "disproportionately burden small issuers." Therefore, it is possible that the SEC could exempt smaller reporting companies from these requirements in the future.
- Proxy Access for Director Nominees. The Act specifically authorizes, but does not require, the SEC to issue rules requiring issuers to include nominees submitted by shareholders in their proxy materials for the election of directors, in accordance with a to-be-prescribed procedure.
- Prohibition on Broker Voting of Securities Without Instruction. The Act requires the SEC to require each national securities exchange to prohibit brokers and others who are not beneficial owners from granting a proxy to vote shares if it has not received voting instructions from the beneficial owner in the case of a vote on the election of directors, executive compensation or any other "significant matter" (as determined in rules of the SEC).
New Public Company Governance and Accountability Standards
- Independence Standards for Compensation Committees and Their Advisors. Codifying substantially similar rules already in place at each national securities exchange, the Act requires that each national securities exchange require its listed companies to have a compensation committee that consists solely of members of its board of directors and solely of directors who are independent.
The Act further requires the SEC to identify factors that affect the independence of a compensation committee's consultants, legal counsel or other advisors and provides that a compensation committee may only select a consultant, legal counsel or other advisor after taking these factors into account. The factors must be competitively neutral in order to preserve the ability of a compensation committee to retain the services of members of any such category and must include the provision of other services to the issuer, the relationships of the fees paid by the issuer to the total revenue of the service provider, the policies and procedures of the service provider that are designed to prevent conflicts of interest, any business or personal relationship between the service provider and any member of the compensation committee, and any issuer stock owned by the service provider.
The Act requires that a public company's compensation committee have the authority to retain or obtain the advice of a compensation consultant, whether or not independent, and to be directly responsible for the appointment, compensation and oversight of the work of the consultant. Each proxy statement for an annual meeting of shareholders occurring more than one year after the date of enactment must disclose whether the compensation committee has retained or obtained the advice of a compensation consultant and whether the work of the compensation consultant has raised any conflict of interest and, if so, the nature of the conflict and how the conflict is being addressed.
The Act further requires that the compensation committee of an issuer have the authority to retain and obtain the advice of independent legal counsel and other advisors, and to be directly responsible for the appointment, compensation and oversight of their work.
Issuers must provide appropriate funding, as determined by the compensation committee, for payment of reasonable compensation to a compensation consultant and independent legal counsel and other advisors.
The Act requires the SEC to promulgate rules within 360 days after the President signs the Act requiring each national securities exchange to prohibit the listing of any issuer that is not in compliance with these requirements.
Contrary to some reports, the Act does not require a compensation committee to retain independent legal counsel; only that it have the right to do so. Any requirement that a compensation committee be "directly responsible" for the oversight of counsel's work may produce a change in the way some compensation committees with independent counsel currently work.
- Clawback Policies. The Act requires that listed companies be required to disclose their policies for incentive-based compensation that is based on information required to be reported under the federal securities laws. It also requires that listed companies' policies require the recovery from any current or former executive officer (regardless of culpability) of any incentive-based compensation (including stock options awarded as compensation) received by the executive during the three-year period preceding the date on which the issuer is required to prepare an accounting restatement due to any material non-compliance of the issuer with any financial reporting requirements under the securities laws, based on erroneous data, to the extent the compensation exceeds the amount that would have been paid under the accounting restatement. Any SEC rules on the required clawbacks can be expected to cover matters such as whether the rule applies to compensation awarded, earned or paid, and how to determine the amount that would have been paid under an accounting restatement when the amount is based on something not directly related to the financial statement, such as stock price.
The Act does not establish a time frame for the SEC to act.
New Investor Disclosure Requirements
- Proxy Statement Disclosure of Executive Pay Relative to Performance. The Act requires the SEC to amend its disclosure rules for proxy statements to require a disclosure of the relationship between compensation actually paid to named executive officers and the financial performance of the issuer, taking into account changes in stock price, dividends and other distributions. The disclosure is required in proxy statements for annual meetings of shareholders. The Act does not establish a time frame for issuance of amended rules.
- Disclosure of Ratio of CEO Pay to Median Pay. The Act also requires the SEC to amend its regulations to require that any prospectus, proxy statement or annual report filed with the SEC include a disclosure of (a) the median of the annual total compensation of all employees of the issuer (other than the chief executive officer), (b) the annual total compensation of the chief executive officer, and (c) the relationship between the foregoing amounts. Total compensation for these purposes is based on the definition of total compensation used for the last column in the summary compensation table included in the SEC's disclosure regulations as in effect on the day before enactment. It appears that this definition may only be changed by legislative action and includes equity compensation awards based on their value for accounting expense when granted regardless of when they are vested and regardless of their ultimate realized value. It also would exclude the value of certain broad-based benefits such a health, life, disability and other insurance benefits that may constitute a disproportionately high percentage of the total pay and benefits of lower paid workers. It is not clear how the compensation of part-time and part-year workers will be addressed. It is not clear what flexibility the SEC will have to address these issues.
- Disclosure Regarding Employee and Director Hedging. The Act requires the SEC to amend its proxy disclosure rules for annual meetings of shareholders of reporting companies to require a disclosure regarding whether any employee or member of the board if directors, or their designees, is permitted to purchase financial instruments (such as prepaid variable forward contracts, equity swaps, collars and exchange funds) that are designed to hedge or offset any decrease in the value of equity securities of the issuer granted by the issuer as compensation or held directly or indirectly by the employee or director. The Act does not establish a time frame for the SEC to issue rules on this topic.
- Disclosure of Institutional Investors' Say-on-Pay Votes. The Act requires institutional investment managers to report at least annually how they voted on any shareholder say-on-pay or golden parachute proposal, unless their vote is otherwise required to be publicly reported.
Special Provisions for Financial Institutions
- Interagency Guidance on Compensation and Risk. The Act requires the Board of Governors of the Federal Reserve System ("Federal Reserve"), the Office of the Comptroller of the Currency ("OCC"), the Federal Deposit Insurance Corporation ("FDIC"), the Office of Thrift Supervision ("OTS"), the National Credit Union Administration, the SEC and the Federal Housing Finance Agency to issue joint regulations or other guidance not later than nine months after the date that the Act becomes law.
The guidance is supposed to require each covered financial institution, whether publicly or privately held, to disclose to its applicable federal regulator information regarding the structure of its incentive compensation programs sufficient to enable the regulator to determine whether the structure provides an executive officer, employee, director, or principal shareholder with excessive compensation, fees or benefits or could lead to a material financial loss to the institution. The guidance is also supposed to prohibit any types of incentive-based payments, or any features of such arrangements, that the regulators determine encourages inappropriate risks by providing excessive compensation, fees or benefits or creating the potential to lead to material financial loss.
The guidance will apply to all depository institutions, depository institution holding companies, registered broker-dealers, credit unions, investment advisors, Fannie Mae, Freddie Mac and any other entity which the regulators jointly determine should be covered by the guidance. A foreign bank or company that is treated as a bank holding company for purposes of the Bank Holding Company Act of 1956 as amended ("BHC Act"), pursuant to section 8(a) of the International Banking Act of 1978, is treated as a bank holding company for purposes of the Act and is also subject to the guidance. The Act provides an exemption for entities with less than $1 billion in assets.
The likely effect of these provisions will be to bring all financial institutions under a uniform supervisory regime for executive and incentive compensation that is substantially similar to the Interagency Guidance on Sound Incentive Compensation Policies issued jointly by the Federal Reserve, the OCC, the OTS and the FDIC on June 21, 2010.
- Mandatory Risk Committees at Public Financial Companies. The Act requires the Federal Reserve to issue regulations mandating the establishment of a risk committee at each publicly traded bank holding company (including a foreign bank or company treated as a bank holding company for purposes of the BHC Act) with consolidated assets of at least $10 billion and at certain publicly traded non-bank financial companies supervised by the Federal Reserve, and permitting (but not requiring) the Federal Reserve to require the establishment of a risk committee at publicly traded bank holding companies with less than $10 billion of consolidated assets.
The risk committee must be responsible for enterprise-wide risk management practices. The specific duties and responsibilities of the risk committee are not set forth in the Act and will be determined in the rulemaking process. When required, the risk committee must consist of such number of the company's independent directors as the Federal Reserve determines, and must include at least one risk management expert having experience in identifying, assessing, and managing risk exposure of large, complex firms. Depending on the content of the regulations and the composition of the current board of directors, this latter requirement could have the effect of requiring certain bank holding companies to search for additional directors meeting these qualifications.
The Federal Reserve is required to issue these rules within one year after the transfer of the authority and powers of the OTS to the other federal banking agencies (generally expected to occur within one year after the Act becomes law) to be effective within 15 months after such transfer occurs.
- Recovery of Executive Compensation Paid by Systemically Significant Failing Financial Companies. The Act expands the FDIC's powers to serve as receiver for the orderly liquidation of financial institutions, including non-public institutions, to include "covered financial companies" as well as insured depository institutions.
Financial companies include domestic entities (foreign entities are excluded from the FDIC's expanded resolution powers) that are bank holding companies, non-bank financial companies supervised by the Federal Reserve, other companies determined by the Federal Reserve to be predominantly engaged in activities that are financial in nature or incidental thereto, and the subsidiaries of any of the foregoing entities. A financial company is a "covered" financial company if the Secretary of the Treasury has determined, among other things, that it is in default or in danger of default, its failure or other resolution would have serious adverse effects on financial stability in the United States, and no viable private resolution alternative exists.
The Act empowers the FDIC, as receiver of any covered financial company, to recover from any current or former senior executive or director substantially responsible for the failed condition of the covered financial company any compensation received during the two-year period preceding the date the FDIC is appointed receiver. In the case of fraud, the right of recovery is not limited to two years of compensation. The FDIC is required to issue regulations for this purpose defining compensation to include any financial remuneration, including salary, bonus, incentives, benefits, severance, deferred compensation or golden parachute benefits, and any profits realized from the sale of securities of the covered financial company. Based on this definition, recoverable compensation could, under the regulations, include items such as qualified retirement benefits and gains on the sale of securities not acquired through equity compensation plans.