The Dodd-Frank Wall Street Reform and Consumer Protection Act has added a number of provisions to the proxy statement and annual report requirements which are unlikely to be implemented in time for this year’s proxy statement and annual report but are likely to be required to be addressed in next year’s proxy statement and annual report. This Alert summarizes some of the most significant requirements, including the new disclosures required by these provisions, the actions that you can take now to begin to prepare for the implementation of these provisions and the possible timing of the implementation of these provisions.
Disclosure Regarding Executive Compensation
Internal Pay Equity. The Dodd-Frank Act requires the SEC to amend Item 402 of Regulation S-K to require registrants to disclose in many of their filings, including proxy statements and annual reports: (1) the median of the annual total compensation of all employees of the registrant, except its Chief Executive Officer, (2) the annual total compensation of the Chief Executive Officer; and (3) the ratio of the two amounts described above. According to the text of the Dodd-Frank Act, total compensation for purposes of this disclosure must be determined in accordance with the required procedures used to calculate “total compensation” in the Summary Compensation Table.
Pay versus Performance. New Securities Exchange Act Section 14(i) requires that the SEC adopt rules requiring registrants to disclose in the annual meeting proxy statement information showing the relationship between compensation and financial performance. This disclosure may be presented in narrative or graph form.
It is unlikely that these requirements will affect 2011 proxy statements because the SEC has not yet adopted the required rules and is not expected to even propose rules on these subjects before August 2011, and may do so as late as December 2011. Nevertheless, registrants should begin assessing their ability to collect and analyze the potentially large amount of data that will be needed to perform these calculations. The components that comprise “total compensation” are numerous and may be particularly troublesome for registrants with employees located in multiple countries.
The Dodd-Frank Act directs the SEC to adopt rules requiring the securities exchanges to delist any exchange listed registrant that does not develop and implement a policy for recovering from current and former executives any incentive-based compensation based on erroneous financial information in the event that an accounting restatement is required to correct material non-compliance with the financial reporting requirements of the securities laws.
The amount of compensation to be recovered is the difference between what was actually paid to the executive and what would have been paid under the restated financial statements, in each case for the three year period preceding the date on which the registrant is required to prepare the accounting restatement. This clawback provision is broader than the one imposed by Section 304 of the Sarbanes-Oxley Act of 2002 (“SOX”) in that it applies to all “executives” rather than merely the Chief Executive Officer and Chief Financial Officer. In addition, it is not necessary for the executive to have committed any personal misconduct in order to be subject to a clawback. The SEC has not yet proposed rules to implement this provision of the Act, and it is not expected to do so before sometime in August-December, 2011.
Many aspects of this provision are unclear and will need to be addressed by the rules. These questions include:
- What is the effect on existing employment agreements that do not include clawback provisions? Will they be required to be amended?
- What is the effect on compensation paid in the past under a plan that did not include a clawback provision?
- What is the effect of releases entered with former executives?
- What is the effect of existing indemnification agreements? At least one judicial decision has held that indemnification for the SOX clawback provision is unenforceable.
Exchange listed registrants can take a number of steps to better prepare themselves for compliance in the future. For example, consider:
- Amending existing clawback provisions to conform to the requirements of the Act.
- Include clauses in new employment agreements, plans, awards and releases making them subject to the requirements of any policy adopted pursuant to the Act.
Compensation Committee Independence and Advisers
New Securities Exchange Act Section 10C requires that the compensation committee of any exchange listed registrant be comprised entirely of independent directors and requires certain disclosure with respect to the independence of compensation consultants and other advisers retained by a registrant’s compensation committee. Section 10C will not become effective until the SEC has adopted rules implementing its provisions, which it is required to do no later than July 16, 2011.
Independence of Committee Members. The SEC’s rules will require securities exchanges to prohibit the listing of any registrant whose compensation committee is not comprised entirely of “independent” directors. The SEC has authority to establish the criteria for “independence,” but the Act requires that these criteria must include (1) the source of the director’s compensation, including any advisory, consulting or other fees paid to the director by the registrant and (2) whether the director is an affiliate of the registrant, any of its subsidiaries or any affiliate of any of its subsidiaries.
In anticipation of SEC rules implementing this requirement, exchange listed registrants should consider:
- Whether any current members of the compensation committee will need to be replaced in order to comply with the new independence requirements.
- Whether their compensation committee charter or other corporate governance policies should be modified to comply with the new independence requirements.
Compensation Consultants and Other Advisers. The SEC’s rules will require securities exchanges to prohibit the listing of any registrant that does not grant its compensation committee the authority to retain its own compensation consultants, legal counsel and other advisers and require the registrant to provide sufficient funding to pay for any such consultants and advisers. When retaining an adviser of any type, the compensation committee will be required to consider factors affecting the adviser’s independence. The SEC has authority to establish these factors, but the Act stipulates that they must include:
- Whether the adviser’s employer provides any other services to the registrant.
- The percentage of the total annual revenue of the adviser’s employer that is comprised of fees paid to it by the registrant.
- Whether the adviser’s employer has any policies in place to prevent conflicts of interest.
- Personal or business relationships between the adviser and any compensation committee members.
- The adviser’s ownership of any stock in the registrant.
New Section 10C also requires that registrants to disclose, in any proxy statement for a shareholder meeting held after July 20, 2011, (1) whether the compensation committee engaged a compensation consultant and (2) whether the compensation consultant’s work raised any conflict of interest, and if so, the nature of the conflict and how it is being addressed.
Hedging by Employees and Directors
New Securities Exchange Act Section 14(j) requires that the SEC adopt rules requiring registrants to disclose in the annual meeting proxy statement whether employees and directors are permitted to purchase financial instruments designed to hedge or offset any decrease in the market value of the registrant’s shares. Section 14(j) will not become effective until the SEC has adopted rules implementing its provisions. There is no deadline for adopting these rules, and the SEC has only indicated an intent to propose these rules sometime in August-December, 2011.
In anticipation of these rules, registrants may wish to consider:
- Whether to adopt a hedging policy.
- Whether to restrict hedging or to require pre-approval.
Although Securities Exchange Act Section 16(c) prohibits short sales by insiders, this new provision significantly exceeds the scope of Section 16(c), both by extending to hedging activities not constituting short sales and by extending beyond insiders to all employees.