President Barack Obama today signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law . The Act provides for a new Financial Stability Oversight Council, governmental “resolution authority” for failing financial institutions, agency reorganization, a new Consumer Financial Protection Bureau and a federal Insurance Office, and it imposes tougher capital, leverage and liquidity requirements on depository institutions.
It also creates new requirements for derivatives, hedge funds, private-equity funds, credit rating agencies, debit card interchange fees and corporate governance, among others. Our comprehensive summary on the Act and the deadlines of anticipated rulemaking by the regulators can be found here. In addition, the complete text of the provisions of the Act summarized in this client alert can be found here.
In this client alert, we discuss the provisions of the Act addressing executive compensation, corporate governance, the definition of “accredited investor” for purposes of capital raising and relief from the independent auditor attestation provision of the Sarbanes-Oxley Act for certain public companies. Many of the executive compensation and corporate governance provisions are expected to be applicable to the 2011 proxy season. We note below the SEC rulemaking schedule and possible exemptions. We also provide where appropriate “Action Items” that companies should consider pending further regulatory action.
The final version of the Act did not address majority voting for election of directors, limits on executive compensation or mandatory board risk committees for non-financial companies.
1. Mandatory shareholder “say on pay” or “SOP” voting on executive compensation
Section 951 of the Act requires companies subject to the proxy solicitation rules to submit for stockholder vote a separate non-binding advisory resolution to “approve the compensation of executives, as disclosed pursuant to” Item 402 of Regulation S-K, not less frequently than once every three years. In addition, at least once every six years, stockholders in such companies must be given the opportunity to determine whether the say on pay proposal will be submitted annually, biennially or triennially.
Over the past several years, stockholder groups and governance activists have sought a stockholder vote on executive compensation as a means to influence senior executive pay. The proposals have generally taken the form of a nonbinding resolution requesting that the company seek approval of some or all of a company’s executive compensation disclosed in its proxy statement. Such proposals are known as Say on Pay (SOP). SOP proposals have become common in the United Kingdom and Europe and have gained popularity here in the United States; here, some public companies have voluntarily submitted SOP proposals to their stockholders.
The SOP proposal required by Section 951 of the Act is non-binding and advisory in nature. This means that, whether the SOP proposal is approved or rejected by a company’s stockholders, a company will not be required to take any specific action based solely on the outcome of the vote. Indeed, the broad nature of the SOP proposal, which is essentially an up or down vote on all of the executive compensation disclosed in the company’s proxy statement, will make it difficult to gain clarity as to the reasons behind either approval or rejection of the proposal. Moreover, while SOP proposals are prevalent outside the United States, these proposals do not have a significant history in the United States, and accordingly, there is not much experience on what the rejection of an SOP proposal might mean to a public company. The stockholders of three public companies failed to approve SOP proposals so far in 2010; unfortunately, however, it is difficult to generalize about the reasons for a failure to obtain stockholder approval.
Stockholders will be reviewing both the information about executive compensation, and perhaps more importantly, the company’s explanation as to the compensation paid to the executives, in considering these SOP proposals. Compensation committees should therefore focus on good governance principles in making compensation decisions for executives, and companies should be transparent in disclosure regarding the process undertaken and the reasons for all executive compensation decisions. Stockholder rejection of a SOP proposal may be viewed as a vote of no confidence by the stockholders in the company’s executive compensation program, and will likely have repercussions with respect to the company’s governance posture and stockholder relations.
The Act requires two proposals to be included in the proxy statement for the first annual or other meeting requiring compensation disclosure occurring more than six months after the enactment of the Act: (1) an advisory proposal on executive compensation and (2) another proposal relating to the frequency of submitting the SOP proposal to stockholders at future annual meetings.
The SEC has the authority to exempt an issuer or a class of issuers from any of the requirements relating to the requirements relating to these SOP proposals, and is expressly directed to consider if these requirements disproportionately burden small issuers. Every institutional investment manager is required to report at least annually how it voted on any SOP proposal.
SEC action required: No. However, SEC rulemaking is likely since the SEC adopted new Rule 14a-20 under the Exchange Act earlier this year addressing instances when a recipient of financial assistance under the Troubled Asset Recovery Program is required to provide its stockholders with a non-binding SOP vote to approve the compensation of executives, as disclosed pursuant to Item 402 of Regulation S-K.
Companies will want to study the policies of advisory firms such as Risk Metrics/ISS and Glass, Lewis & Co. in reviewing compensation and, to the extent the company’s compensation policies may run afoul of those policies, consider alternatives or develop explanations for the current compensation policies based on the company’s unique circumstances.
Pay for performance is clearly a key area of stockholder concern, and companies will want to focus on demonstrating this element in the company’s executive compensation design, as applicable. See below regarding the new requirements for disclosure regarding pay versus performance in Section 953 of the Act.
- In addition, companies will want to consider the appropriate frequency of SOP proposals for their company (e.g., every one, two or three years), in light of the company’s governance posture generally, in making the proposal relating to frequency of such proposals.
2. Mandatory “say on pay” or “SOP” voting on “golden parachute” payments
Section 951 of the Act requires companies to provide a non-binding advisory vote on compensation paid to named executive officers in connection with an acquisition, merger, consolidation, or proposed sale or other disposition of all or substantially all of the company’s assets in a business combination transaction (generally referred to as “golden parachutes”). The vote would occur at the time the transaction is approved by the stockholders, and is required unless the golden parachutes were previously subject to a stockholder vote pursuant to the SOP proposal described above in Section 1 of this client alert. Section 951 also requires the enhancement of disclosure required for golden parachute arrangements.
Following the stockholder vote on the initial SOP proposal described in Section 1 of this client alert, the company’s existing arrangements should be exempt from the further nonbinding advisory vote. New compensation arrangements following the SOP vote will require the separate advisory vote, however. It remains to be seen what effect the separate advisory vote on golden parachute payments will have on the stockholder vote for the business combination transaction itself; separating the issues of compensation from the business combination transaction may be beneficial to the goal of obtaining votes on the transaction itself, because it allows a separate vote on the compensation, or it may further highlight the executive compensation paid or payable as a result of the deal, making it more difficult to get affirmative votes on the transaction itself in some cases.
The SEC has the authority to exempt an issuer or a class of issuers from any of the requirements relating to the requirements relating to these golden parachute proposals, and is expressly directed to consider if these requirements disproportionately burden small issuers. Every institutional investment manager is required to report at least annually how it voted on any golden parachute proposal.
SEC action required: Yes. The SEC is required to adopt rules relating to this section within six months after the enactment of the Act.
- The company’s compensation committee should carefully consider any new agreements or contracts with the named executive officers entered into in the context of a business combination, or otherwise providing compensation in a change of control transaction, and not previously subject to stockholder vote under prior SOP proposals.
To the extent there are any new change in control arrangements, severance agreements or other retention or incentive payments triggered by the business combination transaction, and not previously described in the company’s proxy statement, the company will need to be able to explain the rationale for these payments.
- It is likely that following the adoption of new SEC rules, there will be enhanced disclosure regarding existing golden parachute arrangements.
3. Compensation Committee Independence
Section 952 requires the SEC to adopt rules directing the national securities exchanges and national securities associations to prohibit the listing of equity securities of a company that does not have an independent compensation committee. In this regard, the Act imposes separate and higher standards for independence of compensation committees, much like the independence requirements for audit committees imposed by the Sarbanes-Oxley Act. The SEC rules are to require exchanges and associations to take into account the sources of compensation of a member of the board of directors of a company, including any consulting, advisory, or other compensatory fee paid by the company to the member and whether the committee member is affiliated with the company.
A specific exemption is available for controlled companies as defined in the Act. Certain foreign private issuers are exempt from these provisions. The Act specifically gives the SEC exemptive authority to allow the exchanges and associations to exempt other relationships with respect to the members of the compensation committee taking into account the size of the issuer and any other relevant factors.
SEC/Exchange action required: Yes. The SEC is required to adopt rules relating to Section 952 no later than 360 days after the enactment of the Act. The exchanges and associations will also have to revise their “independence” rules to comply with the SEC’s new rules. The SEC is to provide appropriate procedures for a company to have a reasonable opportunity to cure any defects that would be the basis for delisting under these rules. The Act does not set a time within which the exchanges and associations are required to act once the SEC revises its rules.
Following the promulgation of the new SEC standards on independence, each company’s nominating committee or board of directors should review the qualifications of the members of its compensation committee to determine whether all members are likely to satisfy these new independence requirements, and consider if additional or different directors need to be recruited to the board of directors to permit constitution of a wholly independent compensation committee meeting these requirements.
Similarly, if a company has relied on the “exceptional and limited circumstances” exemption available under listing standards, attention should be given to changing the composition of the compensation committee once the new SEC standards are promulgated.
If a company does not currently have a separate compensation committee, relying on exchange rules permitting the board of directors to serve such functions, the board of directors should consider the formation of such a committee following the promulgation of the SEC rules on independence, and consider whether the company needs to recruit additional directors who will satisfy these new independence requirements.
The charter of an existing compensation committee may need to be updated to take into account the new independence standards.
4. Independence of Compensation Consultants and other Advisors
Section 952 provides that compensation committees that engage compensation consultants or legal counsel must consider factors that may affect their independence. The SEC is directed to adopt rules directing the national securities exchanges and national securities associations to prohibit the listing of equity securities of a company that does not comply with this requirement.
These rules will identify the factors to be included in the listing standards for the exchanges, that affect the independence, including other services provided to the company by the advisor, the amount of fees received from the company by the advisor as a percentage of the total revenue of the advisor, conflict of interest policies of the advisor, any business or personal relationships between the members of the compensation committee and the advisor, and any stock of the company owned by the advisor. These factors are to be competitively neutral and are to preserve the ability of compensation committees to retain the services of providers. A specific exemption is provided for controlled companies as defined in the Act.
This section does not require independence of any advisor and leaves the selection of advisors to the direction of the compensation committee which remains directly responsible for the appointment, compensation and oversight of the work of the compensation consultant, independent legal counsel or other advisors.
Beginning with the first annual meeting of stockholders held more than one year after the enactment of the Act, companies are required to disclose whether the compensation committee 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. Each company is also required to provide appropriate funding, as determined by the compensation committee, for reasonable compensation to consultants, independent legal counsel and other advisors.
The Act specifically gives the SEC exemptive authority to allow the exchanges and associations to exempt a category of issuers from the requirements of this section taking into account the potential impact on smaller reporting issuers. The SEC is also instructed to conduct a study and review the use of compensation consultants and the effect of such use, to be submitted to Congress no later than two years after enactment of the Act.
SEC action required: Yes. The SEC is required to adopt rules relating to this section no later than 360 days after the enactment of the Act. The SEC is directed to provide in its rules appropriate procedures for a company to have a reasonable opportunity to cure any defects that would be the basis for delisting.
Companies should consider revisions to the charter of the compensation committee upon the publication of the new rules in light of these new requirements.
Compensation committees will want to review any existing engagements of compensation consultants, legal counsel and any other advisors in light of these new requirements, once promulgated, and prepare any necessary disclosure regarding the engagement of compensation consultants.
5. Additional Executive Compensation Disclosure
Section 953 requires the SEC to adopt rules requiring each public company to disclose in its annual proxy statement the relationship between executive compensation actually paid and the financial performance of the issuer, taking into account any change in the value of the shares of stock and dividends of the company and any distributions to stockholders. Graphic presentations are expressly permitted.
Further, the rules will require disclosure of the median of the annual total compensation of all employees of the company other than the chief executive officer, the annual total compensation paid to the chief executive officer, and the ratio of those two amounts.
SEC action required: Yes. There is no specific deadline for SEC action pursuant to this section.
- New compensation disclosure, potentially including new graphical representations, will need to be developed once the SEC rules are promulgated. We expect the SEC to provide additional clarity when it proposes the relevant rules.
- Compensation committees will want to review the information required by this section and determine if any changes in executive compensation are appropriate in light of the ratios and the disclosure regarding financial performance, and consider any further disclosure of the compensation committee’s view of executive compensation in light of these disclosures.
6. Clawback policies
Section 954 requires the SEC by rule to direct the national securities exchanges and the national securities associations to prohibit listing the equity securities of a company that does not implement a clawback policy allowing the company to recoup incentive-based compensation if the company is required to restate its financials due to material noncompliance with any financial reporting requirement under the securities laws.
The clawback policy must apply to any current or former executive officer of the company who received incentive-based compensation (including stock options awarded as compensation) during the three-year period preceding the date on which the company is required to prepare an accounting restatement. This means that the clawback policy must have a three-year lookback from the date of the restatement and require repayment of incentive compensation in excess of what would have been paid under the accounting restatement.
The clawback required by this section would require recovery in a broader set of circumstances than the SEC’s recovery authority under Section 304 of the Sarbanes-Oxley Act, and in particular, without regard to whether there was any misconduct. Further, a broader class of persons is subject to the clawback policies under Section 954, than under Section 304 of the Sarbanes-Oxley Act, which addressed recovery from a company’s chief executive officer or chief financial officer, while Section 954 seeks recovery from any current or former executive officer.
This Section also directs the SEC to promulgate enhanced disclosure rules for incentive-based compensation.
SEC action required: Yes. There is no specific deadline for the rules required by this section.
- Once the final rules are promulgated, compensation committees will want to review existing compensation policies, agreements and benefit plans to see whether any amendments are necessary in light of the new rules.
- Any “clawback” policies previously adopted by a company may not apply to all executive officers, or to all incentive-based compensation, or may not reach former executive officers.
- Compensation committees will need to consider whether or how to impose the new requirements on any former employees not subject to such policies at the time of their departure; the new rules promulgated by the SEC may address this issue of retroactivity.
- Companies will need to prepare disclosure required by the new rules on the company policies.
7. Authority Granted to the SEC to Adopt Proxy Access.
Section 971 amends Section 14(a) of the Exchange Act to give the SEC express permission to issue rules requiring that a solicitation of proxy, consent, or authorization by or on behalf of a company include a nominee submitted by a stockholder to serve on the board of directors of the company, including procedures in relation to such solicitations (also know as “proxy access”).
By the way of background, stockholders and corporate activists have championed proxy access as a means to remove impediments under the federal proxy laws to a stockholder’s ability to exercise their fundamental rights under state corporate law to nominate and elect directors. The SEC has previously proposed changes to the federal proxy rules to address proxy access, but has met considerable opposition from the business community. The bulk of the controversy surrounding the adoption by the SEC of these rules revolves around the percentage of beneficial ownership a stockholder must have and the length of the period for which such securities of the company should be held by the stockholder before such stockholder can submit a proposal to the company
This section permits, but not require, the SEC to issue rules permitting the use by a stockholder of proxy solicitation materials supplied by a company for the purpose of nominating individuals to membership on the board of directors of the company, “under such terms and conditions as the SEC determines are in the interests of stockholders and for the protection of investors.”
We expect the SEC to adopt these rules on a fairly expedited basis. In fact, the SEC Chair Mary Schapiro has indicated that she expects proxy access to be adopted in time for the 2011 proxy season. The SEC’s rules may resemble its most recent proposal on proxy access, which companies may wish to review. A summary of the prior SEC’s proposals on “proxy access” made by the SEC in June 2009 is available here.
The SEC is expressly authorized to exempt classes of issuers and is directed to consider whether the rules disproportionally burden small reporting issuers.
SEC action tequired: Yes. There is no specific deadline for SEC action.
Action items: No action is required until the SEC publishes rules on proxy access.
8. Disclosure of Employee and Director Hedging
Section 955 requires the SEC to adopt rules requiring each company to disclose in its proxy statement whether its employees or directors may purchase financial instruments (including prepaid variable forward contracts, equity swaps, collars and exchange funds) that are designed to hedge or offset any decrease in the market value of the company’s securities.
SEC action required: Yes. There is no specific deadline for SEC action.
- The appropriate board committee should review company policies, including the company’s insider trading policies and corporate governance guidelines, in light of the new rules to be issued by the SEC, and determine if the company requires any revisions to or a new policy with respect to hedging.
9. Establishes new rules related to broker non-votes
Section 957 prohibits broker discretionary voting on director elections, executive compensation or other significant matters to be determined by the SEC based upon its rulemaking. Broker discretionary voting on most of these matters has, however, already been eliminated
SEC action required: Yes. There is no specific deadline for the rules required by this section.
- Companies will need to review the new SEC rules when promulgated to determine any further impact on voting and the ability to obtain a quorum.
10. Disclosures Regarding Chairman and CEO Structures
Section 972 requires the SEC to adopt rules that require a company to disclose in its proxy statement the reason why the company chose either the same person or different persons to fill the role of Chairman of the Board and Chief Executive Officer.
SEC action required: Yes. SEC rulemaking is required within 180 days after the enactment of this subsection. New Item 407(h) of Regulation S-K appears to cover this requirement, however.
Action items: Following the promulgation of any new SEC rules, companies will need to determine if any further action is required.
11. Beneficial Ownership and Short Swing Profit Reporting
Section 929R amends Section 13(d)(1) of the Exchange Act to permit the SEC to shorten the time for filing reports on beneficial ownership required under Regulation 13D-G from the time period now applicable and by eliminating the requirement to send to the company and the applicable national securities exchange a copy of the filing. Similarly Section 16(a) of the Exchange Act is amended to permit the SEC to shorten the time period for filing initial reports of beneficial ownership on Form 3 from the ten day period now applicable, and to eliminate the requirement to deliver a copy of the filing to the applicable national securities exchange.
SEC action required: No, but this provision permits the SEC to take regulatory action to shorten filing deadlines for Schedules 13D and Forms 3. There is no specific deadline for SEC action.
Action items: No action is required at this time.
12. Changing Definition of an Accredited Investor.
Section 413 of the Act adjusts the net worth threshold for “accredited investors” who are natural persons to US$1 million, effective upon the enactment of the Act and for the four years thereafter. The Act does not change the definition of “qualified purchaser” standard under the 1940 Act.
The Act also provides that the value of a person’s primary residence shall no longer be taken into account in determining whether a person’s net worth is $1 million dollars.
Pursuant to current SEC Rules 215 and 501(a), “accredited investors” include natural persons with income in each of the two most recent years in excess of $200,000, or $300,000 for a couple and with a reasonable expectation to reach the same level in the current year, or with a net worth of $1 million either individually or jointly with the person’s spouse. The amendment to exclude the value of a potential investor’s primary residence in determining whether such “natural person” can be deemed to be an “accredited investor” will likely have a significant impact on capital raising.
The SEC is authorized to undertake an initial review of the definition of accredited investor thresholds that are not related to net worth and to adjust or modify the definition of the term. In undertaking this review, the SEC is given a very broad mandate of issues like “protection of investors, in the public interest, and in light of the economy.”
In addition, 4 years after the enactment of the Act and not less frequently that once every 4 years thereafter, the SEC is authorized to undertake a subsequent review of the accredited investor definition as such term applies to “natural persons” and to determine whether the requirements of the definition should be adjusted or modified for the “protection of investors, in the public interest, and in light of the economy.”
SEC action required: Not initially. However, SEC rulemaking is expected, since the SEC is instructed to undertake two separate reviews and it is likely that each review will result in some changes to the defined term.
- Any public or private companies, funds or other intermediaries involved in raising capital will need to revise their subscription documents to incorporate the new net worth test for individual accredited investors and distribute new forms to their agents and prospective investors.
13. Revising the Sarbanes-Oxley attestation requirements under Section 404(b)
Section 989C of the Act amends Section 404 of the Sarbanes-Oxley Act so that Section 404(b) no longer applies to an issuer that is neither a “large accelerated filer” nor an “accelerated filer” as each term is defined by Rule 12b-2 promulgated by the SEC.
The SEC is also directed to undertake a study to determine how to reduce the burden of complying with Section 404(b) of the Sarbanes-Oxley Act for companies with market capitalization between $75 million and $250 million for the relevant reporting period. The SEC is to deliver this report to the Congress within nine months after the enactment of the Act. The Sarbanes-Oxley Act imposed numerous substantive corporate governance and disclosure requirements on all SEC reporting companies. As part of this process, Section 404(b) required an independent auditor to attest to, and report on, management’s assessment regarding the effectiveness of a company’s internal control over financial reporting.
As a result of the high costs associated with obtaining the independent auditor’s attestation, the SEC has been under pressure to find a solution for smaller companies. After numerous delays in implementing the requirements of Section 404(b), in October 2009, the SEC granted a six month extension for non-accelerated files to begin complying with this section. Non-accelerated filers were required to include an auditor’s report on the effectiveness of internal control over financial reporting beginning with their annual reports for fiscal years ending on or after June 15, 2010. The SEC was on record stating that there would not be any more extensions for Section 404(b) compliance. Accordingly, this section is welcome news to many smaller public companies; it permanently exempts issuers who are neither “large accelerated filer” nor an “accelerated filer” from compliance with the internal control auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act.
SEC action required: Not initially. However, SEC is required to undertake a study to determine how to reduce the burden of complying with Section 404(b) of the Sarbanes-Oxley Act. It is likely that additional SEC rulemaking may occur once the study is completed.
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