Dodd-Frank Wall Street Reform and Consumer Protection Act to Impose New Governance and Executive Compensation Requirements on Public Companies
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) will soon be law (and may, in fact, be law by the time you read this). As of the print time of this Client Alert, the Act has been passed by the House and Senate and is expected to be promptly signed by President Obama. Like other recently enacted “reform” legislation, the Act is immense (over 2,300 pages) and leaves much of the details to federal regulators to fill in through the rulemaking process. Over a dozen federal agencies will be required to engage in a massive amount of rulemaking in the next one to two years to implement the requirements of the Act.
While the focus of the Act is obviously on the banking and financial services sector, it also will affect virtually every publicly traded company, law firms who represent boards of directors and compensation committees, any company that hedges risks using financial instruments, rating agencies and insurance companies.
This Client Alert focuses on provisions of the Act which will affect publicly traded companies generally, including executive compensation practices, corporate governance and an exemption for smaller companies from certain internal controls requirements. Note, however, that many of these new rules will not go into effect immediately and instead will require rulemaking by the SEC. We have noted the effective date of the various provisions in the summary below. Greensfelder will be publishing other alerts in the near future covering other subject matter in the Act.
The regulation of executive compensation practices at public companies has been relentless over the past several years. Most public companies have just adjusted to new rules adopted in December of 2009 concerning disclosures regarding risks created by compensation practices and relationships with compensation consultants. The Dodd-Frank Act will add significant new requirements.
Say on Pay; Golden Parachutes
Publicly traded companies will now be required to submit non-binding “say on pay” resolutions giving shareholders the opportunity to approve executive compensation, as disclosed in the company’s Compensation Discussion and Analysis. The say on pay resolution must be submitted not less frequently than every three years. Every six years, shareholders must be given the opportunity to vote on the frequency of the say on pay resolution.
This requirement takes effect shortly after final passage of the Act. All companies must include both resolutions in their proxy for the first meeting of shareholders occurring after the six month anniversary of the enactment of the Act into law.
In mergers or other transactions for which shareholder approval is sought, issuers must now disclose all compensation to management (including deferred, or contingent) that is based on or otherwise relates to the transaction and the aggregate total of all such compensation that may (and the conditions upon which it may) be paid or become payable to or on behalf of such executive officer. This presumably includes both “single trigger” payments (triggered solely by the transaction) and “double trigger” payments (triggered by a termination of employment following or in anticipation of a transaction). If this compensation has not been previously approved under the regular say on pay approval process, shareholders must be given the opportunity to separately approve the golden parachute payments. As with the regular say on pay requirement, the golden parachute approval is technically non-binding.
While the Act does not provide for any exemptions, the SEC has the authority to exempt certain classes of issuers, such as smaller reporting companies, from these requirements in the rulemaking process.
Compensation Committee Independence
Within one year after the Act’s enactment into law, the SEC must adopt final rules mandating the following:
Independence of Compensation Committee Members. Stock exchanges and securities associations must adopt listing standards requiring that an issuer’s compensation committee consist solely of independent directors. In adopting these standards, the stock exchanges and securities associations must consider relevant factors, including (A) the source of compensation of a board member, including any consulting, advisory, or other compensatory fee; and (B) whether a board member is affiliated with the issuer or its subsidiaries or affiliates of subsidiaries. We note that all stock exchanges, such as the NYSE and Nasdaq, have already adopted independence standards for compensation committees. It seems likely that these existing independence standards will be heightened as a result of this requirement.
Independence of Compensation Committee Advisers. Stock exchanges and securities associations must adopt listing standards requiring that a listed company’s compensation committee may only select consultants, legal counsel and other advisers after taking into consideration the independence of such advisers, based on factors to be determined by the SEC. These factors must be competitively neutral among categories of advisers and include certain factors identified in the Act, such as other work the advisor performs for the company, stock of the issuer owned by the adviser and business and personal relationships between the adviser and members of the committee. The SEC’s rules must provide reasonable opportunity for a company to cure noncompliance with this requirement. Compensation committees will now have sole discretion over the engagement of consultants, legal counsel and other advisors. Compensation committees must be directly responsible for the appointment, compensation and oversight of the work of such advisors and are required to disclose whether a compensation consultant was retained and whether the work of the compensation consultant raised any conflict of interest.
Since February of this year, companies have already been required to disclose fees paid to consultants for work other than executive compensation planning. Some large consulting firms saw the writing on the wall months ago and have already spun off their executive compensation divisions from their other compensation and benefits consulting. Now, companies may be required to retain separate counsel to represent the compensation committee rather than using the company’s usual corporate or securities counsel.
New Disclosures Regarding Executive Pay
Disclosure of Pay Versus Performance. The SEC is charged with adopting rules requiring that, in all proxy filings related to the election of directors, companies must disclose 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 issuer and any distributions.
Disclosure of Executive Versus Median Pay. The SEC must also adopt rules requiring publicly traded companies to disclose (A) the total annual compensation paid to the chief executive officer ratio, (B) the median annual total compensation of all employees (excluding the CEO) and the ratio of between (A) and (B). Total compensation must be calculated in accordance with the rules for the Summary Compensation Table, as in effect on the date the Dodd-Frank Act becomes law.
Stock exchanges and securities associations will be required to adopt listing standards mandating disclosure of incentive-based compensation by the issuer that is based on publicly reported financial information. In addition, issuers will be required to have clawback policies enabling the recovery of incentive-based compensation from current or former executive officers following a restatement. The company’s clawback rights must allow the company to recoup incentive compensation paid during the 3-year period preceding the date on which a company is required to prepare the restatement. The amount subject to recoupment must equal the excess of the actual incentive compensation payment over the amount that would have been paid under the restated results. There is no effective date specified for these rules.
Disclosure of Hedging by Employees and Directors
The SEC must issue rules requiring companies to disclose whether employees and directors are allowed to hedge the value of any equity securities, including equity securities granted as compensation.
The provisions of the Act affecting corporate governance seem almost minor in comparison to the executive compensation provisions and are focused on three main areas: proxy access, disclosures regarding executive chairperson structure and risk committees for regulated financial companies.
The Act does not propose any new rules concerning shareholders’ rights to directly nominate directors. Instead, the Act gives the SEC the authority (but not a requirement) to adopt rules on the subject, which is really no change from the existing regulatory framework. The SEC has already recently proposed proxy access rules permitting shareholders to directly nominate directors if they owned at least 1% of the voting securities of a large company, at least 3% of the voting securities of a mid-sized company ($75 million to $700 million in market value), or at least 5% of a smaller company. Shareholders could aggregate holdings to meet those levels. Those rules, proposed within the last year, met with strong opposition from management and not-so-strong support from shareholder activists because of the ownership requirements. It remains to be seen whether the SEC will make this a priority.
Disclosures Concerning Executive Chairpersons
The Act requires the SEC, within 180 days after enactment, to issue rules requiring companies to disclose in the proxy statement why they have separated, or combined, the positions of chairman and CEO. The SEC has already adopted rules, which became effective in February 2010, requiring discussion of this matter in proxy statements, so it is unclear what the effect of the Act will be in this regard.
Risk Committees Required for “Systemically Important Nonbank Financial Companies” and Large Bank Holding Companies
Public companies that are deemed to be “systemically important nonbank financial companies” and public bank holding companies with assets of not less than $10 billion will be required to have a risk committee. The Board of Governors of the Federal Reserve has the authority to make rules implementing this requirement, including the ability to impose this requirement on bank holding companies with assets of less than $10 billion, if it deems appropriate.
The risk committee (A) will be responsible for the oversight of the enterprise-wide risk management practices of the company, (B) must include such number of independent directors as the Board of Governors may determine appropriate, based on the nature of operations, size of assets, and other appropriate criteria related to company, and (C) include at least 1 risk management expert having experience in identifying, assessing, and managing risk exposures of large, complex firms. “Independent” is not defined, and thus could potentially lead to a third definition of “independence” for a public company, which already have special independence standards for audit committees and now for compensation committees.
Systemically important nonbank financial companies” are financial companies identified by a new Financial Stability Oversight Council as engaging in activities that could pose a risk to the financial system of the country as a whole. This will obviously only include a small number of financial firms. Obviously however, there are many more bank holding companies with assets as low as $10 billion. Even bank holding companies that do not meet the $10 billion threshold may eventually be required to have a risk committee by the Federal Reserve. Not to mention the fact that having a risk committee may come to be viewed as a “best practice,” even if the institution is much smaller than $10 billion.
The Board of Governors is charged with adopting the regulations to implement this requirement within two years after the enactment of the Act into law.
Exemption from Internal Control Attestation for Smaller Companies
The Act grants long-requested relief to small publicly traded companies that are neither a large accelerated filer nor an accelerated filer (i.e., those with less than $75 million in market capitalization) from complying with the Section 404(b) of Sarbanes-Oxley which requires a registrant to provide an attestation report on management’s assessment of internal controls over financial reporting by the registrant’s external auditor. The Act also directs the SEC to conduct a study to determine how to reduce the burden of complying with section 404(b) for companies whose market capitalization is between $75,000,000 and $250,000,000. The Act further directs the GAO to conduct a study of the effect of the Act’s exemption on smaller companies’ cost of capital and accuracy of their financial statements.
This exemption, which is effective immediately, negates the SEC’s final rule, effective for fiscal years ending after June 15, 2010, which required all companies, including smaller companies, to comply with the attestation report requirement. The management attestations under existing Section 404(a), however, will continue to be required for all companies, including smaller companies.