United States: New Financial Regulatory Reform Bill Impacts Corporate Governance

In November 2009, Sen. Christopher Dodd (D-Conn.) introduced a draft discussion bill titled the "Restoring American Financial Stability Act of 2009." The draft bill was a sweeping proposal to overhaul the national financial regulatory regime by, among many other things, creating an independent regulatory body with the responsibility to monitor consumer financial products as well as an independent agency tasked with identifying risks posed to the economy by the complex products and activities of "too big to fail" financial institutions and other companies. The draft also contained several provisions impacting corporate governance at public companies, including provisions relating to say on pay, majority voting in uncontested elections, and independent compensation committees, among others. (For more information see our alert: http://www.foley.com/publications/pub_detail.aspx?pubid=6593 .)

On March 15, 2010, Mr. Dodd unveiled the proposed bill in its current form, now appropriately titled the "Restoring American Financial Stability Act of 2010." In many ways, the portions of the bill impacting corporate governance are very similar to those in the discussion draft. However, there are a few notable exceptions as well as some portions of the bill that may raise significant questions for boards, compensation committees, and their respective advisors.

Corporate Governance Provisions

Say on Pay

Mr. Dodd's bill would require issuers to include in their proxy statements "a separate resolution subject to shareholder vote to approve the compensation" of their executives. The vote would not be binding and expressly could not be construed as overruling any of the board's decisions, creating any new or different fiduciary duties, or limiting the ability of shareholders to make proposals for inclusion in proxy materials related to executive compensation.

Majority Voting

The bill would require directors in uncontested elections to receive a majority of the votes cast to be elected. If a director receives less than a majority of the votes cast, he or she would be forced to tender his or her resignation, whereupon the board would be required to either accept the resignation and determine (and disclose) a date on which the resignation will take effect, or unanimously decline to accept the resignation and disclose the specific reasons for that decision and why that decision was in the best interests of the issuer and its shareholders. With respect to contested elections, the Dodd bill provides that directors would be elected by a plurality.

Shareholder activists may find this effort unsatisfying since it seemingly fails to force public companies to adopt a true majority standard for election of directors in uncontested elections. Others may wonder why this legislation on this subject is necessary since the prevailing investor attitudes and institutional marketplace pressure have already led well over half of the Fortune 500 to adopt some form of majority voting, with the trend ostensibly continuing in that direction.

Proxy Access

The Dodd bill provides express authority for the SEC to promulgate rules requiring inclusion of shareholder nominees in the issuer's solicitation materials and outlining the procedures to be followed by the issuer in relation to that solicitation. The bill only authorizes, and does not actually require, the SEC to take action in this regard (as opposed to the November 2009 discussion draft, which would have required the SEC, within 180 days of enactment of the proposed legislation, to issue proxy access rules). Some may view this provision as unnecessary since the prevailing view has been that the SEC already possesses the authority to pass proxy access rules. Indeed, the SEC has already proposed proxy access rules and appears to be headed in the direction of adopting rules, perhaps in the near term.

Compensation Committee Independence

The Dodd bill requires listed companies to have an entirely independent compensation committee. Independence for this purpose would be determined considering certain factors, including the source of the director's compensation (including any consulting, advisory, or other compensatory fee paid by the issuer) and whether the director is affiliated with the issuer or its subsidiaries. The rules promulgated by the SEC pursuant to this provision must allow the exchanges to exempt certain relationships from the independence requirements as the exchanges determine appropriate.

Arguably, this section of the bill is largely unnecessary given the current NYSE and Nasdaq rules that require independent compensation committees, subject to certain phase-in rules and certain exceptions that the exchanges have determined are appropriate (e.g., the "controlled company" exemptions). It seems likely, however, that the desired end result is a stricter independence standard than the current exchange rules (one that looks more like the audit committee independence requirements contained in the Securities Exchange Act of 1934). If that is the case, then one could wonder why the bill leaves the final definition up to the SEC's rules as opposed to specifying it directly in the statute.

Compensation Consultants and Other Advisors

Prior to selecting a compensation consultant, legal counsel, or other advisor, compensation committees would be required to take into consideration certain factors — which the SEC is to identify in rules — that bear on the independence of those advisors. The Dodd bill lists some of those factors, including the provision by the advisor's firm of other services to the issuer; the amount of fees received from the issuer as a percentage of the advisor firm's total revenue; the policies and procedures of the advisor's firm that are designed to prevent conflicts of interest; and with respect to the advisor himself or herself (as opposed to the advisor's firm), any business or personal relationship of the advisor with a member of the compensation committee, and any stock of the issuer owned by the advisor.

In addition, issuers would be required to disclose in their proxy materials whether the compensation committee retained or obtained the advice of a compensation consultant and whether "the work of the compensation committee has raised any conflict of interest and, if so, the nature of the conflict and how the conflict is being addressed" (this latter requirement presumably relating to conflicts of interest with respect to compensation consultants only).

Note that this does not actually mandate the use of only "independent" compensation consultants or other advisors or prohibit "conflicts of interest." Instead, it simply requires the compensation committee to take certain independence-related factors into account before retaining those advisors. Furthermore, in the absence of clarifying rules by the SEC, it is not entirely clear if the issuer would need to disclose whether the compensation committee reviewed any of those factors or its conclusions in connection with that review. The bill does provide for disclosure of whether the work of the compensation committee raised any conflict of interest, but it is not clear what that means with respect to the independence of advisors. For example, if a compensation consultant performs other services for the issuer, or owns stock of the issuer, or otherwise has circumstances that, based on the independence factors to be outlined by the SEC, would negatively bear on the consultant's independence, would that constitute a conflict of interest that must be disclosed? In addition, the inclusion of "legal counsel and other advisors" may raise interesting issues for company counsel participating in activities that could be considered rendering advice to compensation committees such as drafting or reviewing portions of the issuer's proxy statement or providing guidance on issues related to executive employment or severance agreements. Will this provision result in compensation committees thinking twice about using long-time company counsel on these matters? In situations where company counsel is not retained directly by the compensation committee but is nevertheless asked by management or the committee to render advice to the committee (such as during the course of a meeting), would the committee be required under that circumstance to evaluate the advisor's independence before acting on its guidance?

Disclosure of Pay Versus Performance

The bill would require the SEC to promulgate rules requiring issuers to disclose in their proxy materials information showing the relationship between executive compensation and the financial performance of the issuer. The bill provides that such information should take into account any change in the value of the issuer's shares and may include a graphic representation of the information required to be disclosed.

If this bill becomes law, it will be interesting to see what rules the SEC proposes regarding disclosure of the relationship between executive compensation and financial performance. The term "financial performance" can be broadly interpreted, and it is not entirely clear from the text of the bill what is intended in that regard. To further muddy the waters, the 11-page bill summary that the United States Senate Committee on Banking, Housing and Urban Development posted describes this section in a manner very different from the actual text of the bill, saying that it "[d]irects the SEC to clarify disclosures relating to compensation, including requiring companies to provide charts that compare their executive compensation with stock performance over a five-year period" (emphasis added). The text of the bill does not require charts (rather, it allows charts), it does not require a comparison of compensation with stock performance (instead it requires a comparison with financial performance, as discussed above), and there is no mention in the text of the bill of a five-year period (in fact, by tying the discussion to the information required to be disclosed by Item 402 of Regulation S-K, it appears that the comparison should cover no more than a three-year period).

Clawbacks

A listed company would be required to develop and implement a policy providing:

Section 304 of the Sarbanes-Oxley Act of 2002 (SOX) already contains a clawback provision. However, the standard proposed under the Dodd bill is stricter than the SOX standard because SOX requires that the restatement due to material noncompliance occur "as a result of misconduct" before it mandates clawing back executive compensation. The Dodd bill dispenses with the "misconduct" idea altogether.

Employee and Director Hedging Disclosure

Issuers would be required to disclose whether any employees or directors are allowed to purchase financial instruments to hedge a decline in value of equity securities (i) granted to them as part of their compensation, or (ii) otherwise held by them directly or indirectly (presumably the securities intended to be covered by this second clause are only securities of the issuer, although the bill is not written that way). The bill does not require disclosure of whether or not such individuals have actually purchased those hedging instruments or address penalties the issuer may impose on those individuals if they do so. Note that Item 402 of Regulation S-K arguably already requires this disclosure in an issuer's compensation discussion and analysis (CD&A) because it includes "the registrant's equity or other security ownership requirements or guidelines (specifying applicable amounts and forms of ownership), and any registrant policies regarding hedging the economic risk of such ownership" as an example of what may constitute material information that should be disclosed.

Chairman and CEO Structure

Under the Dodd bill, issuers would be required to disclose in their proxy statements the reasons why the issuer has chosen either to combine or separate the positions of chairman of the board and CEO. Item 407 of Regulation S-K already essentially requires this disclosure.

Notable Omissions

The current bill contains some notable omissions from the corporate governance provisions proposed in the November 2009 discussion draft. The discussion draft would have required issuers to disclose in their proxy statements any policy relating to "golden parachute" payments for executives and would have provided shareholders with a non-binding vote on that policy. The current bill contains no such requirements. In addition, the discussion draft provided that public companies would be prohibited from having a board of directors with staggered terms unless adopted or ratified in advance by the shareholders of the company (companies that already had boards with staggered terms not approved by shareholders would have been required to seek shareholder approval at the first annual meeting after the SEC rules are adopted). The recently released version contains no such prohibition.

Conclusion

It is difficult to anticipate the full effect that the Dodd bill would have on corporate governance practices without knowing the content of the various rules that the SEC would issue under it. Nevertheless, a few things are apparent: Majority voting in some form and say on pay would likely become required practices in the very near term; the legislative and regulatory emphasis on independence in the board room and on curbing perceived abuses in executive compensation practices would continue unabated; and if there was any question about the SEC's authority on proxy access rules, the Dodd bill would put those questions to rest. The Senate Committee on Banking, Housing, & Urban Affairs approved the Dodd bill in a 13-10 vote on March 22, 2010, and the bill will now make its way to the Senate floor. Senate Majority Leader Harry Reid (D-Nev.) has indicated that he would like to see the Senate vote on the bill before its recess at the end of May.

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