Early planning for the 2011 proxy season will be needed to address the increased scrutiny of executive compensation that will result under the Dodd-Frank financial reform law.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act), which was passed by the U.S. Senate on July 15, 2010, and is expected to be signed by President Obama this week, does much more than take steps to avoid another financial crisis. Most public companies, not just financial institutions, will be subject to important new executive compensation requirements that will necessitate careful consideration and planning before the 2011 proxy season. While the full scope of these requirements remains to be shaped by U.S. Securities and Exchange Commission (SEC) rulemaking, it is clear that there will be increased scrutiny of executive compensation. This article addresses the executive compensation provisions of the Act. Further analysis of these provisions will be provided in future McDermott publications in the coming weeks.
The Act requires a non-binding shareholder vote at least once every three years to approve the compensation provided to named executive officers and disclosed in the proxy statement. In addition, a separate vote is required every six years that allows shareholders to impose a say-on-pay vote more frequently (i.e., annually or bi-annually). Failure to obtain stockholder approval does not invalidate any prior compensation actions, require a return of compensation or imply a breach of fiduciary duty. However, supporters of the Act believe that the vote will be a powerful tool for shareholders to send a message to boards and their compensation committees, particularly for public companies that use majority voting for directors. Obtaining a favorable say-on-pay vote is not always assured. Earlier this year, shareholders voted not to approve executive compensation practices at three public companies that had voluntarily adopted say-on-pay. The Act also requires a non-binding advisory vote regarding compensation arrangements that are triggered by a merger or acquisition. This vote must be separately solicited in connection with the vote on the transaction unless these arrangements were subject to an earlier say-on-pay vote.
The say-on-pay/say-on-parachute provisions apply to annual meetings that occur six months or more after the enactment of the Act, which means that they will apply to calendar year companies for the 2011 proxy season. Obtaining shareholder approval will likely involve compensation committee members communicating directly with institutional shareholders in advance of sending the proxy statement. Institutional investors may want to receive assurances of future changes, particularly as the Act requires them to disclose their say-on-pay/say-on-parachute votes. Further complicating matters, brokers and other "street name" holders will not be able to vote to approve executive compensation in the absence of a beneficial owner direction. Having these communications will require close coordination with management, the compensation committee consultant, investor relations and the proxy solicitor, as well as assistance from legal counsel to comply with securities law requirements. Management and directors are well advised to learn from the recent experiences of other companies that have already adopted say-on-pay practices, including alternatives for structuring the vote. Failure to do a good job in 2011 might result in an annual say-on-pay vote going forward.
Compensation Committee Independence
The Act provides for the SEC to establish enhanced independence requirements for members of the compensation committee through stock exchange listing standards. The text of the Act suggests that the new standards will focus on certain factors currently used to evaluate enhanced audit committee independence as required under Sarbanes-Oxley. Given the breadth of the existing NYSE and Nasdaq independence standards, any changes are likely to be minimal. As under current listing standards, an exemption from the independence requirement is provided for controlled companies.
The Act codifies the compensation committee's full authority and responsibility over its consultants and legal counsel. Similar to the current requirements for audit committees, the Act provides for the compensation committee to have exclusive control over the appointment, compensation and oversight of any advisor that it hires, as well as reasonable access to funding for advisors. In exercising this authority, the Act requires the compensation committee to consider independence factors to be developed by the SEC, which will include the provision of other services to the company and relationships between the advisor and board members.
While stopping short of requiring that any consultants or advisors that are engaged must be independent, the Act will put more pressure on compensation committees to hire consultants and other advisors that do not have relationships that suggest the potential for a conflict of interest in rendering advice. More compensation committees will likely engage counsel that have fewer relationships with the company and its management, and do so in advance in order to facilitate quick access to independent advice. If there is a reasonable possibility of a conflict of interest, there will be a requirement to disclose the conflict in any proxy statement that is filed a year or more after enactment. An issue to monitor is how the SEC applies this rule to existing engagements—if the committee did not previously consider all of the independence factors prior to selecting an existing advisor, must it do so now?
Expanded Clawback Policies
Virtually all existing clawback policies will need to be modified in light of expanded compensation recovery rules that are mandated through listing standards required under the Act. Specifically, Congress has decided to significantly expand the circumstances in which an accounting restatement required because of material noncompliance with financial reporting standards triggers a clawback. All current and former executive officers are to be covered by a clawback policy, not just the CEO and CFO, as required under Sarbanes-Oxley. The Act also eliminates any need to prove misconduct before erroneously awarded compensation must be recovered. For this purpose, "erroneously awarded compensation" includes incentive compensation paid during the three years—not one year as under Sarbanes-Oxley—preceding the restatement in excess of what would have been paid to the executive officer after giving effect to the accounting restatement. Perhaps most troubling is that the SEC might adopt rules to foreclose the board's discretion to determine that it is not in the best interests of the company to exercise rights under a clawback policy because of the costs of doing so. Also be on the lookout for RiskMetrics to put its own spin on this new requirement through its governance risk indicators (GRId) ratings, such as extending these rules to other types of misconduct. For more details regarding clawback policies, please click here.
New Executive Compensation Disclosure Elements
Yet more executive compensation disclosure will be required for annual proxy statements. Companies will be required to provide more information about the relationship between compensation provided to named executive officers and the financial performance of the company as measured by stock price and paid dividends. Given that this change is being imposed in connection with say-on-pay, it is reasonable to expect that companies will consider going beyond what is legally required. Expect companies to use graphs similar to what had been previously required to compare a registrant's stock price to that of peers.
In addition, companies will also need to disclose the ratio of CEO pay to the median pay of all other employees within the organization. Not only may this requirement be quite burdensome—consider the compliance effort if a public company with thousands of employees worldwide must do the equivalent of a summary compensation table for each employee—but it can lead to results that can be quite provocative depending upon compensation practices that significantly vary among industries. Expect companies to implement policies prohibiting hedging arrangements, given that the Act requires disclosure of whether any director or employee can hedge ownership of equity securities.
We anticipate that the SEC will act quickly to adopt rules implementing many of these changes. It will be important for management to monitor these developments and to inform directors how they affect planning for the 2011 proxy season. In some cases, companies may want to actively participate in the SEC comment letter process. To the extent that new SEC rules are effective for the 2011 proxy season, companies will not have much time to comply, particularly given the resources that will likely be devoted to addressing say-on-pay. Regardless, any compensation decisions that are being considered going forward should be evaluated in light of the Act's new requirements.
The McDermott Difference
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is set to overhaul the complex system regulating the financial industry. To help clients, colleagues and friends focus on the most pressing changes, adjust strategic direction and plan accordingly, McDermott Will & Emery's top industry specialists will present a special webcast dedicated to this profound legislation. For more information, click here.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.