Activists Get Their Wish: Financial Regulatory Reform's Executive Compensation and Corporate Governance Provisions

By Casey M. Nault
June 2, 2010

Overview

On May 20, 2010, the U.S. Senate adopted its version of financial regulatory reform: the Restoring American Financial Stability Act of 2010. The Senate bill now must be reconciled with the House bill passed in December 2009. Congressional leaders have signaled an intent to complete a final bill by early July. Both bills contain executive compensation and corporate governance provisions. Although there are some differences between the bills, it seems clear that the final legislation will enact major elements of the shareholder activist “wish list”.

Scope

The provisions noted below would apply to all companies with securities listed on a national securities exchange (such as the New York Stock Exchange or NASDAQ). They would not apply to other SEC-reporting companies whose securities may be quoted on the over-the-counter bulletin board or pink sheets. Some of the provisions already apply in some form to participants in the Troubled Asset Relief Program’s Capital Purchase Program (CPP).

Corporate Governance Provisions

Majority Voting in Director Elections. Under the Senate bill, directors would be elected by majority vote in uncontested elections (a plurality standard would apply in contested elections). Any director nominee who does not receive a majority of votes cast in uncontested elections would be required to tender his or her resignation to the board. The board could reject the resignation, but would need to do so by unanimous vote and disclose, within 30 days of the election, its analysis as to why the resignation was not accepted and why its decision was in the best interests of the company and its shareholders. The Securities and Exchange Commission (SEC) would have the authority to exempt small companies from this rule.

The House bill did not contain a majority voting provision.
Although majority voting has become more common than not among S&P 500 companies, it remains the minority practice among all public companies.

Proxy Access. Both the House and Senate bills provide the SEC with explicit legislative authority to adopt rules granting shareholders access to management’s proxy statement for the purpose of nominating directors to the board. There has been some question whether the SEC has such authority. The SEC’s most recent proxy access rule proposal would give a shareholder or a group of shareholders holding 1% (for large accelerated filers), 3% (for accelerated filers) or 5% (for non-accelerated filers) of outstanding shares the ability to include nominees in management’s proxy statement.

Proxy access is high on the SEC’s agenda and appears likely to be adopted.

Further Restrictions on Broker Discretionary Voting. The Senate bill would require further restrictions on the scope of matters on which brokers can exercise discretion in voting when they have not received specific instructions from beneficial holders. For the 2010 proxy season, for the first time brokers were not permitted to cast discretionary votes in director elections. The Senate bill would also restrict brokers from exercising discretion on executive compensation or “any other significant matter” as determined by SEC rule.

The House bill did not contain a similar provision.

Executive Compensation Provisions

Say on Pay. Both the House and Senate bills include a “say on pay” provision requiring listed companies to provide shareholders with an up-or-down non-binding vote on the compensation of executives as disclosed in the proxy statement.

In recent weeks, U.S. companies have lost “say on pay” votes for the first time, and it is somewhat noteworthy that none of those companies was a major Wall Street financial institution (Occidental Petroleum, Motorola, KeyCorp).

Say on Golden Parachutes. The House bill would require a non-binding shareholder vote to approve “golden parachute” compensation disclosed in merger proxies.
Enhanced Compensation Committee Independence. Under both bills, compensation committee members would be subject to heightened independence standards. In addition, enhanced proxy disclosure regarding compensation consultants and their independence would be required. The SEC would have the authority to exempt small companies from this rule.
Clawback of Previously Awarded Compensation. The Senate bill would require listed companies to adopt a policy to recover or “claw back” incentive compensation awarded to current or former executive officers (including stock options) during a three-year look-back period if such compensation turns out to be unearned based on a restatement of financial results due to material noncompliance with financial reporting requirements.

In one respect this is a narrower standard than applies to CPP participants, which are required to recover compensation based on any erroneous data, regardless whether an accounting restatement occurred.

Enhanced Disclosure Obligations. The Senate bill would require the following enhanced proxy disclosures:

Pay/Performance Link. Disclosure of the relationship between company performance and compensation actually paid would be required. Changes in the value of stock would be taken into account.
Ratio of CEO to Median Employee Pay. Companies would be required to disclose the ratio of CEO total compensation to median total compensation of all employees other than the CEO (and also disclose the actual amounts). “Total compensation” would be calculated according to proxy rules, a measure many companies may not currently track for the general employee population.
Policy on Hedging Company Stock. Disclosure would be required whether employees and directors are permitted to hedge company stock.

Potential Implications
The combined effect of several of the proposed reforms could be significant for many companies. For example, the combined effect of restrictions on broker discretionary voting, say on pay, and majority voting could put compensation committee members at heightened risk. The “for” vote on say on pay proposals likely would decline substantially if broker discretionary votes were prohibited, which could result in more negative say on pay votes, which could trigger “vote no” campaigns against compensation committee members by activists and proxy advisory firms. Under the new majority voting standard and the recent loss of broker discretionary voting for directors, compensation committee members at companies with significant negative say on pay votes could be at heightened risk in director elections.

Moreover, the SEC’s proxy access proposal could create a significant distraction for boards and management as holders of a relatively small percentage of the outstanding shares insert their candidates in proxy statements and potentially on boards.

Finally, as noted above, there could be a significant additional compliance burden on companies to, for example, calculate “total compensation” under the SEC’s proxy rules for all employees.

What Should Companies Do Now?

Given the heightened re-election risk for directors, companies should consider whether any of their policies or practices are likely to draw negative recommendations from the major proxy advisory firms (such as RiskMetrics Group and Glass Lewis).
CPP companies may want to assess whether the policies and practices they have adopted to comply with Treasury rules will satisfy the proposed new requirements.
With proxy access likely to be adopted before next year’s proxy season, companies may want to assess the likelihood that any shareholder, or group of shareholders, exceeding the applicable threshold (1%, 3% or 5%) would run a slate of director nominees in the company’s proxy statement if given the opportunity. Outreach to major shareholders may be appropriate in some circumstances.
Assess whether any compensation committee members may be at risk of not satisfying enhanced independence requirements, and what that would mean for stock exchange listing standards compliance (e.g., whether there would be enough other directors to fully populate the compensation committee).
Consider whether tools are in place to calculate the “total compensation” for all employees under the SEC’s proxy rules.

Conclusion

These developments reflect the current political climate and momentum toward more restrictive regulation and disclosure of executive compensation and the federalization of corporate governance standards. Given public anger and backlash over perceived excesses and lack of accountability among corporate executives and boards, particularly major Wall Street firms, it is highly likely that most of the above reforms will be enacted and applied to all listed companies when final legislation is signed into law. We will publish further updates on these issues as developments warrant. In the meantime, please contact your usual Graham & Dunn attorney or Casey M. Nault (206.903.4808 or cnault@grahamdunn.com) or Stephen M. Klein (206.340.9648 or sklein@grahamdunn.com) should you have any questions or wish to discuss these issues further.