Dodd-Frank Rulemaking Part II: New Compensation Rule Proposals and More to Come

By Casey M. Nault
May 2, 2011

Overview

New rules required by the Dodd-Frank Wall Street Reform and Consumer Protection Act continue to be proposed on a rolling basis, including two recent rule proposals on compensation. The following is a summary of these proposals and a look ahead at the timeline for future compensation and governance rulemaking.

Compensation Committee and Advisor Independence

On March 30, 2011, the Securities and Exchange Commission proposed rules under Section 952 of Dodd-Frank to require the national securities exchanges to adopt listing standards governing the independence of compensation committees and their advisors. The proposed rule essentially covers the same ground as Section 952, which leaves it to the stock exchanges to adopt substantive requirements for the independence of compensation committee members. As noted in our prior alert, available here, Section 952 of the Act requires the stock exchanges to consider certain factors when adopting independence requirements, including the source of all forms of compensation paid to committee members and their various affiliations with the company. However, specifics are left for the exchanges to determine.

The Act and the rules also will require compensation committees to consider independence factors before retaining advisors, including legal counsel, also covered in our prior alert. The rules do not prohibit retaining advisors who are not independent; they only require considering independence factors.

In addition, the proposed rule would revise the proxy disclosure rules on compensation consultant involvement in compensation-setting and conflicts of interest, expanding the scope of disclosure to cover any consultant who provided advice, whether or not resulting from a formal engagement, and eliminating the current carve-out for advice on broad-based plans or providing non-customized benchmarking data.

Interagency Proposed Rule on Incentive Compensation at Financial Institutions

Also on March 30, 2011, seven federal agencies announced a joint proposed rule under Section 956 of Dodd-Frank, covering incentive compensation practices at financial institutions with assets of $1 billion or more. The proposed rule is subject to public comment, with the final rule becoming effective six months after it is published. The proposed rule would prohibit incentive arrangements for directors, executives and employees that encourage inappropriate risks by providing excessive compensation or that could lead to a material financial loss. Institutions with assets of $50 billion or more are subject to heightened requirements, including mandatory three-year deferral and loss adjustment of at least 50% of executive officer incentive compensation. The framework for institutions with less than $50 billion in assets is principles-based, requiring boards and compensation committees to apply standards and factors contained in existing rules and guidance, and recognizing that appropriate policies and procedures will vary by the size of the institution and the complexity and scope of its incentive arrangements.

The factors for assessing whether pay is excessive are those contained in the Federal Deposit Insurance Act, and include (among others) the total level of compensation, the financial condition of the institution and peer practices. The factors and guidance for guarding against material financial loss are those contained in the June 2010 interagency guidance issued by the key federal banking regulators, which focuses on ensuring that risk and reward are properly balanced, risk management personnel are involved in structuring incentive arrangements, and incentive structures and arrangements are supported by strong internal controls and corporate governance.

A key substantive requirement for all covered institutions is a new annual report. The specific form of the annual report will be prescribed by each agency, but would describe the structure of incentive arrangements and the policies and procedures governing those arrangements, and explain why those arrangements do not create incentives that could lead to a material financial loss or result in excessive compensation.

Institutions that participated in the Treasury’s Capital Purchase Program (CPP) under the Troubled Asset Relief Program will be familiar with many key elements of the policies and procedures required. In particular, the procedures and disclosure required for the new annual report appear similar to the board-level incentive compensation risk assessments and certifications required under the CPP rules. This should give institutions who participated in the CPP a head start on compliance with the new rules.

The Road Ahead

The SEC has revised its anticipated rulemaking schedule to implement Dodd-Frank compensation and governance provisions. It currently forecasts rulemaking in the August-November 2011 timeframe regarding, among other things, disclosure of pay-for-performance, CEO/Median Employee pay ratios, hedging company stock by employees and directors and recovery (clawback) of executive compensation. In addition, while it is difficult to predict which proposals will gain any traction, there are proposals in Congress to repeal aspects of Dodd-Frank, such as the requirement for CEO/Median Employee pay ratio disclosure, which would impose a significant administrative burden on many public companies who would have to calculate and track “total compensation” for all employees as defined by the SEC’s proxy rules, which is not the same as W-2 compensation for IRS purposes.

What Should Companies Do Now?

Financial institutions with assets over $1 billion should begin to understand and map compliance against the interagency proposed rule on incentive compensation. This will be particularly important for institutions that did not participate in the CPP, as the processes and reporting to be required under the new rule will be less familiar to them than to CPP participants.
Compensation committees of exchange-listed companies may want to begin assessing whether the proposed independence rules for the committee and its advisors raise any concerns, although the specific standards for committee independence will not be known until the stock exchanges issue proposed rules within 90 days after the SEC rule goes final.
Non-exchange listed companies may want to consider which aspects of the proposed rules apply.

Conclusion

We are somewhere midstream on the process of Dodd-Frank rulemaking on compensation and corporate governance. Several key rules have been proposed and, in some cases, adopted, but several others are still to come. We are assisting the management and boards of a variety of companies with these requirements, will continue to closely follow emerging trends, and will publish further updates 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.