Executive Compensation and Corporate Governance - The SEC and Treasury Strike Again

By Casey M. Nault
July 10, 2009

Introduction and Background

On July 1, 2009, the Securities and Exchange Commission (SEC) voted to propose new rules on executive compensation and corporate governance and to approve a controversial rule change with respect to broker voting in director elections. These actions come on the heels of the U.S. Treasury Department’s issuance of rules on executive compensation and corporate governance applicable to companies receiving government assistance or investment under the Troubled Asset Relief Program (TARP), including its Capital Purchase Program. The SEC’s actions were not unexpected, and represent concrete steps toward the adoption of the agenda covered in our May 28, 2009 alert, available here. Treasury’s rules had been long awaited, as they were required by the February 2009 stimulus bill. All public companies should begin to consider how the SEC’s actions will impact them, and all TARP companies must take prompt action to comply with the Treasury rules. In addition, all companies - regardless of their participation in TARP - may want to consider applicable portions of the Treasury rules for potential best practices.

SEC Actions

The SEC took action on four fronts:

Broker Voting in Director Elections. The SEC approved the New York Stock Exchange’s proposed change to Rule 452 to re-classify director elections as “non-routine” matters and thereby prohibit brokers from voting shares for which they receive no voting instructions from the beneficial holder. This rule change impacts all public companies, not just NYSE-listed companies, because the rule applies to all NYSE member brokers; the exchange on which a particular company’s stock is listed is irrelevant for purposes of applying the rule. Historically brokers have typically voted uninstructed shares according to the board’s recommendations. More recently, some brokers have adopted a “proportional voting” model, under which they vote uninstructed shares in the same proportion as shares for which they receive instructions, which usually results in a strong majority of “retail” shareholder votes in line with the board’s recommendations. The net effect of this rule change will be the loss of previously reliable block of voting support generally corresponding to the size of the company’s retail shareholder base (since retail voting tends to be very low). Companies with a large retail shareholder base need to consider whether quorums will be threatened (which typically will not be an issue if a “routine” matter under Rule 452, such as ratification of auditors, is included on the ballot), and if they have a majority voting standard for director elections, whether the loss of broker votes may place directors at risk. The revised rule is effective for shareholder meetings occurring on or after January 1, 2010.
New Disclosure Rules. The SEC voted to propose new or revised disclosure rules in the following areas:

Risk Analysis of General Employee Compensation Programs. If the risks arising from the incentives driven by general employee compensation policies and programs could have a material effect on the company, the Compensation Discussion & Analysis (CD&A) would need to discuss and analyze those programs on a company-wide basis (i.e., not limited just to the named executive officers).
Compensation Consultant Conflicts of Interest. If the board or compensation committee retains a compensation consultant that also provides other services to the company, the company would need to disclose the fees for the board/compensation committee advice, the other services and related fees, management’s role in retaining the consultant for other services and whether the board or compensation committee approved the other services.
Equity Compensation Reporting. Equity compensation awards now would be reported in the Summary Compensation Table and the Director Compensation Table as the aggregate grant date fair value of awards granted during the fiscal year, as opposed to the amount expensed during the fiscal year for all outstanding awards.
Board Leadership Structure. Companies would be required to discuss in their proxy statements the reasons for their particular board leadership structure (i.e., insider Chair separate from CEO, Chair/CEO combination, independent Chair), why that structure is appropriate for the company, and any impact of the board leadership structure on the board’s risk management function.
Director Qualifications. Director and nominee biographies in proxy statements would need to include disclosure of the experience, qualifications, attributes and skills that qualify the director or nominee to serve on the board and the committee(s) on which they serve. Biographies also would need to disclose all public company directorships held during the last five years, as opposed to only current directorships as is presently required.
Form 8-K Reporting of Shareholder Meeting Results. Companies would be required to report voting results from shareholder meetings within four business days under a new Item of Form 8-K. Currently, voting results are not required to be reported until the Form 10-Q for the quarter during which the meeting occurred.

Proxy Solicitation Rule Changes. The SEC proposed amendments that would allow shareholders and other third parties to distribute unmarked copies of the company’s proxy card, along with their own views, without having to file their own proxy statements. This would allow, for example, dissidents to send proxy cards with “vote no” literature.
Say on Pay for TARP Companies. The SEC proposed rules to require public companies that are TARP participants to include in their annual proxy materials a separate non-binding proposal to approve executive compensation, and disclose what effect the vote will have. This rule proposal was required by the stimulus bill and does not materially change public TARP companies’ obligations in this area, which were already effective for the 2009 proxy season. Notably, the SEC clarified a point of ambiguity in the original legislation: that “smaller reporting companies”, which are not required to include a CD&A in their proxies, do not need to include one merely to satisfy the statutory language that the advisory vote be on executive compensation as disclosed in the proxy statement, including the CD&A (among other disclosures).

Treasury Actions

The Treasury Department issued “interim final” rules on executive compensation and corporate governance for TARP companies, which are immediately effective but also subject to public comment for 60 days and possible revision. The interim final rules clarified and expanded upon some provisions of the February 2009 stimulus bill, left other provisions vague and ambiguous and used the authority delegated to Treasury to impose some new requirements not contemplated by the original legislation. Some of the more notable provisions of the rules are:

Golden Parachute Payment Restrictions. These restrictions cover the “senior executive officers” (the CEO, CFO and next three most highly compensated executives) (SEO’s) and the next five most highly compensated employees (HCE’s). Severance in any amount is prohibited for this group, as are any payments triggered by a change in control. In addition, there can be no acceleration of any vesting (such as under outstanding stock or option awards, or supplemental retirement benefits) as a result of termination or change in control.
Bonus, Incentive and Retention Payment Restrictions. TARP companies may not accrue or pay any bonus, incentive or retention payment to a group of employees that depends on the amount of government investment. The rules provide an exception for restricted stock that cannot vest sooner than two years and otherwise becomes transferable in 25% increments as a like percentage of government investment is repaid. Another exception applies for grandfathered arrangements that existed on February 11, 2009 and provide a legally binding right to a specific payment. The definitions of bonus, incentive and retention awards are broad; for example, a supplemental retirement benefit subject to vesting can be considered a retention award.
Gross-Ups. Tax gross-ups are prohibited for the SEO’s and the next 20 HCE’s. Like the restriction on golden parachute payments, there is no carve-out for pre-existing arrangements.
Perquisites. Companies must not only disclose but also justify perquisites with a value over $25,000 provided to anyone covered by the bonus restriction.
Clawback and Luxury Expenditures Policies. TARP companies must ensure that all incentive compensation to the SEO’s and the next 20 HCE’s is subject to clawback if the underlying performance metrics were inaccurate. TARP companies also must adopt a luxury expenditures policy covering expenditures for entertainment and events, transportation services, office renovations and other similar matters.
Say on Pay for Non-Public Companies. It still remains unclear whether non-public TARP companies are required to include a Say on Pay proposal in their proxy statements. The original legislation, SEC rules and Treasury rules all tie the advisory vote to executive compensation disclosure provided under SEC rules. It seems reasonable for non-public TARP companies, which are not required to provide any executive compensation disclosure under SEC rules, to conclude that a Say on Pay vote is not required because it would be meaningless in the absence of anything to vote on, and that a requirement for Say on Pay tied to SEC disclosure does not bootstrap them into having to provide SEC-like executive compensation disclosure. This latter position is supported by analogy to the SEC’s clarification that smaller reporting companies do not need to prepare a CD&A merely because the Say on Pay requirement references CD&A among other disclosures. This issue will need to be clarified.
Special Master for Executive Compensation. Treasury has created the Office of the Special Master for TARP Executive Compensation. The Special Master is charged with carrying out Treasury’s obligation to review prior compensatory payments by TARP companies to determine whether they were inconsistent with the purposes of TARP or contrary to the public interest. The Special Master also has authority to issue interpretive opinions on executive compensation, either upon the request of a TARP company or on his own volition.

Conclusion

These developments reflect the current political climate and represent a continuation of recent trends in favor of broader and more restrictive regulation and disclosure of executive compensation and corporate governance. Reforms now being adopted may have seemed out of reach to shareholder activists just a couple of years ago. 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 ), Stephen M. Klein (206.340.9648 or sklein@grahamdunn.com ), or Bart E. Bartholdt (206.340.9647 or bbartholdt@grahamdunn.com ) if you should have any questions or wish to discuss these issues further.