The Final Regulatory Reform Bill - The Fallout on Executive Compensation and Corporate Governance

By Casey M. Nault
July 29, 2010

Overview

On July 21, 2010, President Obama signed into law what many view as the most sweeping reform of financial regulation since the Great Depression. As forecast in our prior alert of June 2, 2010, in addition to financial reform the legislation also enacted major elements of the shareholder activist agenda on executive compensation and corporate governance.

Scope

As noted below, some of the reforms apply to all SEC-reporting companies, including companies whose securities may be quoted on the over-the-counter bulletin board or pink sheets, while others apply only to companies with securities listed on a national securities exchange (such as the New York Stock Exchange or NASDAQ) (“listed companies”).

Executive Compensation Provisions

Say on Pay. The Act requires every public company to hold a periodic “Say on Pay” vote, providing shareholders with an up-or-down non-binding vote on the compensation of executives as disclosed in the proxy statement. The SEC will have discretion to exempt certain companies, so it remains to be seen whether smaller reporting companies will be covered. In a surprise, the legislation requires companies to hold an annual, biennial or triennial vote, and to have shareholders vote at least every six years on whether the Say on Pay vote will be held every one, two or three years. The first Say on Pay vote would be required for the first annual meeting occurring after January 20, 2011. The SEC is expected to add Say on Pay as one of the proposals that does not trigger a preliminary proxy statement filing requirement.
Say on Golden Parachutes. The Act requires a non-binding shareholder vote to approve “golden parachute” compensation disclosed in merger proxies. The SEC has authority to exempt certain companies from this requirement.

Enhanced Compensation Committee Independence. For listed companies, compensation committee members will be subject to heightened independence standards. These new standards will be reflected in revised stock exchange listing standards, which must be adopted by July 2011. It is widely believed that compensation committee members will now be subject to similar standards as audit committee members have been subject to since the adoption of Sarbanes-Oxley. These enhanced standards will take into account indirect sources of compensation, such as consulting or advisory fees, which previously may not have violated applicable independence standards. The stock exchanges have the authority to exempt small companies from these new requirements.

Compensation Committee Advisors and Conflicts. Compensation committees of listed companies will be required to consider certain independence factors to be determined by the SEC before retaining consultants, legal counsel and other advisors. The factors must include (i) other services provided, (ii) fees as a percentage of total revenue for the advisor, (iii) the advisor’s internal conflicts of interest policies, (iv) relationships between committee members and the advisor, and (v) the advisor’s holdings of client stock, if any. In addition, proxy statements for annual meetings held after July 20, 2011 must include enhanced disclosure regarding compensation consultants and their independence. The stock exchanges have the authority to exempt small companies from these new requirements.
Clawback of Previously Awarded Compensation. The Act directs stock exchanges to require listed companies to adopt a policy to recover or “claw back” incentive compensation awarded to current or former executive officers (including equity awards) 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, regardless whether the individual committed any misconduct. The amount recovered would be the incremental amount resulting from the misstatement (not necessarily the entire award). The SEC must clarify the treatment of equity awards in rulemaking; for example, whether only awards that vest based on achieving financial targets are included. This clawback requirement is a narrower standard than applies to participants in the Treasury’s Capital Purchase Program, which are required to recover compensation based on any erroneous data, regardless whether an accounting restatement occurred.
Enhanced Disclosure Obligations. The Act requires the SEC to adopt rules providing for the following enhanced proxy disclosures:

Ratio of CEO to Median Employee Pay. Companies will 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” is to be calculated according to the SEC’s proxy rules, a measure many companies may not currently track for the general employee population.
Pay/Performance Link. Disclosure of the relationship between company performance and compensation “actually paid” will be required. Changes in the value of stock will be taken into account.
Policy on Hedging Company Stock. Disclosure will be required whether employees and directors are permitted to hedge company stock.

Corporate Governance Provisions

Proxy Access. The Act provides the SEC with explicit authority to adopt rules granting shareholders access to management’s proxy statement for the purpose of nominating directors to the board. 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. After recently re-opening the comment period, the SEC reportedly will adopt proxy access in time for the 2011 proxy season.

Further Restrictions on Broker Discretionary Voting. The Act further restricts the scope of matters on which brokers can exercise discretion in voting when they have not received specific instructions from beneficial holders. Broker discretion to vote in director elections was prohibited for the first time in the 2010 proxy season, and now brokers will be restricted from exercising discretion on executive compensation or “any other significant matter” as determined by SEC rule. The loss of broker discretionary voting could have a particularly significant impact on “Say on Pay” voting.

No Majority Voting Requirement. One major item not included in the final legislation was majority voting. However, we do not expect the momentum toward adoption of majority voting to subside, particularly for larger companies.

What Should Companies Do Now?

These recommendations were included in the prior Cyber-Graham, but bear repeating now that the final provisions are known.

Consider whether tools are in place to calculate the “total compensation” for all employees under the SEC’s proxy rules, in order to meet the requirement to disclose median “total compensation” for all employees (and the ratio compared to CEO compensation). This is an important new disclosure control and procedure.
Consider whether executive compensation or corporate governance policies or practices are likely to draw negative recommendations from the major proxy advisory firms (such as RiskMetrics Group and Glass Lewis), since the loss of broker discretionary voting combined with Say on Pay could put directors at greater re-election risk. We do not suggest that companies should blindly adhere to standards mandated by RiskMetrics, but do urge companies to be aware of which of their practices may draw negative attention so appropriate planning and communications can occur.
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).

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.
If insider trading policies do not currently address (or address but do not prohibit) hedging company stock, companies may want to review and possibly revise those policies before next year’s proxy season so they won’t have to disclose that they have no policy against hedging.

Conclusion

It is no surprise that most of the proposed provisions survived in the final Act, given the current political environment. We will publish further updates on these issues as developments warrant, including related SEC rulemaking. 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.