The Dodd-Frank Wall Street Reform and Consumer Protection Act requires rulemaking on a variety of executive compensation topics, including: say-on-pay, compensation committee independence, clawbacks of incentive compensation, enhanced compensation disclosure, disclosure of hedging policies, and compensation design at financial institutions.
Say-on-Pay
The Act requires a non-binding shareholder vote on executive compensation as disclosed in a proxy statement for any shareholders meeting. The vote is required once every three years, with shareholders having a right once every six years to decide whether the vote will occur annually, biannually or triennially. Earlier drafts of the law would have mandated an annual say-on-pay vote, so the flexibility for a biannual or triennial vote gives shareholders some ability to tailor say-on-pay at each company. The requirement becomes effective for the first shareholders meeting for which executive compensation disclosure is required in the related proxy statement held six months after adoption of the requirement. As a result, most companies will need to submit an advisory vote on executive compensation, and a proposal for the frequency of the say-on-pay vote thereafter, in their proxy statement for the 2011 shareholders meeting.
The Act also requires a non-binding shareholder vote on "golden parachute" compensation at any meeting at which shareholders are asked to approve a merger, sale or acquisition. The person soliciting proxies must provide clear and simple disclosure of all arrangements and understandings with any named executive officers that provide for compensation based on or related to the merger, sale or acquisition, and the aggregate amount of the compensation that may be paid or become payable to those executives. With respect to any contingent consideration, the proxy statement should explain the conditions for payment. Shareholders will also have the right to provide a non-binding vote on these "golden parachute" payments to the extent they have not been subject to shareholder approval under a periodic say-on-pay vote. Similar to the periodic say-on-pay votes, a say on "golden parachute" compensation vote will be required for any meeting occurring six months after adoption of the requirement.
As described in more detail here, brokers and other nominees will not have authority to vote on these proposals without receiving direction from the beneficial owners. The Act makes clear that the shareholder votes on these matters do not overrule the board's decisions or create or change the fiduciary duties of the directors. In addition, the Act clarifies that the mandatory say-on-pay votes do not limit shareholder rights to submit shareholder proposals on executive compensation matters. The SEC has authority to exempt a class of issues from the say-on-pay requirements and, in particular, the SEC must consider the burdens of say-on-pay on small issuers. Finally, institutional investment managers will be required to report annually how they voted on both periodic say- on-pay proposals and "golden parachute" proposals.
To prepare for say-on-pay, companies should review executive compensation arrangements that may be classified by investors and governance rating agencies as "poor" practices. Companies should communicate any feedback received from investors on executive compensation to the board, and decide the appropriate level of proactive shareholder engagement in this area. Companies will also want to review and clarify any complex disclosure of executive compensation arrangements to avoid misunderstandings on compensation design and prepare to explain any compensation structures or levels that may be unique to the company. Companies will also want to think about the preferred frequency of periodic say-on-pay votes and consider how the board will recommend shareholders vote on this matter.
Compensation Committee Independence
The Act requires the SEC to direct stock exchanges to require independent compensation committees and independent compensation consultants and advisors. The SEC must adopt the rules within 360 days of the Act's approval, and the rules may exempt certain issuers, such as controlled companies and foreign private issuers. The exchanges may also exempt other issuers and, in particular, the exchanges must consider whether issuers of a certain size should be exempt. The rules must also provide companies with an opportunity to cure any violation before becoming subject to delisting.
Specifically, the rules will require exchange-listed companies to have only independent directors serving on the compensation committee, and the exchanges' independence definition must consider compensation paid to the committee members (including compensation for consulting or advisory work) and whether the members are affiliates of the issuer.
The Act also requires the SEC to adopt factors that companies must consider before selecting any consultant, legal counsel or other advisor to the compensation committee. The factors for consideration should include:
- Whether the consultant, counsel or advisor provides other services to the company;
- The amount of fees the consultant, counsel or advisors receives from the company as a percentage of the total revenue of the consultant, counsel or advisor;
- The conflict of interest policies of the consultant, counsel or advisor;
- Any business or personal relationships between the consultant, counsel or advisor with any member of the compensation committee; and
- Any stock of the company owned by the consultant, counsel or advisor.
Companies must also give compensation committees authority to engage and oversee compensation consultants, independent legal counsel and other advisors and provide the funding necessary for those engagements. Commencing with the first proxy statement for annual meetings held after the one year anniversary of adoption of the Act, companies would be required to disclose whether the compensation committee engaged any compensation consultants and describe any potential conflicts of interest, including the nature of the conflict and how it is being addressed. The requirement to provide this disclosure contemplates further SEC action setting forth the specific disclosure obligation.
Since most exchange-listed companies currently have independent compensation committees, it is unlikely that the new rules will require significant changes to compensation committee composition; however, each compensation committee member's independence will need to be assessed in light of any enhanced requirements resulting from the final stock exchange rules. It is likely that the final independence standards for compensation committees will look similar to those currently applicable to audit committee members.
In addition, recent SEC rules already require certain information about fees paid to compensation consultants that may raise independence concerns; however, the current SEC rules do not generally cover legal counsel or other advisors. Notably, the Act does not prohibit any particular engagements, but merely requires compensation committees to consider certain factors before engaging consultants, counsel and other advisors. The Act clarifies that the rules are not intended to require compensation committees to follow any advice received from the advisors. The Act also requires the SEC to conduct a study of the use of compensation consultants and the effects of such use, and report the SEC's findings to Congress within two years.
Clawbacks of Incentive Compensation
The Act requires the SEC to direct all stock exchanges to require disclosure of each company's policies on incentive compensation based on financial information and adopt a clawback policy. The clawback policy must apply to all current and former executive officers and require the forfeiture of incentive compensation awarded to any such executive officer during the three years preceding the date on which a restatement resulting from material noncompliance with financial reporting requirements becomes required and requires a recalculation of the incentive compensation that would have been awarded based on the actual results. Stock options awarded as compensation are included as incentive compensation for this purpose, but it is unclear exactly how the clawback policy should apply to stock options – whether it relates to the number of options awarded or any gains recognized. It is also unclear how the clawback policies would relate to incentive compensation arrangements and stock options that have been granted prior to the effective date of the rule.
The new requirement expands the clawback currently required under the Sarbanes-Oxley Act, which only applies to the CEO and CFO and only applies to financial restatements resulting from misconduct. Several companies have adopted broader clawback policies in recent years, and those policies will need to be reviewed and revised when the final SEC rules implementing this requirement are adopted. The Act does not specify a deadline for SEC rulemaking on this topic.
Enhanced Compensation Disclosure
The Act requires the SEC to adopt a rule requiring clear disclosure of executive compensation, including the relationship between executive compensation actually paid and the company's financial performance. The assessment of the company's financial performance should be based on total shareholder return, looking both at the change in value of the company's stock and the amount of any dividends and other distributions. The Act does not specify the time period(s) over which the assessment will be required. The disclosure may take the form of a graphic presentation. The rule will require specific disclosure of the median of the total annual compensation of all employees other than the CEO, as compared to the total annual compensation of the CEO, each calculated in accordance with the calculation of total compensation as presented in the Summary Compensation Table. The Act does not specify a deadline for SEC rulemaking on this topic.
Companies may wish to revise incentive compensation programs to provide more alignment between compensation levels and financial performance, specifically considering total shareholder return.
Disclosure of Hedging Policies
The Act requires the SEC to adopt a rule requiring disclosure in each annual meeting proxy statement of whether any employee or director, or their designees, are permitted to engage in hedging transactions. For this purpose, hedging transactions include the purchase of any financial instrument, such as prepaid variable forward contracts, equity swaps, collars and exchange funds, that are designed to hedge or offset decreases in the company's stock price.
Companies should review their insider trading policies, including those policies applicable to all employees and any designees of employees, to determine whether these transactions are currently prohibited, or whether the company wants to add such a prohibition.
Compensation Design at Financial Institutions
Certain financial institutions will be subject to additional reporting obligations and prohibitions related to incentive-based compensation arrangements. The appropriate federal regulators will be required, within nine months of the enactment of the Act, to issue rules requiring covered financial institutions to report to the regulators on incentive-based compensation arrangements that provide excessive compensation or could lead to material financial loss to the institution. Disclosure of actual compensation of particular individuals will not be required. At the same time, the appropriate federal regulators will be required to issue rules prohibiting incentive-based compensation arrangements that provide excessive compensation or could lead to material financial loss. Covered financial institutions with assets less than $1 billion will be exempt from the requirements.
The Faegre & Benson Financial Reform Working Group continues to monitor and provide analysis on substantive topics; additional articles and webcasts will be posted from time to time to assist clients in understanding the implications of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Click here to subscribe to the Financial Reform Update and contact the authors of this article with any questions.
