May 24, 2010
On May 20, 2010, the U.S. Senate passed the Restoring American Financial Stability Act of 2010 (the "Senate Bill"), the most significant financial regulatory reform legislation in decades. This legislation impacts not only the financial services industry but also all public companies. This memorandum focuses on the corporate governance and executive compensation provisions that will apply to public companies if the Senate Bill is enacted, and points out how the Senate Bill differs from the financial regulatory reform bill passed by the House of Representatives in December 2009 (the "House Bill"; available here). This memorandum also addresses the steps that companies should consider taking now in order to be prepared to comply with these provisions and the implementing rules and regulations to be adopted by the Securities and Exchange Commission ("SEC") and the exchanges.
The Senate Bill and House Bill are now in a conference committee process to reconcile the differences between the two versions.[1] As described below, many provisions in the two bills are consistent with each other, except that the Senate Bill contains a number of provisions that are not in the House Bill. Once the committee agrees on the final version, the bill would then have to be approved by a simple majority of both the House and the Senate before it would be sent to President Obama to be signed into law. Though the timing of enactment is not certain, the Administration has suggested that it would like to sign the bill into law before the July 4th holiday. We will continue to provide updates on these matters, as well as provide memorandums on other securities law and SEC reforms contained in the Senate Bill. A comprehensive memorandum describing all of the significant provisions of the Senate Bill is forthcoming shortly.
1. Corporate Governance Provisions
Title IX, Subtitle G of the Senate Bill contains corporate governance provisions relating to majority voting in uncontested director elections (applicable to listed companies), proxy access, and disclosures of board leadership. In addition, Title I, Subtitle C requires the establishment of risk committees at certain publicly traded financial institutions.
A. Majority Voting in Director Elections
Section 971 of the Senate Bill would amend the Securities Exchange Act of 1934 (the "Exchange Act") by inserting a new Section 14B that would require director nominees at listed companies to receive a majority of votes cast by shareholders in uncontested elections and a plurality vote in contested elections in order to be elected. Directors not receiving a majority of votes cast in an uncontested election would be required to tender their resignation to the board. A director who tenders his or her resignation could then remain on the board only if the board unanimously rejects the director’s resignation and issues a public statement within 30 days of the election. This statement must discuss the analysis used in reaching the decision not to accept the resignation and explain how the decision was in the best interests of the company and its shareholders.
New Section 14B requires the SEC to issue rules within one year of enactment directing the exchanges to prohibit the listing of any company not in compliance with the rules described in the previous paragraph. The SEC, however, would have the authority to exempt companies from these requirements based on the size of the company, market capitalization, public float, the number of shareholders of record or other criteria.
The House Bill does not contain any provision relating to majority voting in uncontested director elections.
Most listed companies do not currently use majority voting in uncontested director elections. According to a 2010 survey, 31% of the S&P Composite 1500, which consists of companies in the S&P 500, MidCap and SmallCap indices, have adopted majority voting.[2] The survey finds that majority voting is more common at larger companies, with 59% of the S&P 500 having adopted a majority vote standard for uncontested director elections.
B. Proxy Access
Section 972 of the Senate Bill would amend Section 14(a) of the Exchange Act to grant the SEC the authority to issue rules permitting shareholders to use company proxy solicitation materials for the purpose of nominating directors. Similar to the House Bill[3] and unlike an earlier Senate bill, it would not require the SEC to issue proxy access rules.
The Senate Bill’s proposal follows extensive debate on the issue of proxy access at both the state and federal levels. Delaware amended its corporation law in 2009 to allow companies to adopt bylaw provisions requiring the inclusion of shareholder nominees in the company’s proxy solicitation materials. Also in 2009, the ABA’s Committee on Corporate Laws amended the Model Business Corporation Act to include a proxy access provision similar to that enacted in Delaware.
In June 2009, the SEC issued proposed rules that would: (1) establish a federal proxy access right pursuant to proposed Rule 14a-11 and related amendments; and (2) permit proxy access shareholder proposals pursuant to an amendment to Rule 14a-8.[4] The proposed Rule 14a-11 would allow a shareholder or group of shareholders to nominate directors and have those nominees included in a company’s proxy materials if the shareholder or group beneficially owned a certain minimum percentage (ranging from 1-5%) of the company’s voting shares for at least one year prior to submitting the nomination. The proposed amendment to Rule 14a-8 would require companies to include shareholder proposals relating to proxy access in their proxy materials, except in limited circumstances. The SEC received hundreds of comments in response to the proposed proxy access rules, some of which questioned the SEC’s authority to implement the rules. The SEC currently is considering final adoption of the proxy access rules.
C. Disclosures Regarding Board Leadership Structures
Section 973 of the Senate Bill would add a provision to new Section 14B of the Exchange Act (as discussed above) that directs the SEC to issue rules requiring companies to include in their annual proxy statements the reasons why they have chosen the same person, or different people, to serve as chairman and chief executive officer. Unlike an earlier Senate bill, the Senate Bill would not require that separate individuals serve as chairman and CEO. The House Bill does not require disclosure of board leadership structures or that separate individuals serve as chairman and CEO.
The Senate Bill’s disclosure-based approach is similar to the proxy disclosure rules adopted by the SEC in December 2009.[5] These rules require enhanced disclosure about a company’s board leadership structure, including a discussion of: (1) whether the company has combined or separated the CEO and chairman positions; (2) if combined, whether the company has a lead independent director and the specific role of such director in the company’s leadership; and (3) why the company believes its structure is the most appropriate for the company.[6]
The Senate Bill requires the SEC to issue rules within 180 days of enactment. Given the similarities between what the Senate Bill requires and the rules adopted in December 2009 by the SEC, it appears that the Senate Bill would not require the SEC to significantly alter its current rules.
D. Risk Committees
Section 165 of the Senate Bill would require publicly traded nonbank financial institutions supervised by the Federal Reserve and large publicly traded bank holding companies to establish a separate risk committee of the board of directors. The Senate Bill also authorizes the Federal Reserve to issue regulations requiring smaller public bank holding companies to form risk committees. The risk committee would be required to: (1) oversee the financial institution’s risk management practices; (2) include a number of independent directors determined by the Federal Reserve, based on the nature of operations, size of assets and other criteria; and (3) include at least one risk management expert with experience in identifying, assessing and managing risk at large, complex financial institutions.
This provision differs from that in an earlier Senate bill, which would have required that the boards of all listed public companies, with limited exceptions, form a separate risk committee composed solely of independent directors. The Senate Bill’s risk committee provision will not affect the vast majority of public companies, many of which currently address risk through the full board or another board committee. The House Bill does not address risk committees.
All public companies, however, should be aware of the SEC’s new requirement regarding disclosure of the board’s role in risk oversight. Under the rules adopted in December 2009, a company must disclose the extent of the board’s role in the company’s risk oversight, including a description of how the board administers its oversight function, whether through the whole board, a separate risk committee or the audit committee.[7] Companies also must discuss the effect of the risk oversight function on the board’s leadership structure, such as how the risk oversight function is coordinated if different aspects of it rest in different board committees.
2. Executive Compensation Provisions
The compensation provisions of the Senate Bill are set forth in Subtitle E of Title IX under the heading "Accountability and Executive Compensation." These provisions impose substantive requirements related to executive compensation and enhance compensation disclosure obligations.
A. Advisory Shareholder Votes on Executive Compensation (or Say on Pay)
Section 951 of the Senate Bill would add Section 14A of the Exchange Act to require every public company to hold a shareholder advisory vote to approve the compensation of named executive officers as disclosed pursuant to the executive compensation requirements of Item 402 of Regulation S-K. As opposed to the House Bill, there is no requirement for a separate shareholder advisory vote on golden parachute payments in connection with a merger or acquisition. Both the Senate Bill and House Bill make clear that any shareholder vote is nonbinding and will not overrule any decision of the company or its board of directors or otherwise impact the board’s fiduciary duties.
This say on pay provision would be applicable to shareholder meetings occurring six months after enactment of the Senate Bill. Unlike both the House Bill[8] and the Emergency Economic Stabilization Act of 2008 (as amended, "EESA"), which required all TARP recipients to hold say on pay votes, this bill does not mandate that the SEC adopt any rules or regulations to implement this provision, although the SEC has general rulemaking authority to do so under the Exchange Act.[9] The House Bill directs the SEC to issue final rules within six months of enactment, with the say on pay requirement applying to meetings held six months after the effectiveness of those rules.
B. Compensation Committee Independence and the Role of Compensation Consultants and Other Advisors
Similar to the heightened independence requirements imposed on audit committees and their advisors under the Sarbanes Oxley Act of 2002 (the "Sarbanes-Oxley Act"), Section 952 of the Senate Bill would add Section 10(C) of the Exchange Act focusing on compensation committee independence. The Senate Bill would require the SEC to direct the exchanges to prohibit the listing of any company whose compensation committee members do not meet enhanced independence requirements. The timeline for adoption requires the SEC to issue rules not later than 360 days after enactment. The Senate Bill also directs the SEC to grant the exchanges exemptive authority to exclude certain types of listed companies based on size or other relevant factors and to provide a company with a cure period before its securities would be delisted. Following is a brief description of each subsection of Section 10(C).
Committee Member Independence. Section 10C(a) requires that each member of a board’s compensation committee be independent under a definition of independence to be established by the exchanges that considers the sources of compensation paid to compensation committee members (including any consulting, advisory or other compensatory fees paid) and whether the members are affiliated with the listed company.[10]
Compensation Consultant Independence. Section 10C(b) requires that any compensation consultants and other advisors retained by the compensation committee may only be selected after a listed company has taken into account independence factors to be established by the SEC. These factors include: (1) provision of other services by the person that employs the compensation consultant or advisor (the "Consulting Firm"); (2) the amount of fees received by the Consulting Firm as a percentage of its total revenue; (3) the Consulting Firm’s policies designed to prevent conflicts of interest; (4) any business or personal relationship of the compensation consultant or advisor with a member of the compensation committee; and (5) any stock of the company owned by the compensation consultant or advisor.
Authority to Retain, and Disclosure Regarding Use of, Independent Compensation Consultants. Section 10C(c) provides that a compensation committee be directly responsible for the appointment, compensation, and oversight of its independent consultants and advisors. However, the Senate Bill provides that the committee is not required to follow the recommendations of such consultants and advisors and shall continue to exercise its own judgment in fulfilling its duties. In addition, a listed company would be required to disclose in its annual proxy statement whether a compensation consultant is used, whether there are any conflicts of interest and how any such conflicts are being addressed. This new disclosure requirement would apply to annual proxy statements filed by a listed company on or after one year following enactment of the Senate Bill. Existing SEC rules include similar disclosure requirements regarding the use of independent compensation consultants.[11]
Independence of Other Advisors. Section 10C(d) requires that a compensation committee also shall have the authority to retain and obtain the advice of independent counsel and other advisors. Any such advisors may only be retained after the committee has taken into account the independence factors to be established by the SEC under Section 10C(b) (as described in more detail above under "Compensation Consultant Independence"). Again, the committee would be directly responsible for the appointment, compensation and oversight of these independent advisors, but would not be required to follow the recommendation of such counsel or advisors.
Funding. Under Section 10(C)(e), each listed company would be required to provide for appropriate funding for independent compensation consultants, counsel and other advisors.
The House Bill contains compensation committee provisions substantially similar to all of the provisions set forth above,[12] except that it does not include a list of factors to be used by the SEC in developing its independence standard for outside consultants, legal counsel and other advisors, instead directing the SEC to see that regulations are competitively neutral among categories of consultants and preserve the ability for compensation committees to retain consultants. The House Bill also requires an SEC study and report to Congress on the use of outside consultants meeting the new standards for independence. In addition, the timeline for adoption under the House Bill is nine months, rather than 360 days.
Section 954 of the Senate Bill would add Section 10D of the Exchange Act to require the SEC to direct the exchanges to prohibit the listing of any company that does not adopt "clawback" policies to recover compensation in certain circumstances. Specifically, listed companies would be required to adopt policies to recoup unearned payments awarded to executive officers, current or former, as incentive compensation during a three year look back period if the company is required to prepare an accounting restatement based on erroneous data due to material noncompliance with any financial reporting requirement under the securities laws, regardless of whether the individual was involved in misconduct that led to the restatement. The Senate Bill does not specify a time period in which the SEC is required to direct the exchanges to adopt rules. There is no corresponding provision under the House Bill.
This clawback provision represents a middle ground between the provision applicable only to TARP recipients under EESA and the current provision applicable to all public companies under the Sarbanes-Oxley Act, but is more stringent than the clawback provisions voluntarily adopted by many companies. Under the Sarbanes-Oxley Act, the clawback is limited in scope (i.e., applicable only to the Chief Executive Officer and Chief Financial Officer), duration (i.e., a twelve month look back period) and grounds (i.e., misconduct is required). The clawback provision under EESA is not triggered by an accounting restatement, but only requires a material inaccuracy in the company’s financial statements and/or performance metrics and does not contain a misconduct requirement.
D. Executive Compensation Disclosures
Pay for Performance. Section 953 of the Senate Bill would amend Section 14 of the Exchange Act by adding subsection (i) that directs the SEC to adopt rules requiring a public company to disclose in its annual proxy statement the relationship between executive compensation actually paid and the company’s financial performance. Although not explicitly defined, "financial performance" presumably will be based on some aspect of stock price performance, as the Senate Bill provides that the SEC’s implementing regulations are to take into account changes in the value of the shares of stock and dividends of the company and any distributions. The disclosure may, but is not required to, include a graphic representation of this required information. A stock price performance graph is required to be included in a company’s annual report to shareholders pursuant to existing SEC rules,[13] but the Senate Bill provision is more prescriptive than current requirements and requires that companies present an explicit comparison between pay and financial performance.
Internal Pay Ratio. Section 953 of the Senate Bill also directs the SEC to amend Item 402 of Regulation S-K to require each company to disclose in its annual proxy statement (1) the median of annual total compensation, as determined in accordance with Item 402(c) of Regulation S-K, of all employees, other than the CEO (or any equivalent position); (2) the annual total compensation of the CEO (or any equivalent position); and (3) the ratio of those two amounts. Given the complexity of calculating compensation under Item 402(c) for named executive officers, the need to calculate total compensation for all employees could be an extremely burdensome and expensive undertaking for companies.
Hedging Policy. Section 955 of the Senate Bill would amend Section 14 of the Exchange Act by adding subsection (j) that directs the SEC to adopt rules requiring each company to disclose in its annual proxy statement whether its employees or directors (or any of their designees) may purchase financial instruments that are designed to hedge or offset decreases in the value of securities granted to employees or directors as a part of employee compensation or other securities held by the employees or directors.
The House Bill does not contain compensation disclosure provisions comparable to those set forth above, and the Senate Bill does not provide an effective date or prescribe a time period in which the SEC must adopt rules implementing these new disclosures. SEC rules will be critical for defining a company’s obligations under these disclosures, particularly internal pay ratio. As noted above, companies may face an enormous burden if they are required to calculate total compensation in accordance with Item 402(c) of Regulation S-K for all of their employees.
Section 957 of the Senate Bill would amend Section 6(b) of the Exchange Act to prohibit a broker that is not the beneficial owner of a company’s shares (e.g., shares held in street name on behalf of retail investors) from granting a proxy to vote the shares in connection with a shareholder vote on executive compensation or other significant matters (as determined by the SEC by rule) unless the beneficial owner has provided the broker with voting instructions. In effect, this expands the effect of the SEC’s July 2009 approval of amendments to NYSE Rule 452 to eliminate uninstructed broker voting in uncontested director elections so that it also applies to say on pay votes and other matters.[14] The House Bill does not contain a corresponding provision.
3. What Companies Should Do Now
Although the Administration has previously suggested that it is committed to enacting financial reform legislation this summer, the Senate Bill and House Bill must still go through the conference committee reconciliation process and be approved by the House and the Senate before legislation can be enacted. Assuming it is enacted, much work will remain to be done by the SEC to develop rules implementing the corporate governance and compensation provisions contained in the legislation, particularly on the pay for performance and internal pay ratio disclosures. In the short term, however, the following sets out steps that companies should consider taking now to be prepared for any coming changes.
- Majority Voting. If a listed company’s governing documents currently provide for plurality voting in uncontested director elections, consider whether to adopt majority voting in uncontested director elections in advance of SEC rules that will result from any final legislation that includes this requirement.
- Proxy Advisory Firms and Director Elections. Companies should carefully examine whether the major proxy advisory firms, such as RiskMetrics Group, Inc. and Glass Lewis & Co., are likely to recommend "against" votes with respect to their director nominees. Companies should be mindful that RiskMetrics Group and Glass Lewis typically recommend "against" votes with respect to directors who do not meet the firms’ own independence standards–which are stricter in some cases than those of the major exchanges–if these directors serve on any of the three "key" committees (audit, compensation and nominating/governance). Both firms also issue "against" recommendations on compensation committee members where a company has pay practices that the firms view negatively. The firms’ recommendations typically have more influence on director elections where majority voting is in place, because a greater percentage of "for" votes is required in order to elect a nominee. If the Senate Bill’s majority voting requirement were implemented, an "against" recommendation from the major proxy advisory firms may result in a director nominee receiving less than a majority of votes cast, which would force an incumbent director to tender his or her resignation to the board.
- Proxy Access. With the comment period for the SEC’s proxy access proposal closed, final adoption of the proposed rules currently is under consideration at the SEC. In the months leading up to the next shareholder proposal and proxy seasons, companies should assess whether any of their director nominees are vulnerable (for example, if in connection with the last shareholders’ meeting they received a negative recommendation from RiskMetrics Group and/or significant "against" or "withhold" votes) and anticipate potential implications associated with possible proxy access candidates.
- Risk Oversight. Although the Senate Bill’s risk committee provision applies only to certain publicly traded financial institutions, all companies should consider carefully their risk oversight process and structure, including whether the oversight function should rest with the whole board, the audit committee and/or another committee. The SEC’s 2009 proxy disclosure rules focused on risk oversight, rather than risk management, which suggests that companies should pay particular attention in their proxy statement disclosures to the process in place.
- Say on Pay
- Revisit how compensation programs are presented in the company’s Compensation Discussion and Analysis. Keep in mind that although the say on pay vote is not binding, a majority negative vote should be avoided, and the loss of broker votes on say on pay proposals will amplify the issue. In particular, consider RiskMetrics Group’s guidelines as to pay practices that will cause it to issue a negative vote recommendation (refer here to our previous client alert describing RiskMetrics Group’s current policy updates). The Council of Institutional Investors has also developed a list of "red flags" for shareholders to consider when analyzing compensation programs (available here).
- Monitor SEC rulemaking that will determine whether any specific language or form of resolutions is required to be used when drafting a say on pay proposal and whether the inclusion of a say on pay vote will trigger a preliminary proxy filing.
- Begin to enhance communication with the proxy voting department at institutional investors, if not already established, to encourage affirmative voting on say on pay and any other anticipated significant matters.
- Enhanced Compensation Committee Independence
- Analyze compensation committee members’ director and officer questionnaires in order to determine if any independence issues may arise. For example, the prohibition on affiliates serving on the committee will be an issue if a significant investor or a provider of professional services serves on the compensation committee.
- Analyze engagements with outside compensation consultants, legal counsel and other advisors in order to be in a position to identify issues raised by the SEC rules on heightened independence requirements. This should be done on a worldwide basis for the company and its subsidiaries and also take into account affiliates of the consultants and advisors. One particular item to monitor is how the SEC rules will impact the independence of outside legal counsel who typically provides services to both the compensation committee and the company.
- Clawbacks
- Evaluate all compensation arrangements that might be subject to the new clawback requirements, and then consider whether to adopt or modify a clawback policy that goes beyond the requirements set forth in the Senate Bill, such as a policy that meets the requirements set forth in EESA. According to its 2009 proxy voting policies, RiskMetrics Group considers the clawback provisions contained in EESA to be the new "best practice" in the area and would recommend votes "for" a shareholder proposal seeking adoption of a clawback policy if the company’s current policy is not as broad as the EESA provisions.
- Keep in mind that further modifications may be necessary when listing standards are adopted.
- Pay for Performance
- Analyze how compensation will compare with financial performance, as determined under various measures such as stock performance and net earnings. This provision is similar to the information that RiskMetrics Group currently includes in its reports, the connection between CEO compensation and stock performance, and RiskMetrics Group has advised that it may issue a negative vote recommendation if changes to the CEO’s total pay is not aligned with Total Shareholder Return over certain time horizons.
- Consider developing several alternative presentations that a company believes may more effectively present the relationship between pay and performance based on its specific compensation programs.
- Internal Pay Ratio. Assess mechanisms to determine whether it is possible to compute total compensation for all employees’ in accordance with Item 402(c) of Regulation S-K in order to determine the median amount of compensation to be compared to that of the CEO’s. Companies should also begin to assess the factors that may contribute to a large disparity in the ratio, including number of employees and complexity of work performed by employees, in order to explain the disparity. RiskMetrics Group currently includes information in its reports on the pay disparity between the CEO and the next most highly compensated employee.
- Hedging disclosure. Consider whether to adopt an anti-hedging policy applicable to employees and directors, or, if one already in place, review the current policy. While there is currently no SEC disclosure requirement for hedging policies, many companies already discuss them in their proxy statements and other address them in their insider/securities trading policies.
Final Recommendation: Be prepared and be involved. Above all, if the legislation is enacted, companies should be prepared to actively participate in commenting on SEC rulemaking, as company input into the practical challenges and issues presented by the new legislation will be important.
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Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you work, or any of the following:
John F. Olson – Washington, D.C. (202-955-8522, [email protected])
Brian J. Lane – Washington, D.C. (202-887-3646, [email protected])
Ronald O. Mueller – Washington, D.C. (202-955-8671, [email protected])
Amy L. Goodman – Washington, D.C. (202-955-8653, [email protected])
James J. Moloney – Irvine, CA (949-451-4343, [email protected])
Stephen W. Fackler – Palo Alto (650-849-5385, [email protected])
Sean C. Feller – Los Angeles, CA (213-229-7579, [email protected])
Gillian McPhee – Washington, D.C. (202-955-8230, [email protected])
Elizabeth Ising – Washington, D.C. (202-955-8287, [email protected])
Amber Busuttil Mullen – Los Angeles (213-229-7023, [email protected])
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