Introduction
For the first time a specifically designated regulatory entity will be overseeing how large institutions impact the nation’s economic health and the stability of its markets, and be able to undertake targeted actions against institutions that pose a systemic risk. This broad focus on the systemic risk imposed on the markets generally by particular institutions and specific transactions and practices can also be seen in the operations of various regulatory agencies. On July 16, 2010, the Division of Corporation Finance of the Securities and Exchange Commission (the “Commission”) announced it is creating three new specialized offices that will focus on large financial institutions, asset-backed securities and other structured products, and securities offering trends.
The Dodd-Frank Act contains several provisions that will affect public companies including companies outside the financial services industry. Title IX of the Act contains the Investor Protection and Securities Reform Act of 2010, which includes the executive compensation and corporate governance reforms applicable to all public companies. Except for Say on Pay, most of these provisions require rulemaking by the SEC and/or the national stock exchanges to implement them. This Alert summarizes certain of the provisions of the Act including the executive compensation and corporate governance provisions, which will impact all public companies.
New shareholder vote requirements
Say on pay
Section 951 of the Dodd-Frank Act includes a “say on pay” provision that requires, not less frequently than once every three years, a non-binding shareholder vote on the compensation of executive officers as disclosed in an issuer’s proxy statement in accordance with the executive compensation rules contained in Item 402 of Regulation S-K. In addition, not less frequently than once every six years, the proxy statement must include a separate resolution for shareholders to vote on whether the say on pay shareholder vote will occur every one, two, or three years. These requirements will apply to any proxy or consent or authorization for an annual or other shareholder meeting for which the SEC’s proxy solicitation rules require compensation disclosure. This provision will begin to apply to meetings of shareholders occurring on a date six months after the enactment of the Act. At the first meeting occurring after such time, a say on pay resolution and a separate resolution on whether the say on pay votes will occur every one, two, or three years must be included in the proxy or consent.
Golden parachute compensation
Section 951 also includes a requirement for a non-binding shareholder vote of “golden parachute compensation.” A proxy statement relating to a meeting at which shareholders are asked to approve an acquisition, merger, consolidation, or sale of all or substantially all of the assets must provide disclosure, in a clear and simple form in accordance with rules to be adopted by the SEC, of any agreements and understandings with any named executive officers concerning the type of compensation that is based on or otherwise relates to the transaction and the aggregate total of all such compensation that may be paid or become payable to or on behalf of the named executive officer. Any condition upon which the payment of such compensation is based must also be disclosed. In addition, the proxy statement must include a separate resolution for shareholders to vote to approve such agreements and compensation as disclosed. This provision will apply to any meeting of shareholders occurring on a date six months after the enactment of the Act.
Other related matters
The non-binding shareholder votes described above will not be construed:
- as overruling a decision by such issuer or board of directors;
- to create or imply any change to the fiduciary duties of the issuer or board of directors;
- to create or imply any additional fiduciary duties of the issuer or board of directors; or
- to restrict or limit the ability of shareholders to make proposals for inclusion in proxy materials related to executive compensation.
Institutional investment managers subject to Section 13(f) of the Securities Exchange Act of 1934 will be required to report, at least annually, how it voted on any non-binding shareholder votes on executive compensation and golden parachute compensation.
The Dodd-Frank Act permits the SEC to provide an exemption from these non-binding shareholder vote requirements for an issuer or class of issuers such as for smaller reporting companies.
Proxy access
Section 14 of the Exchange Act will be amended to permit, but not require, the SEC to adopt rules that would require a solicitation of proxy, consent, or authorization by an issuer to include a nominee for director submitted by a shareholder. Although this provision does not mandate proxy access, it does clarify the authority of the SEC to issue rules requiring proxy access. The SEC’s rules may permit such use of issuer proxy materials by shareholders under such terms and conditions as the SEC determines are in the interests of shareholders and the protection of investors. In addition, the SEC may provide exemptions from this requirement such as for smaller reporting companies. While the final Senate bill contained a provision requiring majority voting in the election of directors, this provision was negotiated out of the final Act during the House-Senate conference.
Additional independence requirements for compensation committee members
The SEC must adopt rules to direct the national stock exchanges and national securities associations to prohibit listing of any security of an issuer that does not have an independent compensation committee meeting the requirements of new Section 10C of the Exchange Act. This requirement does not apply to an issuer that is a controlled company, limited partnership, company in bankruptcy proceedings, open-ended management investment company registered under the Investment Company Act of 1940, or a foreign private issuer that provides annual disclosure to shareholders of the reasons why the foreign private issuer does not have an independent compensation committee.
The new additional independence requirements under Section 10C for compensation committee members are similar to the additional independence requirements for audit committee members under existing law. In this regard, the national stock exchanges and national securities associations will be required to consider consulting, advisory, and other compensatory fees paid by the issuer to the member of the committee and whether the committee member is an affiliate of the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer.
The SEC’s rules will permit a national stock exchange or a national securities association to exempt a particular relationship with respect to members of a compensation committee taking into consideration the size of an issuer and any other relevant factors.
Compensation consultants
New Section 10C(b) of the Exchange Act will permit a compensation committee to engage compensation consultants, legal counsel, and other advisors only after considering their independence based on factors to be set forth by the SEC in new rules. The SEC’s rules are required to include the following factors:
- other services provided to the issuer by the entity that employs the compensation consultant, legal counsel, or other advisor;
- the amount of fees received by the entity that employs the compensation consultant, legal counsel, or other advisor as a percentage of total revenue of such entity;
- the policies and procedures of the entity that employs the compensation consultant, legal counsel, or other advisor designed to prevent conflicts of interest;
- business and personal relationships of compensation consultant, legal counsel, or other advisor with a member of the compensation committee; and
- ownership of the stock of the issuer by the compensation consultant, legal counsel, or other advisor.
The SEC’s rules are required to be competitively neutral among categories of consultants and preserve the ability of the compensation committee to retain services of members of any such category.
New Section 10C(c) of the Exchange Act provides the compensation committee the authority to retain or obtain the advice of a compensation consultant in its sole discretion. Also, it provides for the compensation committee to be directly responsible for the appointment, compensation, and oversight of the work of compensation consultants. This new authority will not be construed to require the compensation committee to implement the advice or recommendations of the compensation consultant or affect its ability or obligation to exercise its own judgment in the fulfillment of its duties.
Issuers will be required to disclose whether the compensation committee retained or obtained the advice of a compensation consultant and whether their work raised any conflict of interest and, if so, the nature of the conflict and how such conflicts are being addressed. This disclosure will be required in any proxy or consent solicitation material for an annual meeting (or special meeting in lieu thereof) occurring one year after the date of enactment of the Act.
New Section 10C(d) of the Exchange Act provides the compensation committee the authority to retain or obtain the advice of independent legal counsel and other advisors in its sole discretion. Also, it provides for the compensation committee to be directly responsible for the appointment, compensation, and oversight of the work of independent legal counsel and other advisors. This new authority will not be construed to require the compensation committee to implement the advice or recommendations of independent legal counsel or other advisors or affect its ability or obligation to exercise its own judgment in the fulfillment of its duties.
Issuers will be required to provide appropriate funding for payment of reasonable compensation to compensation consultants, independent legal counsel, and other advisors retained by the compensation committee.
The SEC must adopt rules within 360 days of enactment of the Act directing the national stock exchanges and national securities associations to prohibit listing of an issuer that is not in compliance with new Section 10C. The SEC’s rules may provide for an opportunity for issuers to cure defects and may permit the national stock exchanges and national securities associations to exempt a category of issuers from new Section 10C as they deem appropriate. Section 10C provides a statutory exemption for “controlled companies,” which means a listed company in which more than 50% of the voting power is held by an individual, a group, or another issuer.
Executive compensation disclosure
The Dodd-Frank Act requires the SEC to amend its rules to modify the executive compensation disclosure requirements to include “pay versus performance” and “internal pay disparity” disclosure. Issuers will be required to provide disclosure in their annual meeting proxy and consent solicitation materials that show the relationship between executive compensation actually paid and the financial performance of the issuer, taking into account any change in the value of the shares of stock and dividends of the issuer. The SEC may require a graphic representation of the pay versus performance disclosure.
In addition, the SEC must amend its rules to require internal pay disparity disclosure by issuers in their periodic reports filed with the SEC as well as registration statements filed under the Securities Act of 1933. Issuers will be required to disclose the median annual total compensation of all employees excluding the CEO, the annual total compensation of the CEO, and the ratio of the median non-CEO employee total compensation to that of the CEO. The Act provides that total compensation of an employee shall be determined in the same manner as the total compensation column in the summary compensation table required by Item 402(c)(2)(x) of Regulation S-K.
Clawback policy
The Dodd-Frank Act amends the Exchange Act to add new Section 10D, which requires the SEC to revise its rules to direct the national stock exchanges and national securities associations to prohibit listing of any security of an issuer that does not develop and implement a “clawback” policy. The policy must provide for:
- disclosure of the policy of the issuer on incentive-based compensation that is based on financial information required to be reported under the securities laws; and
- recovery from any current or former executive officer who received incentive-based compensation (including stock options) during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws.
The amount of the recovery will be the amount paid to the executive officer that exceeds what would have been paid to the executive officer under the accounting restatement. Unlike Sarbanes-Oxley, this provision applies to all executive officers and does not only apply to restatements involving misconduct.
Hedging disclosure
The Act requires the SEC to adopt rules requiring disclosure in an issuer’s annual proxy or consent solicitation materials as to whether any director or employee of the issuer, or any designee of such employee or director, is permitted to purchase financial instruments that are designed to hedge or offset any decrease in the market value of equity securities of the issuer granted to the employee or director as part of their compensation or held, directly or indirectly, by the employee or director.
Broker discretionary authority
Section 957 of the Dodd-Frank Act further restricts the ability of brokers to vote shares without instructions from the beneficial owners of the shares. The rules of the national stock exchanges and national securities associations will be required to prohibit broker discretionary voting with respect to the election of directors, executive compensation, or any other significant matter (as determined by the SEC by rule). This provision expands the restriction on discretionary voting by brokers from the action recently taken by the New York Stock Exchange and approved by the SEC to eliminate discretionary voting in uncontested director elections.
Chairman and CEO structure disclosure
The Dodd-Frank Act requires the SEC to adopt rules that require disclosure in an issuer’s annual proxy statement of the reasons why the issuer has chosen the same person as chairman of the board and CEO or different individuals to serve as chairman and CEO. This requirement has substantially been implemented already by the SEC in December 2009 and should not require the SEC to significantly amend its current rules.
Changes to the regulation of credit rating agencies
Regulation FD revision for communications with credit rating agencies
Regulation FD, adopted by the SEC in 2000, contains rules designed to address the problem of selective disclosure made to those who would reasonably be expected to trade securities on the basis of the information or provide others with advice about securities trading. Currently, the rules do not apply to communications to an entity whose primary business is the issuance of credit ratings, provided the information is disclosed solely for the purpose of developing a credit rating and the entity’s ratings are publicly available. The Dodd-Frank Act directs the SEC to amend Regulation FD within 90 days of enactment of the Act to remove the exemption for communications with credit rating agencies. Therefore, absent another exemption, public companies will not be permitted to provide material non-public information to credit rating agencies. Companies should review and revise as necessary their disclosure policies to address this upcoming change.
Consent of credit rating agencies in connection with public offerings
Section 939G of the Dodd-Frank Act revoked Rule 436(g) adopted by the SEC under the Securities Act of 1933. Rule 436(g) provided that the security rating assigned to a class of debt securities, convertible debt securities, or preferred stock by a credit rating agency is not considered part of the registration statement prepared or certified by an expert. As a result, a consent from the credit rating agency was not required to be filed as an exhibit to the registration statement. In an attempt to make credit rating agencies more accountable, Congress included Section 939G in the Act and did not include a phase-in period. Therefore, this provision took effect July 22nd.
On July 22, 2010, the Division of Corporation Finance of the SEC issued new interpretations clarifying the applicability of the new consent requirements. Any registration statement or post-effective amendment that becomes effective on or after July 22, 2010, or any prospectus or prospectus supplement that is first filed or used on or after July 22, 2010, and includes, or incorporates by reference, ratings information, other than “issuer disclosure-related ratings information,” must include a consent from the credit rating agency. Issuer disclosure-related ratings information means disclosure related to (1) changes to a credit rating, (2) the liquidity discussion of the issuer (such as in MD&A), (3) the cost of funds for an issuer, or (4) the terms of an agreement that refers to credit ratings. A consent will not be required if the disclosure of a credit rating in, or incorporated by reference into, a registration statement or Section 10(a) prospectus only includes issuer disclosure-related ratings information.
Issuers may continue to use registration statements on Form S-3 or Form F-3 that were declared effective before July 22, 2010 and include or incorporate by reference ratings information that is not limited to issuer disclosure-related ratings information until such time as a post-effective amendment or a periodic report containing ratings information that is not limited to issuer disclosure- related ratings information and incorporated by reference into the registration statement is filed. The consent of the credit rating agency will be required upon filing a post-effective amendment, which includes the filing of a Form 10-K, 20-F, or 40-F. A consent is not required if the ratings information is included in a free writing prospectus that complies with Rule 433 or in a term sheet or press release that complies with Rule 134.
Exemption from SOX auditor attestation report on internal controls
The Dodd-Frank Act provides an exemption for smaller reporting companies from the requirement of an auditor attestation of management’s report on internal controls over financial reporting under Section 404(b) of the Sarbanes-Oxley Act.