UPDATED ON OCTOBER 4, 2010.
This post is a director’s summary of the key corporate governance provisions applicable to most public companies of the July 21, 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”). See a Special Director's Primer on Dodd-Frank on my website (here), including a Director's Slide Show and a Management-Board Timetable to deal with the provisions discussed below.
Governance Changes with Potentially Large Impact
1. Proxy Access. The Act authorizes the SEC to require companies to include nominees submitted by shareholders and to follow certain procedures in relation to proxy solicitation materials. Stockholders who have held 3% of the company's stock for 3 years can nominate on the company's proxy statement the 25% (rounded down) of the current full board size (and at least one director in any event). On October 4, the SEC put its newly promulgated rules ON HOLD, pending the outcome of a lawsuit by The Business Roundtable and Chamber of Commerce. Most pundits do not expect the new rules to be in effect for the 2011 proxy season, but.... The legislation has increased the power of the more well organized and special agenda stockholders. While the rules are not likely to make hedge funds any more or less effective in their campaigns, the rules should lower hedge fund costs. Public employee, union and social activist funds will be the primary beneficiaries of proxy access, and many have director candidates at the ready. As a practical matter, however, rather than actually nominating competing candidates, these shareholders are more likely to use their new power in negotiations with management.
2. Majority Voting. The Act does not require majority voting for uncontested director elections. We expect public pension funds and union funds to continue to press issuers to voluntarily adopt majority voting because it is a relatively inexpensive, reasonably effective tool of intimidation. To use the majority voting weapon virtually requires no holding periods, minimum ownership requirements, responsible alternative candidates, alternative visions or business plans. We predict that issuers will successfully counter arguments for majority voting with the argument that proxy access obviates the need for – and is a more responsible approach than -- majority voting. Nonetheless, the proxy access power may be so significant in particular cases that the shareholder is able to negotiate a majority voting concession from management and the board.
3. Say-on-Pay. At least once every three years, a proxy statement must include a separate non-binding shareholder vote to approve the company’s executive compensation as disclosed in the proxy statement. At least once every six years, the shareholders must vote by separate resolution on the how frequently to have the say-on-pay vote ( every year, every two years or every three years). More frequent voting should keep the company in better touch with investors, reduce the likelihood of pent up shareholder anger and make the compensation issue “routine,” but issuers may be subject to other circumstances (e.g. cost constraints, labor union -such as the Carpenters Union -negotiations, etc.) that press for less frequent voting.
4. Pay Ratio Disclosure. Companies will be required to disclose the median annual total compensation of all employees other than the CEO, the annual total compensation of the CEO and the ratio of the two. These three data points, standing only in relation to each other and without context, are meaningless, will be misinterpreted and are potential flash points. It will be important for companies to provide that context – such as depth, scope and complexity of the business, number of employees, revenue, earnings, assets, geographic expanse and so forth to support the compensation level of the CEO. The compensation discussion and analysis portion of, and the new executive summaries in, proxy statements should be revised accordingly.
5. Responding to these Changes: Close to the Constituents. Briefly stated, Management and the Board, in a well-coordinated effort, must engage and listen to shareholders more than ever and make a concerted, continuous effort to provide meaningful shareholder education in a straightforward, understandable manner on every occasion, including the proxy statement. More on this in a separate update.
Lower Impact Governance Changes
6. Board Leadership and CEO Disclosures. The Act redundantly orders the SEC to require issuers to disclose in their annual proxy statements the reasons why the company has chosen to combine or separate the board chairman and CEO positions. This provision is substantially similar to current SEC regulation.
7. Broker Discretionary Voting. Stock exchanges must prohibit broker discretionary voting in connection with the election of directors, executive compensation or any other significant matter, as determined by the SEC. NYSE requirements already prohibit such voting in connection with the election of directors and equity pay plans. Adding additional areas of prohibition is not expected to make a difference in the outcome of these votes.
8. Say-on-Golden Parachutes. Proxy statements seeking shareholder approval of an acquisition, merger, consolidation or proposed sale of all or substantially all of a company’s assets must disclose “golden parachute” payments and, in the unlikely event this compensation was not previously voted upon under the regular say-on-pay votes, must include a separate nonbinding shareholder resolution to approve such agreements. This provision, like many of the corporate governance provisions of the Act, is redundant. Companies already discuss these agreements on an annual basis in the proxy statements, and the golden parachutes will be part of the mandated regular say-on-pay voting. Furthermore, in the unlikely event that a precatory vote on the parachute is required, what is the impact if the stockholders were to vote in favor of the deal but against the parachute?
9. Compensation Committee Composition. Stock Exchanges are to require compensation committees to meet new “independence” standards that include consideration of the source of compensation for the director (such as consulting, advisory or other compensatory fees paid by the company) and whether the director is affiliated with the company. The vast majority of committees already meet these standards.
10. Compensation Committee Consultant Standards. Compensation committees will be required to consider certain independence factors (to be determined by the SEC) with respect to their consultants, legal counsel and other advisers. Companies are required to disclose the performance and possible conflicts of interest of compensation consultants. These provisions have some procedural implications, none of which is material. Many companies already have these policies in place.
11. Compensation Committee Authority. The Act redundantly grants compensation committees the power of hiring and overseeing compensation consultants, legal counsel and other committee advisers and requires companies to provide appropriate funding for these advisers. These practices are already in place for the vast majority of committees.
12. Pay-for-Performance Disclosure. The Act requires companies to disclose in their annual proxy statements the relationship between executive compensation and the company’s financial performance, basically as measured by total shareholder return. Many issuers are already following this practice.
13. Compensation Clawbacks. Companies must develop, implement and disclose policies with respect to the clawback of incentive-based compensation paid to current or former executive officers following a restatement. For all but a handful of companies, complying with this requirement will be an academic exercise.
14. Hedging disclosure. Issuers must disclose in their annual proxy statements whether employees or directors of the company are permitted to hedge any company equity securities granted as compensation or otherwise held. Issuers and Boards who have not yet adopted anti-hedging policies should do so, but we expect the impact of the legislation in this area to be negligible.
Changes Affecting Certain Classes of Companies
15. Financial Institution Compensation Restrictions. Bank holding companies and certain other financial institutions will be prohibited from providing executive officers, employees, directors or principal shareholders with compensation that is excessive or that could lead to material financial loss to the financial institution. The SEC already requires disclosure of such compensation, and we have come across no proxy statement of any financial or other institution acknowledging that compensation of this nature is being paid to employees.
16. Disclosure of Say-on-Pay and Say-on-Golden Parachute Votes by Institutional Investors. Institutional investment managers subject to Section 13(f) of the Securities Exchange Act of 1934 must disclose their say-on-pay and say-on-golden-parachute voting records annually. Mutual funds already make these disclosures. The Act has broadened the list to include other institutional investors (e.g. banks), but if the previous experience with mutual fund disclosure is any guide, this requirement is another non-event.
17. Board of Director Requirements for Nationally Recognized Statistical Rating Organizations. The Act substantially increases the oversight, liability, disclosure obligations and procedural requirements for credit rating agencies. In addition, at least one half of the Board (and no fewer than two) directors must be “independent” as described in the Act, and some of them must be users of the ratings. Director compensation must not be linked to corporate performance and must otherwise be structure to “ensure” independence of judgment. The maximum term of board service is a non-renewal 5 years. Among their duties, directors are required to oversee policies and procedures for determining credit ratings, conflicts of interest and the effectiveness of internal controls for credit rating. Compliance with this requirement is not expected to be burdensome.
18. Smaller Public Companies Permanently Exempt from Sarbanes-Oxley Internal Control Requirements. The Act exempts smaller public companies from compliance with the internal control auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act. This is good news for these companies, who had previously been relying on the SEC’s discretion (which had run out) in postponing the effective date.