Corporate Governance and Reform - The Impact of the Dodd-Frank Act

Charles 'Casey' Cogut - Simpson Thacher & Bartlett LLP

The renowned and respected Charles "Casey" Cogut provides his sought-after expertise on the impact of the Dodd-Frank Act in setting new standards for corporate governance.

Charles "Casey" Cogut

Charles "Casey" Cogut

On 21 July 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act), a comprehensive set of reforms representing the most sweeping set of changes to the US financial regulatory system since the Great Depression. The Act also has various provisions that will impact corporate governance of US public corporations. As the Act becomes effective in stages most public companies will need to respond to changes in the regulatory framework over the next few years. Provisions of the Act are in many respects incomplete (and in some cases intentionally so), and Congress has authorised the SEC and other federal regulators to fill in these gaps and complete this process through further analytical review, rule making and interpretation. This administrative process will dictate important aspects of the reform and the exact ways in which the new legislation will affect corporate governance concerns. As a result, it is likely to be quite some time until such reforms are broadly implemented and the direct and indirect impact of the Act is fully understood.

The Act sets new standards relating to executive compensation and corporate governance. In some cases, the reach of the Act is limited to companies that have listed their securities on a national securities exchange, such as the NYSE or the NASDAQ Stock Market, but in other cases it extends to companies that are otherwise subject to specified SEC reporting requirements, such as the requirement to deliver to shareholders a proxy or information statement. The Act also authorises the SEC to exempt companies from certain requirements, in particular with respect to compensation committee independence, compensation-related shareholder voting and shareholder proxy access, based on the size of the issuer and other relevant factors.

The Act requires the SEC to issue rules directing the national securities exchanges to prohibit the listing of any equity security of a company that fails to have a compensation committee comprised entirely of independent directors, subject to a number of limited exceptions, including an exception for ‘controlled companies’ and for foreign private issuers that provide annual disclosure of their reasons for not maintaining an independent compensation committee. This legislative mandate tracks the requirement of the Sarbanes-Oxley Act of 2002 (Sarbanes Oxley) that audit committees of listed companies be comprised entirely of independent directors. The Act imposes additional requirements relating to the retention and independence of compensation consultants and legal and other advisers, and disclosure regarding the use of such consultants and advisers.

On 30 March 2011, the SEC proposed rules for comment relating to this new requirement for an independent compensation committee. The proposal would require the securities exchanges to develop compensation committee independence standards for directors after considering relevant factors including any ‘affiliate’ relationship between the director and the issuer; a subsidiary of the issuer or an affiliate of the issuer; and the sources of a director’s personal compensation, including any consulting or other fees paid to the director by the issuer (other than standard directors’ fees). The proposed rules also focus on the independence of advisers to compensation committees and the disclosure requirements with respect to advice obtained by compensation committees from compensation consultants. As the proposed rules need to be finalised by the SEC and thereafter require action by the securities exchanges to modify listing standards, it is not possible to predict the extent to which these proposed rules will be in effect for the 2012 ‘proxy season’.

The Act requires that all public reporting companies, beginning with their first shareholder meeting after 21 January 2011, have a separate, non-binding shareholder vote, no less frequently than once every three years, on compensation paid to certain named executive officers, and a separate resolution, at least once every six years, for the shareholders to determine whether the ‘say on pay’ vote should be held every one, two or three years. The say on pay resolution must be included in a proxy or consent or authorisation for an annual, or other meeting, of the shareholders for which the proxy solicitation rules require compensation disclosure. An analysis posted on the HLS forum on Corporate Governance and Financial Regulation of the first 85 companies to make proposals as to the frequency of  ‘say on pay’ votes indicates a strong preference from shareholders that such votes be held annually (this is consistent with the recommendation of ISS, the well respected shareholder advisory group, that corporation’s have annual votes). However, the HLS forum posting also indicated that of the first 95 companies in 2011 to have ‘say on pay’ votes, shareholders supported the named executive officer compensation practices at 93 companies, usually by a very significant margin. However, a report by the consultants at ClearBridge Compensation Group analysed the proxy statements of the first 100 Fortune 500 companies to file in 2011, and found substantial evidence that in advance of ‘say on pay’ votes, the companies were adopting pay for performance policies to align compensation policies with the perceived interests of their shareholders and help to insure a positive vote from shareholders.     

To the extent that any ‘golden parachute’-related compensation is not approved as part of a ‘say on pay’ vote, the Act requires a separate, non-binding shareholder vote on such ‘golden parachute’ compensation at any meeting at which shareholders are asked to approve a merger, acquisition or other extraordinary transaction that would trigger payments under such ‘golden parachutes’. The Act also includes a requirement that every institutional investor subject to the reporting requirements under Section 13(f) of the Exchange Act disclose how it votes on any ‘say on pay’ or ‘golden parachute’ matters. The Act also includes a requirement that the national securities exchanges prohibit broker discretionary voting in connection with the election of directors, executive compensation or any other significant matter (as determined by the SEC), which would ensure that discretionary voting by brokers would not be permitted in ‘say on pay’ or ‘golden parachute’ votes by shareholders.

Under the Act, the SEC is directed to issue rules requiring companies to disclose in annual proxy statements a clear description of executive officer compensation, including information that shows, graphically or otherwise, 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 and any distributions; disclosure regarding the internal pay disparity between the CEO’s compensation and median annual total compensation of all other employees; and disclosure regarding whether directors and employees of the companies are permitted to hedge the equity they own in their companies.

Under the Act, the SEC is also required to cause national securities exchanges to prohibit the listing of any security issued by a company that fails to adopt and implement a policy providing 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 providing that the issuer, in the event of an accounting restatement due to material non-compliance with financial reporting requirements, will recover from any current or former executive officer any incentive-based compensation received during the three-year period preceding the date on which the issuer is required to prepare a restatement on the basis of inaccurate financial statements, based on the erroneous data, in excess of what would have been paid to the executive officer pursuant to the corrected financial statements in the accounting restatement. This provision reaches further than section 304 of Sarbanes-Oxley in that it extends to all executive officers and not just the CEO and CFO, and applies in the event of any accounting restatement because of the material noncompliance of the issuer with any financial reporting requirement under the federal securities laws, whether or not as a result of misconduct.

Under the Act, federal financial regulators are directed to establish joint compensation rules for bank holding companies and savings and loan holding companies prohibiting any plan that provides ‘excessive’ compensation to executives, employees, directors or principal shareholders or that could lead to material financial loss to the company.

The Act authorised the SEC to promulgate rules, often referred to as proxy access rules, permitting shareholders to use a company’s annual proxy materials to solicit other shareholders for the shareholders’ director nominees. Currently, such activist shareholders must pay for the preparation and mailing of materials to campaign for their own nominees. Although the SEC had already proposed proxy access rules, the Act was intended to resolve questions that had been raised as to whether the proposed proxy access rules exceeded the SEC’s statutory authority under then current law. Commentators had speculated that the SEC had deferred adoption of final proxy access rules pending adoption of legislation explicitly authorising such rules, and following the Act’s enactment, the SEC did finalise and adopt proxy access rules. However, on 4 October 2010, the SEC granted a stay on the effectiveness of these rules in response to litigation commenced by the Business Roundtable and the US Chamber of Commerce in the US Court of Appeals for the District of Columbia Circuit. The petitioners have challenged the SEC’s proxy access rules on many grounds, including allegations that they violate the Administrative Procedures Act, the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the US Constitution. The SEC is hopeful that the Court of Appeals will reach a decision early enough in 2011 so that if it is successful in the litigation the proxy access rules can be implemented for the 2012 ‘proxy season’.

The Act also requires that the SEC promulgate rules requiring public companies to disclose in their annual proxy statements the reasons why they have chosen to either have one person to serve in the dual roles of chairman of the board of directors and chief executive officer or to have different individuals serve in such roles.

As indicated above it will take a few years to appreciate the full impact of the Act on US public corporations. But there is no doubt that the Act has created significant new issues, which must be dealt with by the boards of directors and senior executives of such corporations.

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