Executive Compensation Alert
July 2009
Authors:
Contributors from the
Executive Compensation
Emerging Issues Task Force
K&L Gates is a global law firm with
lawyers in 33 offices located in North
America, Europe, Asia and the Middle
East, and represents numerous GLOBAL
500, FORTUNE 100, and FTSE 100
corporations, in addition to growth and
middle market companies,
entrepreneurs, capital market
participants and public sector entities.
For more information, visit
www.klgates.com.
The Economic Crisis: Broader Executive
Compensation Reforms Coming Soon
On June 15, the U.S. Treasury Department’s Interim Final Rule implementing
limitations on executive compensation for companies receiving funds under the
federal government’s Troubled Asset Relief Program (TARP) became effective.
These rules include significant substantive restrictions on pay for TARP recipients,
including prohibitions on most bonuses and equity incentive awards for top
executives and other key employees, plus additional responsibilities for
compensation committees.
However, these new rules only apply to entities receiving TARP funds. For a
discussion of the scope of the Interim Final Rule, see our Alert titled New TARP
Executive Compensation Rules – Who’s Covered and Who’s Not? What does all of
this mean for the rest of the business world? The widely held view that
compensation practices contributed to the economic meltdown has prompted
Congress, Treasury and the SEC to engage in a renewed focus on several executive
compensation reforms that will have a broad reach if enacted. Consider, for example,
the following excerpt from a recent statement by Gene Sperling, Counselor to the
Secretary of the Treasury, to the U.S. House Committee on Financial Services the
day after the Interim Final Rule was issued:
As we work to restore financial stability, the focus on executive
compensation at companies that have received governmental assistance is
appropriate and understandable. But what is most important for our
economy at large is the topic of this hearing: understanding how
compensation practices contributed to this financial crisis and what steps we
can take to ensure they do not cause excessive risk-taking in the future. And
while the financial sector has been at the center of this issue, we believe that
compensation practices must be better aligned with long-term value and
prudent risk management at all firms, and not just for the financial services
industry.
The following summarizes five key developments in executive compensation that are
likely to have broad impact – beyond just the financial services and automotive
industries – beginning in 2009 and going forward:
1. Say-on-Pay
The Interim Final Rule contains the American Recovery and Reinvestment Act of
2009’s requirement that public companies receiving TARP funds provide for a
separate, nonbinding shareholder vote to approve the compensation of its senior
executive officers, commonly referred to as a “say-on-pay” vote. This vote must
occur at any annual or other meeting of the company’s shareholders and must
comply with the SEC’s rules and other guidance regarding say-on-pay votes.
Executive Compensation Alert
This requirement was effective for TARP recipients
prior to the issuance of the Interim Final Rule and
thus several hundred publicly-traded TARP
companies included a say-on-pay vote as part of
their 2009 annual meetings. Most of these votes
involved a simple up or down vote approving the
company’s overall executive compensation
programs and policies, as disclosed in the
Compensation Discussion & Analysis (CD&A), and
the compensation tables, included in the company’s
proxy statement. To date, it appears that all of the
largest TARP recipients that included a say-on-pay
vote in their proxy statements received a favorable
vote from their shareholders.
In conjunction with the issuance of the Interim Final
Rule, Treasury announced a set of broad-based
principles that would apply beyond the limited time
and scope of TARP, with the goal of better aligning
compensation practices with the interests of
shareholders and reinforcing the stability of firms
and the financial system. One of these broad
principles is the promotion of transparency and
accountability in the process of setting
compensation. In order to put this principle into
action, Treasury disclosed that it intends to propose
legislation that would mandate a say-on-pay vote for
all public companies, not just those participating in
TARP. Treasury’s proposal indicates that the
benefits of a universal say-on-pay requirement
would:
·
Include greater accountability of the board, and,
in particular, the members of the company’s
compensation committee, to the shareholders;
and
·
Encourage boards and shareholders to work
together to design appropriate pay packages.
Critics have complained that a nonbinding thumbsup or thumbs-down vote on a company’s overall pay
does not provide the board with sufficient
information to determine what components of the
pay arrangements do not meet shareholder approval.
Opponents of say-on-pay requirements contend that
shareholders already have an avenue to voice their
displeasure with excessive compensation packages
by voting against the reelection of the responsible
directors.
Perhaps in response to some of these criticisms and
concerns, Treasury’s proposal, in addition to
nonbinding shareholder votes on a company’s
overall compensation arrangements, would allow
companies to provide for additional shareholder
votes addressing specific compensation decisions.
Riskmetrics, for example, provided two separate
say-on-pay votes at its 2009 annual meeting relating
to its overall compensation program and its specific
senior executive officer pay in 2008, respectively.
The Treasury proposal also supports requiring a
nonbinding vote to approve “golden parachute”
compensation for executives in connection with
shareholder meetings relating to a merger,
acquisition or other “change in control” transaction.
On July 1, 2009, the SEC issued proposed rules
addressing the say-on-pay vote requirement for
TARP recipients. Proposed new Rule 14a-20 does
little more than incorporate the TARP statutory
provisions into the SEC’s regulations. However, it
does clarify a couple of issues with the say-on-pay
requirements. First, the SEC confirmed that the
provision in the TARP legislation that the vote must
approve compensation as disclosed in the CD&A
and the compensation tables does not impose a new
requirement on smaller reporting companies which
are TARP recipients and are currently not required
to include a CD&A in their annual proxy
statements. The vote for those companies will be
based on the scaled-down disclosures required
under existing rules for smaller reporting
companies. Second, the proposed rules do not
change the SEC’s existing position that the TARP
say-on-pay vote requires the filing of a preliminary
proxy statement with the SEC for its review and
comment prior to the issuance of the final, or
definitive, proxy statement to investors. The
preliminary process can cause significant
complications and delays in distributing the
company’s proxy, especially if the SEC issues
comments as part of its review. However, the SEC
has requested comments on whether it should
exempt say-on-pay votes from triggering the
preliminary proxy filing process.
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Executive Compensation Alert
2. Compensation Committee Independence
In addition to the say-on-pay proposal, Treasury has
proposed legislation that would require greater
independence for compensation committee board
members of companies listed on national securities
exchanges to foster greater transparency and
accountability. While the Treasury proposal leaves
many of the specifics of the appropriate
independence standard to be developed by the SEC,
the proposal suggests that these independence
standards should be similar to the independence
requirements mandated for audit committees under
the Sarbanes-Oxley Act of 2002. This would
prohibit compensation committee members from
receiving fees or other compensation from the
company or its affiliates for providing consulting or
advisory services, or from otherwise being affiliated
with the company. In addition to setting standards
for a director’s independence, the new requirements
would give compensation committees the authority
and the resources to do the following as part of
setting executive pay:
·
Retain compensation consultants who would
report directly to the committee;
·
Retain legal counsel independent of the
company’s or management’s counsel; and
·
Pay the consultants, legal counsel and any other
advisers engaged by the committee.
Many commentators have suggested that the use of
compensation consultants who also provide services
to management or have other conflicts of interest is
more likely to lead to higher compensation packages
for management. While it is not clear that there is a
direct connection between conflicted consultants and
higher executive pay, to provide investors with
confidence that compensation committees are
receiving objective and independent advice from
their consultants and legal counsel, the Treasury
proposal suggests that the SEC also establish
independence standards for consultants and legal
counsel retained by compensation committees.
3. Compensation Committee Engagement In Risk
Management
Historically, compensation and risk management
were separate and distinct functions. However, one
consistent theme of the regulatory responses to the
current economic crisis is that these functions need
to be looked at together to better understand how
they interrelate. It will be the compensation
committee that bears much of this burden.
There is no doubt that in recent years the job of the
compensation committee has become more and
more intense. In response to the increased focus on
executive compensation issues, committees work
harder and meet more often, reviewing evergrowing quantities of data.
The Interim Final Rule makes the compensation
committee job even tougher. For TARP recipients,
the compensation committee must meet at least
every six months with the company’s senior risk
officers to discuss, evaluate and review (i) whether
the compensation plans of the senior executive
officers encourage unnecessary and excessive risktaking, (ii) whether the compensation plans of all
other employees pose unnecessary risks to the
company and (iii) whether any compensation plans
encourage employees to manipulate reported
earnings. The analysis cannot be superficial. The
committee must review the specific features of the
various compensation plans – such as the mix of
pay elements, the types of performance criteria
used, the amount of potential upside and leverage,
the period over which the pay is subject to offset for
downside risk, etc. – and determine whether any
features should be modified or eliminated as a
matter of appropriate risk management. The
compensation committee also must provide a
narrative discussion in the proxy statement
regarding its analysis of how the company’s
compensation programs do not encourage
unnecessary risk taking.
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Executive Compensation Alert
Although risk-related disclosures began to appear
this past proxy season, including for a number of
companies outside the financial services industry,1
the disclosures for most TARP recipients tended not
to provide much detail. It is clear, though, that many
companies are acting now to put more thought into
this risk analysis in anticipation of next proxy
season. For example, the CEO of Goldman Sachs
recently announced a set of five compensation
principles underlying a framework for the
investment banking firm’s compensation. One of
these principles is to “discourage excessive or
concentrated risk taking.” In the Goldman CEO’s
view, this principle is implemented by, among other
things, untying the compensation of “risk taking”
personnel solely from the profits for which they are
directly responsible and fine-tuning performance
evaluations to reward high quality and recurring
revenues over riskier, home run-type strategies.
Current developments also indicate that
requirements to engage in risk analysis regarding
1
During this past proxy season, several companies outside of
the financial services industry included proxy statement
disclosures about risk management considerations in the
design of executive compensation programs. One notable
example comes from General Electric’s CD&A:
“Consideration of Risk. Our compensation programs
are discretionary, balanced and focused on the long
term. Under this structure, the highest amount of
compensation can be achieved through consistent
superior performance over sustained periods of
time. In addition, large amounts of compensation are
usually deferred or only realizable upon retirement.
This provides strong incentives to manage the
company for the long term, while avoiding excessive
risk taking in the short term. Goals and objectives
reflect a balanced mix of quantitative and qualitative
performance measures to avoid excessive weight on
a single performance measure. Likewise, the
elements of compensation are balanced among
current cash payments, deferred cash and equity
awards. With limited exceptions, the MDCC retains
a large amount of discretion to adjust compensation
for quality of performance and adherence to
company values. As a matter of best practice,
beginning in this year, the MDCC will review the
relationship between our risk management policies
and practices and the incentive compensation we
provide to our named executives to confirm that our
incentive compensation does not encourage
unnecessary and excessive risks. The MDCC will
also review the relationship between risk
management policies and practices, corporate
strategy and senior executive compensation.”
compensation governance and design will extend far
beyond the relatively narrow category of TARP
recipients. The Treasury proposals and a recently
released Obama Administration White Paper on
Financial Regulatory Reform reflect the
administration’s view that risk management is
critical to creating a stable financial system and
economy, and is not just for TARP recipients, but
all companies.
Although the notion that risky compensation
practices was a major contributor to the economic
crisis is a largely unproven hypothesis, it has gained
critical acceptance by regulators and a broad
spectrum of company boards. This, along with the
likelihood that the SEC disclosure proposals
described below will be adopted, means that it is
expected that the TARP risk analysis and disclosure
requirements (or something very similar to them)
will be extended to all public companies. This will
require all compensation committees to engage in
this analysis and to discuss in the proxy statement
how the company’s compensation approach
supports its risk management goals. What will be
the scope of this disclosure and what kinds of
review and analysis will be necessary to support it?
The degree of effort and analysis required under the
Interim Final Rule on this topic may very well set
the de facto standard for all companies.
4. SEC Disclosure Updates
The compensation reforms in the Interim Final Rule
focus on (i) better design, (ii) better governance and
(iii) better disclosure of compensation practices.
The Interim Final Rule includes several disclosure
enhancements for TARP recipients. For example,
the compensation committee must provide a
narrative discussion in the proxy statement
regarding its risk analysis of the company’s
compensation programs, the company’s luxury
expense policy must be posted on the company’s
website and enhanced disclosures must be provided
to Treasury regarding certain perks and the
independence of compensation consultants.
In parallel fashion, the SEC has recently approved
updates and revisions to its executive compensation
disclosure rules that will impact all public
companies. While the details of the proposed
changes are not expected until later this summer,
they will include the following elements:
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Executive Compensation Alert
·
·
A focus on risk management. Additional
disclosure will be required regarding how the
company (and the board) manages risk,
including in creating and operating
compensation plans.
·
Disclosures beyond executive plans. The
current disclosure rules focus on the
compensation arrangements for a limited group
of “named executive officers.” The proposed
new rules will include a requirement that the
compensation committee discuss more broadly
its overall compensation approach beyond the
executive ranks, with a focus on how the
compensation approach squares with the
company’s risk-management goals. It does not
appear the revised rules will require disclosure
of specific compensation levels outside the
executive ranks (unlike the now defunct “Katie
Couric” proposal by the SEC a couple of years
ago).
·
Reporting of stock and option awards.
Currently, the value of stock and option awards
to executives and directors is reported based on
the amount of compensation expense recognized
by the company for the applicable year. It
appears the revised rules will instead require
disclosure based on the aggregate grant date fair
value for accounting purposes of awards granted
for the year. This was the original reporting
method when the disclosure rules were revised
in 2006, but it was changed by the SEC just
before those rules became effective.
·
Compensation consultant independence. When
the current executive compensation disclosure
rules came out in 2006, there was some criticism
that the rules did not require disclosure about
other services provided to the company by its
compensation consultant. The new rules will
provide for enhanced disclosures regarding
potential conflicts of interests of the
compensation consultant, such as other services
the consultant provides to the company, as well
as information regarding the fees paid to
compensation consultants.
Board governance issues. Though not directly
related to compensation disclosures, the
proposed changes will require enhanced
disclosures about the specific experience,
qualifications and skills of directors, executive
officers and nominees up for election as
directors. The new rules also will require a
discussion about why the board has selected its
particular leadership structure, including the
board’s views on the need for an independent
chairman.
Both Secretary Geithner and Chairman Schapiro are
on record saying that they do not intend their rules
to cap pay levels or mandate specific compensation
approaches (other than for TARP recipients). The
focus of the SEC proposals on disclosures about
risk management and board structure seem
consistent with this expressed intent. However, for
those who groan about the length of executive
compensation disclosures under the current rules,
proxy statements may soon get even thicker.
5. Proxy Access
In addition to the proposals regarding new executive
compensation disclosures, on June 10, 2009, the
SEC issued a 200+ page release proposing changes
to the proxy rules which would provide access to
shareholders to nominate candidates for election as
directors through the company’s annual proxy
process. If adopted, these rules would apply to all
Exchange Act reporting companies. Traditionally,
shareholders have not had direct access to the
director nomination process. Rather, shareholders
have been forced to prepare and distribute a separate
proxy statement listing their nominees, which can
be an expensive and complex undertaking. The
SEC release expresses a concern that this may
create “unnecessary obstacles” to the “exercise of
[shareholders’] fundamental right to nominate and
elect members to company boards of directors.”
The proposed Rule 14a-11 is the latest in a long line
of attempts by the SEC to put in place a proxy
access rule. However, chances of this proposal
being finalized appear to be greater than in the past
due to increased state and federal government
attempts to legislate or otherwise mandate a proxy
access right.
In addition, and similar to Treasury’s justification of
its broad executive compensation principles, the
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Executive Compensation Alert
proxy access release indicates that the current
financial crisis has raised additional concerns about
the accountability and responsiveness of boards of
directors to shareholders and suggests that direct and
less onerous access of shareholders to the
nomination process will promote greater
accountability and responsiveness.
The key elements of proposed Rule 14a-11 are:
·
To have access to the proxy nomination process,
a shareholder or group of shareholders must
have owned continuously for a one-year period
at least 1% of the company’s voting securities
(or a higher percentage if the issuer is not a large
accelerated filer);
·
The maximum number of director candidates
nominated by shareholders cannot be more than
25% of the total board membership at the time
of the election (and the 25% must include any
shareholder-nominated directors who are not
then up for reelection);
·
The Rule effectively supersedes proxy access
provisions of state law and company governing
documents that are more restrictive;
·
The nominating shareholder must certify that it
has no intention of causing or effecting a change
in control of the company; and
·
The Rule applies to all Exchange Act reporting
companies.
Critics of a federal proxy access rule argue that it
will not promote the interests of shareholders
generally, but will lead to disruptive activity and
confusion in the director election process by
allowing special interests to hijack the nomination
process. There also is fear that the access rules will
not ensure sufficient minimum requirements for
shareholder-nominated candidates. Moreover,
critics dispute the popular notion that the financial
crisis and the resulting loss of investor confidence in
boards were driven in part by a lack of direct access
by shareholders in the director nomination process.
Regardless of whether these criticisms are valid, the
increased legislative activity and the widespread
desire to “restore investor confidence” in board
accountability means it is very likely that some form
of shareholder proxy access will be embodied in a
final version of Rule 14a-11. The SEC release
requests comments by August 17, 2009 on hundreds
of issues relating to the proposed Rule. Depending
on the number of comments and the time it takes the
SEC to digest them and incorporate appropriate
comments into the Rule, it remains possible that the
proxy access rules could be in place and effective
for the 2010 proxy season.
Conclusion
As described above, the main focus of executive
compensation reform outside of limits on TARP
recipients has been on better governance and
disclosure practices, rather than substantive
limitations on levels of pay or mandates on design
of executive compensation programs. If these
proposed reforms all come to fruition, it certainly
will result in more oversight by regulators and more
work for compensation committees and internal
compliance functions (e.g., HR, legal and risk
management). However, it remains to be seen
whether these developments will result in
meaningful changes in the design of executive
compensation programs outside of the financial
services industry.
These evolving executive compensation standards
and requirements are complex and companies
should be working with legal counsel to determine
what the requirements are and how best to comply
with them.
Executive Compensation Emerging Issues
Task Force
The firm has an Executive Compensation Emerging
Issues Task Force, which is an interdisciplinary
group comprised of lawyers from our Executive
Compensation, Financial Services, Labor &
Employment, Litigation and Public Policy practices
in both our U.S. and U.K. markets. This Task Force
is exploring in detail the evolving regulatory and
marketplace responses to the executive
compensation concerns arising out of the global
economic crisis. If you have any questions, please
do not hesitate to contact the K&L Gates attorney
with whom you regularly work, or one of our
members of the Task Force below.
July 2009
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Executive Compensation Alert
Executive Compensation Emerging Issues Task Force Members
Executive Compensation:
James E. Earle
Douglas J. Ellis
Ian Fraser
Charles A. Grace
Victoria Green*
Julia R. Rhue*
Raleigh A. Shoemaker
Michel P. Vanesse
Lynne S. Wakefield
jim.earle@klgates.com
douglas.ellis@klgates.com
ian.fraser@klgates.com
charles.grace@klgates.com
victoria.green@klgates.com
julia.rhue@klgates.com
raleigh.shoemaker@klgates.com
michel.vanesse@klgates.com
lynne.wakefield@klgates.com
+1.704.331.7530
+1.412.355.8375
+44.020.7360.8268
+1.617.951.9073
+44.020.7360.8202
+1.704.331.7567
+1.704.331.7457
+1.704.331.7464
+1.704.331.7578
Financial Services:
Philip J. Morgan
Sean P. Mahoney
philip.morgan@klgates.com
sean.mahoney@klgates.com
+44.020.7360.8123
+1.617.261.3202
Labor & Employment:
Rosemary Alito
Patrick M. Madden
Laura J. O’Brien*
Daniel Wise
rosemary.alito@klgates.com
patrick.madden@klgates.com
laura.obrien@klgates.com
daniel.wise@klgates.com
+1.973.848.4022
+1.206.370.6795
+44.020.7360.8227
+44.020.7360.8271
Litigation:
Thomas F. Holt, Jr.
thomas.holt@klgates.com
+1.617.261.3165
Public Policy:
Daniel F. C. Crowley
Karishma Shah Page*
dan.crowley@klgates.com
karishma.page@klgates.com
+1.202.778.9447
+1.202.778.9128
*Associate Task Force member
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GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market
participants and public sector entities. For more information, visit www.klgates.com.
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available for inspection at any K&L Gates office.
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in regard to any particular facts or circumstances without first consulting a lawyer.
©2009 K&L Gates LLP. All Rights Reserved.
July 2009
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Executive Compensation Alert
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