Executive Compensation Alert
November 2010
Originally Published July 7, 2010
Updated November 12, 2010
Author:
James E. Earle
jim.earle@klgates.com
+1.704.331.7530
K&L Gates includes lawyers practicing out
of 36 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.
New Executive Compensation and
Governance Requirements in Financial
Reform Legislation
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) was
enacted on July 21, 2010. While the Act’s primary purpose is to broadly reform the
regulation of the financial services industry, within the massive text of the Act lurk
new requirements that will impact executive compensation and corporate governance
practices at most public companies, not just banks. This alert highlights these key
executive compensation and governance changes, with updates on agency rule
making through November 12, 2010.
In many cases, the Act directs the Securities and Exchange Commission (“SEC”) to
implement the Act’s requirements by adopting rules or directing the national
securities exchanges or associations (the “securities exchanges”) to adopt rules. The
Act also authorizes the SEC or securities exchanges to exempt certain companies,
such as smaller issuers, from some of the Act’s requirements.
Key Executive Compensation Changes
1. Say-on-Pay
Section 951 of the Act includes two new requirements for public companies to obtain
non-binding shareholder approval on executive compensation matters (frequently
referred to as “say-on-pay” votes).
First, shareholders must be given a vote on the compensation of the company’s
named executive officers as disclosed in the executive compensation sections of the
annual proxy statement. These disclosures include the Compensation Discussion and
Analysis, Summary Compensation Table and various supporting compensation
tables and disclosures. Companies must hold this shareholder vote at least once
every three years. The shareholders separately determine at least once every six
years whether the vote must be obtained on a cycle of every one, two or three years
(the so-called “say-on-frequency” vote), with an initial shareholder determination
required the first year that the say-on-pay vote is required.
Second, the so-called “golden parachute” say-on-pay rule requires companies to give
shareholders a separate non-binding vote over compensation paid to named executive
officers in connection with shareholder approval of certain mergers, acquisitions or
dispositions. The compensation arrangements, including potential or contingent
payments and the aggregate amount that may be paid to each officer, must be clearly
disclosed in the proxy statement or other materials for the shareholder vote on the
transaction. The shareholder vote on the compensation arrangements must be
separate from the shareholder vote on the transaction. A transaction-related
shareholder vote is not required, however, for an arrangement that was subject to a
shareholder vote at an annual meeting under the first say-on-pay requirement
described above.
Executive Compensation Alert
The SEC issued proposed rules regarding these sayon-pay votes on October 18, 2010 (at
http://www.sec.gov/rules/proposed/2010/339153.pdf). The SEC rule-making calendar
anticipates final rules being adopted sometime in the
first quarter of 2011. (For a summary of the
proposed rules, see “SEC Proposes Rules to
Implement Dodd-Frank’s Say-on-Pay and Golden
Parachute Provisions,” available at
http://www.klgates.com/newsstand/detail.aspx?publi
cation=6720.)
Shareholder votes under these requirements are not
binding on the company. The Act also makes clear
that the shareholder votes do not change or add
fiduciary duties for the board and do not limit the
ability of shareholders to submit proposals on
executive compensation matters. The annual proxy
say-on-pay vote, and the related initial say-onfrequency vote, apply to annual shareholder
meetings occurring on or after January 21, 2011
(i.e., six months after enactment). This means that
these requirements will apply for many companies
for the first time in the spring 2011 proxy season.
The “golden parachute” say-on-pay vote will not
become effective until SEC rules specifying the
required disclosures have become effective.
The October 2010 SEC proposed rules include a
new form of tabular disclosure regarding “golden
parachute” compensation and details about the
proposed approach for obtaining “advanced”
approval of golden parachute payments through the
annual proxy say-on-pay vote. We expect many
companies will consider adding this new form of
tabular disclosure to their annual proxy statements
starting this spring.
Say-on-pay shareholder votes have become more
common in the U.S. over the last several years.
Banks that received financial assistance under the
Troubled Asset Relief Program (“TARP”) were
required to hold a say-on-pay vote. Dozens of other
businesses across various industries have voluntarily
included a shareholder vote on executive
compensation. While three companies have failed to
garner majority support in their say-on-pay votes
during the 2010 proxy season, shareholders have, in
most cases, shown high levels of support for the
disclosed executive compensation.
In addition, one of the main purposes of say-on-pay
votes is to encourage better dialogue between
companies and their key shareholders on executive
compensation matters. To avoid an embarrassing
(although non-binding) “no” vote, companies
should focus on the quality of their executive
compensation disclosures and proactively reach out
to key shareholders in order to discuss any concerns
about the company’s executive compensation
programs.
Neither the Act nor the SEC proposed rules specify
the exact form of shareholder resolution to be voted
on. Companies should consider alternative
formulations for the resolution in order to best
obtain meaningful information from the vote and to
best facilitate dialogue with shareholders. In
addition, many shareholders may look to voting
recommendations from proxy advisory firms, such
as RiskMetrics and Glass Lewis. As a result, the
influence of these proxy advisory firms may further
expand, and public companies should follow closely
the say-on-pay voting policies developed by these
firms. For 2010, RiskMetrics has recommended
votes against approximately 17% of say-on-pay
voting proposals, including TARP companies, most
often citing “disconnects” in pay-for-performance.
2. Compensation Committee Independence
Section 952 of the Act requires that most public
companies have compensation committees
composed exclusively of “independent” directors.
The definition of “independence” for this purpose is
to be developed by the securities exchanges, but at a
minimum must take into account (i) consulting,
advisory or other fees received by the director other
than for service on the board, and (ii) whether the
director is an “affiliate” of the company or its
subsidiaries. The Act requires the securities
exchanges to publish rules regarding these
requirements within 360 days after enactment. The
SEC rule-making calendar targets proposed rules
being published in November-December 2010, with
final rules being published in April-July 2011.
The formulation of the independence standard under
the Act mirrors the independence standard that
applies to audit committee members under Section
301 of the Sarbanes-Oxley Act. The extent to which
this requirement imposes a greater independence
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Executive Compensation Alert
standard than current listing rules will depend on
how the securities exchanges develop the rules.
concerns have been addressed. This disclosure
requirement does not apply to other advisers.
One issue to monitor will be whether significant
share ownership could potentially disqualify a
director from service on the compensation
committee under the new requirement. There will
likely continue to be separate standards for
determining whether compensation committee
members are “non-employee directors” for purposes
of Section 16 under the Securities Exchange Act or
“outside directors” under Section 162(m) of the
Internal Revenue Code.
The Act directs rules to be published regarding
these requirements within 360 days after enactment.
The SEC rule-making calendar targets proposed
rules being published in November-December 2010,
with final rules being published in April-July 2011.
The Act also commissions a study and report by the
SEC on the use of compensation consultants, to be
submitted to Congress within two years after
enactment.
3. Independence of Compensation Consultants and
Other Advisers
Section 952 of the Act also addresses Congress’s
concerns about the independence of compensation
consultants, legal counsel and other advisers to the
compensation committee. While the Act does not
mandate use of independent compensation
consultants or other advisers, it does require the
compensation committee to consider factors that
could affect the independence of the
consultant/adviser. These factors include (i) other
services provided by the consultant’s/adviser’s firm,
(ii) the amount of fees received by the
consultant’s/adviser’s firm from the company
relative to the firm’s total revenues, (iii) the
consultant’s/adviser’s firm’s policies to limit
conflicts of interest, (iv) business or personal
relationships between the consultant/adviser and any
member of the compensation committee, and (v)
share ownership by the consultant/adviser.
The compensation committee retains full authority
to engage and oversee its own compensation
consultants and other advisers, and the company
must provide sufficient resources for the committee
to pay those consultants/advisers. The Act clarifies
that the compensation committee need not follow the
advice of its consultants/advisers, nor does the
retention of consultants/advisers relieve the
compensation committee from the requirement to
exercise its own judgment in fulfilling its duties.
The company must disclose in its annual proxy
statement whether the compensation committee has
retained a compensation consultant, whether the
work of the compensation consultant raises any
conflict of interest concerns, and if so, how those
Proxy statement rules already require disclosure
regarding the use of compensation consultants,
including the identity of the consultant, the types of
services provided, and if other non-compensation
services are also provided, details on those other
services. The disclosures required under the Act do
not appear any more comprehensive. Nevertheless,
over the last several years there has been
considerable pressure on compensation consulting
firms retained by compensation committees not to
provide broader services to the company, and some
management consulting firms have divested or spun
off their compensation consulting units in order to
avoid such potential conflicts. The Act will
continue to increase this pressure.
There has generally not been as much emphasis on
compensation committees retaining independent
legal counsel, but it is not clear how the Act might
impact the delivery of legal services to
compensation committees.
4. Additional Executive Compensation
Disclosures
Section 953 of the Act imposes two new disclosure
requirements regarding executive compensation.
First, under what is styled as “disclosure of pay
versus performance,” the Act requires the SEC to
establish rules regarding “clear disclosures” of
executive compensation, including the relationship
between amounts actually paid and the company’s
financial performance, taking into account stock
prices and dividends. The Act states that this
disclosure may be provided graphically.
Second, the Act requires disclosure of the ratio of
the CEO’s total annual compensation compared to
the median total annual compensation of all
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Executive Compensation Alert
employees other than the CEO. “Total annual
compensation” for this purpose means the total
compensation amount reported in the Summary
Compensation Table.
The Act does not specify a date by which the SEC
must adopt these rules. The SEC rule-making
calendar targets proposed rules being published in
April-July 2011, which means final rules would not
be likely until after July 2011.
It is unclear exactly what additional disclosures will
be required under the first rule. The current proxy
disclosure rules require clear, plain English
disclosures regarding the executive compensation
policies and, particularly in the case of performancebased compensation, payment outcomes. The
reference to a “graphic” disclosure may suggest
disclosures similar to the “performance graph” that
was previously required to be included in annual
proxy statements.
The second new rule raises potentially significant
practical challenges. Determining the Summary
Compensation Table total compensation amounts for
a limited group of executive officers often presents
difficulties, especially in identifying and quantifying
perks, above-market earnings on deferred
compensation, and changes in the present value of
pension benefits. How these amounts can be
determined for all employees in order to derive a
median value may be extremely difficult for many
companies. One can only hope the SEC will provide
clear guidance and rules of convenience to reduce
the potential burdens of this rule.
5. Enhanced Clawbacks
Section 954 of the Act requires companies to adopt
and implement policies that will require recovery of
prior incentive compensation awards (including
stock options) that were based on financial
information later restated due to the company’s
material non-compliance with any financial
reporting requirements under the securities laws.
These are often referred to as “clawback” policies.
The clawback will apply to incentive compensation
awarded to any current or former executive officers
during the three years before the date of the
triggering financial restatement. No misconduct on
the part of the executive officer will be required.
The Act requires the SEC to direct the securities
exchanges to prohibit the listing of any companies
that do not meet this requirement. The Act,
however, does not specify a date by which the SEC
or the securities exchanges must adopt rules
regarding this requirement. The SEC rule-making
calendar targets proposed rules being published in
April-July 2011, which means final rules would not
be likely until after July 2011.
This new rule significantly expands on the
Sarbanes-Oxley Act’s clawback, which applies only
to the CEO and CFO, has only a one-year lookback,
and requires misconduct. However, the new rule is
in some ways less expansive than the clawback
requirement applicable to banks that received
financial assistance under TARP. In particular, the
TARP clawback could be triggered without regard
to whether a financial restatement was required.
For option awards, it is unclear if the clawback
would apply only or primarily to (i) options granted
based on erroneous financial results, (ii)
performance-based options that vest and become
exercisable based on such financial results, or (iii)
any in-the-money option that is exercised during the
prior three-year period regardless of when it was
granted or how it became vested. Another
uncertainty is how the clawback rules will deal with
incentive compensation that is based on a number of
factors in addition to financial performance.
One of the biggest legal challenges for any
clawback policy is establishing an enforceable right
against compensation previously paid. Companies
will need to consider how to most effectively
incorporate this new clawback requirement into
incentive compensation awards. Given the threeyear lookback, depending on how the rules are
developed, the clawback requirement might attach
to individuals who were not executive officers at the
time the incentive compensation was awarded.
6. Disclosure of Hedging Policies
Section 955 of the Act requires disclosure as to
whether directors or employees of the company are
permitted to hedge against stock price drops with
respect to equity compensation awards. Although
some companies have adopted anti-hedging policies
for executives and directors, the requirement under
the Act more broadly refers to all employees.
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Executive Compensation Alert
The Act does not specify a time by which the SEC
must adopt rules regarding this disclosure. The SEC
rule-making calendar targets proposed rules being
published in April-July 2011, which means final
rules would not be likely until after July 2011.
7. Excessive Compensation at “Covered Financial
Institutions”
Section 956 of the Act potentially creates new
regulatory limits on compensation at “covered
financial institutions.” For this purpose, a “covered
financial institution” means any of the following
entities that has $1 billion or more in assets — a
depository institution, a holding company for a
depository institution, a broker-dealer registered
under the Securities Exchange Act, a credit union,
an investment advisor under the Investment
Advisers Act or any other financial institution that
the applicable regulators determine should be
covered. (Fannie Mae and Freddie Mac also are
covered.) Unlike the other executive compensation
provisions in the Act, the covered financial
institutions subject to this rule include both public
and private companies.
The applicable regulators (which include the Federal
Reserve, FDIC, OCC, SEC and others) have nine
months after enactment to establish rules by which
covered financial institutions must disclose to their
applicable regulator all incentive compensation
plans (i.e. not solely executive officer plans). This
disclosure is intended to allow the applicable
regulator to determine whether the covered financial
institution’s incentive plans encourage
“inappropriate risks” (i) through providing
“excessive compensation, fees or benefits” to its
executive officers, employees, directors or principal
shareholder, or (ii) that could lead to a material
financial loss for the covered financial institution.
The rules also will directly prohibit such “excessive
compensation, fees or benefits.” The Act crossreferences certain provisions of the Federal Deposit
Insurance Act regarding the intended meaning of
“excessive” compensation. The SEC rule-making
calendar targets proposed rules being published in
November-December 2010, with final rules being
published in April-July 2011.
It is not clear how the various regulators will
coordinate their rule making or how expansive they
will be in defining “excessive” compensation. Even
the executive compensation limits under TARP did
not impose substantive caps on compensation. It is
worth noting that the Federal Reserve, FDIC, OCC
and OTS issued in June 2010 their Guidance on
Sound Incentive Compensation Policies (“the
Guidance”). The Guidance largely focuses on key
principles for ensuring that incentive compensation
plans at financial institutions appropriately balance
risks with financial performance and compensation
rewards. Perhaps the Guidance will inform the rule
making for this new “excessive compensation”
requirement under the Act, especially given the
Act’s focus on mitigating against “inappropriate
risks.”
Key Governance Changes
1. Broker Non-Votes
Section 957 of the Act prohibits discretionary
voting by brokers on shares they do not beneficially
own on the following matters — (i) election of
directors, (ii) executive compensation, and (iii) any
other “significant matter” as determined by the
SEC. Section 957 of the Act does not prohibit a
broker from voting shares if he or she received
voting instructions from the beneficial owner. This
new requirement codifies the NYSE rules approved
by the SEC in 2009 that preclude discretionary
broker votes on director elections, and it will
potentially broaden those rules as applied to
executive compensation matters. For example, the
SEC proposed rules on the say-on-pay votes under
Section 951 of the Act clarify that executive
compensation matters for purposes of Section 957
include say-on-pay votes. The SEC rule-making
calendar indicates that proposed rules on what
constitutes other “significant matters” will be
published in April-July 2011.
2. Proxy Access
Section 971 of the Act authorizes (but does not
require) the SEC to adopt rules allowing
shareholders to nominate candidates for directors,
using the company’s proxy statement. There were
substantial debates in Congress over whether the
Act should include requirements on the level or
duration of shareholder ownership. However, due
to powerful opposition from shareholder activist
groups, these eligibility requirements, if any, were
left up to the discretion of the SEC.
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Executive Compensation Alert
On August 25, 2010, the SEC adopted (in a 3-2
vote) rules intended to implement proxy access, in
general allowing shareholders with at least a 3%
ownership level held for at least three years to
nominate a specified number of directors through the
company’s annual proxy statement. On October 4,
2010, in response to a lawsuit filed by the U.S.
Chamber of Commerce and Business Roundtable,
the SEC issued an order staying the implementation
of the new rules until the litigation can be resolved.
As a result, it is unlikely that proxy access rules will
be effective for the Spring 2011 proxy season.
Proxy access has been a controversial subject for a
number of years. The SEC has expressed a view
that proxy access could make boards more
responsive and accountable to shareholder interests.
Others have suggested that the SEC lacks authority
to adopt proxy access rules, which arguably infringe
on internal corporate affairs that are ordinarily the
province of state corporate law. Assuming the SEC
proposed rules move forward at some point after the
current litigation is resolved, it remains to be seen
how state lawmakers may react. For more
information, see “SEC Stays Effectiveness of Proxy
Access Rules” at
http://www.klgates.com/newsstand/Detail.aspx?pub
lication=6698.
3. Disclosures Regarding CEO/Chairman
Leadership Structure
Section 972 of the Act directs the SEC to issue rules
requiring disclosure in the annual proxy statement
as to why the company either has one person
serving in the Chairman/CEO positions or separate
people in those roles. The SEC proxy disclosure
rules revised in December 2009 include a
requirement to discuss the rationale for the
company’s selected leadership structure. The Act
seems to simply codify this requirement and does
not appear to add any additional disclosure
requirements on this issue.
Conclusion
Much detail for these new executive compensation
and governance requirements will be developed by
the SEC, securities exchanges or other regulators
over the coming months. Companies will need to
monitor closely these developments and potentially
consider commenting on proposed rules, if a
comment period is made available.
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participants and public sector entities. For more information, visit www.klgates.com.
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November 15, 2010
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