The Dodd-Frank law will affect executive compensation and corporate governance starting in 2011 with the "say on pay" provision. Other elements will come into play as the SEC issues new regulations. Here in summary are key provisions of the law, along with a brief overview of how the changes will affect compensation programs and overall board governance.
Commencing in 2011, most companies must hold a nonbinding shareholder "say on pay" vote on compensation for executives whose salary and other benefits are disclosed in the proxy statement. This vote must be held no less frequently than every three years. Institutional investment managers are required to report annually on how they voted. A separate nonbinding shareholder vote must be held at least every six years (commencing in 2011) on whether the say-on-pay vote should occur annually, every two years, or every three years.
In the event of a change-in-control transaction, a separate say-on-pay vote is required on any compensation arrangements for named executives that relate to the transaction (e.g., golden parachute payments), unless those arrangements have been subject to a prior say on pay vote.
Compensation committee members must generally meet independence standards that consider (among other things) the nature and sources of their compensation and relationship to the company.
The compensation committee is to be directly responsible for the appointment, compensation, and oversight of any compensation consultant or other advisers whom the committee retains. The company must provide funding to pay for such advisers.
In selecting external advisers, the compensation committee must take into account factors affecting independence that are to be identified under rules to be issued by the SEC. There is no requirement that the advisers actually be independent, but the proxy statement must disclose whether the committee has obtained the advice of a compensation consultant, whether the consultant's work raised any conflict of interest, and if so, the nature of the conflict and how it is being addressed.
Other Major Provisions
Proxy-statement executive compensation disclosure must include information related to whether employees or board members are permitted to engage in transactions that hedge the value of company shares they own, a chart comparing executive compensation to absolute total shareholder return for the past five years, and an analysis of the ratio of CEO annual compensation to the median total compensation of all other employees.
Companies must implement a "clawback" policy for recovery of erroneously paid compensation, including stock options, in the event of certain required accounting restatements. The policy applies to current and former executives, must reach back for at least three years prior to the date the accounting restatement is required, and does not require fraud or malfeasance for the clawback provisions to become applicable.
Broker discretionary voting of shares held by their customers will not be permitted in elections of directors, say on pay, or other significant matters.
The proxy statement must disclose the reasons why the company has chosen to have the same person or different persons serve as board chair and chief executive officer.
Financial institutions will be required to disclose to their appropriate Federal regulator information regarding the structure of incentive-based compensation arrangements. The regulators are required to issue rules prohibiting any types of incentive-based compensation arrangements that encourage inappropriate risks (i) by providing excessive compensation to an executive officer, employee, director, or principal shareholder; or (ii) that could lead to material financial loss to the financial institution.
Adapting to "say on pay" requirements is the next big challenge for companies and their board compensation committees. Many institutional investment managers rely on the voting recommendations of advisory firms to vote their proxies, and say on pay will further leverage the power of these firms in driving change in executive compensation. Activist investors and the proxy advisory firms will target specific companies for "against" votes if they deem their compensation policies to be misaligned with best practices or shareholder objectives.
Even if majority support is achieved, significant votes against a company's executive compensation program will create pressure to open a dialogue with investors to identify the individual aspects of the program that fostered investor discontent. A majority vote against the program will create pressure to make corrective changes. Failure to take action may lead to withholding votes or voting against the reelection of the responsible directors (i.e., the compensation committee members). At companies where majority voting provisions exist, this could lead to removal of certain directors from the board. In response to this challenge, board compensation committees are reviewing historic practices and policies and modifying or eliminating those that are highly criticized by investors. To the extent that a company decides to retain practices that are likely to attract criticism, they must be defended with well-wrought business cases.
In addition to pressure to make changes to compensation policy, say on pay may provide a platform for investors to push for changes in operating strategy or to modify the performance goals or targets associated with incentive compensation payouts. This could have the unintended consequence of increasing pressure on companies to manage for the short term, especially if a large block of stock is held by an activist investor, hedge fund, or other investor with a short-term perspective.
Role of Consultants
Provisions for independence of compensation committees are unlikely to have material impact, because most large public companies already retain compensation consultants at the board level, and these consultants (such as my own firm) typically report to the compensation committee. Companies that don't use compensation consultants may well feel pressure to retain them, given the complexities of the law and risks entailed if executive compensation practices become a focal point for shareholder activism.
The independence of compensation committee advisers has been on the governance agenda for several years, and the new law increases the focus. We anticipate that boards will replace advisers who fail to meet strict independence standards as a result of the firm providing other, unrelated services (e.g., benefits outsourcing, pension actuarial services, insurance brokerage). In anticipation of this change, many of the large multiline consulting firms have spun off portions of their executive compensation consulting practices.
Mandates for disclosures about executive compensation may have significant impact on policy as well as internal administration. If interpreted literally by the SEC, the requirement to disclose the ratio of CEO to the median employee total compensation could become a reporting nightmare. For example, a company with 10,000 employees would be required to calculate the annual total compensation for each employee in order to compute the median value. The calculation would presumably require quantifying the values of equity awards, bonuses, perquisites, pension plans, etc. for all employees (full-time or part-time), and conversion of the value of payments to foreign employees into U.S dollar values. Few companies maintain such data or have the resources to develop them, but fortunately there is no deadline for the SEC to issue the required new and amended rules.
The "clawback" provision of the law is a knotty issue and will require SEC guidance. For example, the three-year period does not start on the date of the restatement but on the date the company is "required to prepare the restatement." Since the requirement to prepare a restatement exists on the date the erroneous statement is issued—at least in certain cases—the requirement could be read to apply only to incentive compensation granted before the erroneous financial statement was first issued, which is obviously not what was intended. Also, in cases where the delivery of incentive compensation is not directly tied to a specific performance metric, guidance is needed about how to determine what percentage of incentive compensation was based on the erroneous financial statement.
The impact of the new hedging disclosure rules is open to question but could result in executives and directors "going naked" in the market if companies decide to prohibit hedging. This could have the effect of penalizing directors and named executives if severe stock declines happen through no fault of their own, as occurred in the present recession, and may result in increased insider sale transactions as diversification is used in lieu of hedging strategies.
Prohibitions on discretionary broker voting will end the practice of voting automatically with company recommendations, and a large number of nonvotes will increase the power and influence of the investors who do vote. This will create administrative complexities and shareholder communication challenges for companies with a high percentage of retail investors, since an outreach program may be needed to encourage voting.
The rule to disclose the decision whether to have the same person or different persons serve as board chair and CEO represents a modest expansion of a current proxy rule and should have limited impact on boards.
The impact of the new rules applicable to banks and other financial institutions is unclear. From a disclosure perspective, we anticipate that more detail with regard to compensation arrangements, including those below the senior executive level, will be required. This may be complicated and administratively cumbersome. The prohibition against incentive-based compensation arrangements that may encourage inappropriate risks by providing excessive compensation, fees, or benefits or that could lead to material financial loss to the institution could lead to major changes in compensation design and delivery. Similar rules have been adopted in several European countries, and it appears they will require major change in the structure (i.e., less cash, more equity) and timing of compensation payments (less immediate, more deferred and subject to clawback if investments deteriorate). It is unclear whether comparable restrictions will be imposed in the U.S., but guidelines should be issued within nine months.
While it is too early to predict a decline in executive compensation as a result of the law, there will be pressure on companies that aren't performing to reduce compensation in line with current operating results and changes in shareholder value. This may be resisted, but the law provides leverage to shareholders that will be hard for management and directors to ignore.