Corporate Governance and Compensation Disclosure Provisions of The Restoring American Financial Stability Act of 2010

By Cydney Posner

The Senate financial reform bill, "The Restoring American Financial Stability Act of 2010,'' which was passed by the Senate on May 20, has now been posted online.

As previously indicated, the corporate governance and compensation disclosure-related measures that apply generally to companies outside of the financial services industry have been substantially retained in the bill, although it is always possible that they will be changed by the conference committee, to be headed by Rep. Barney Frank, chair of the House Financial Services Committee, as discussed below. Even though the bill is now up to 1616 pages, many of the provisions in the bill are fairly skeletal and would require regulatory action to make clear the extent of the requirements.

The governance- and compensation-related requirements were adopted against the backdrop of an economic crisis in which the public railed at instances of corporate executives who were highly compensated despite very poor performance by their firms. The Report on the bill by the Senate Committee on Banking, Housing and Urban Affairs (the "Report"), quoting the NYT, cites in particular the example of Charles O. Prince III, the former chief executive of Citigroup, " ‘who "collected $110 million while presiding over the evaporation of roughly $64 billion in market value. He left Citigroup in November with an exit package worth $68 million, including $29.5 million in accumulated stock, a $1.7 million pension, an office and assistant, and a car and a driver. Citigroup's board also awarded him a cash bonus for 2007 worth about $10 million, largely based on his performance in 2006 when the bank's results were better. Citigroup has announced write-offs worth roughly $20 billion and its share has plummeted over 60 percent from last year's high.

Many of these provisions, if retained in the final act, would have a very significant impact on public companies, arguably almost as significant as SOX. Interestingly, most of the battles have been centered around the banking reform provisions of the bill, with the result that these provisions have survived mostly unscathed. Nevertheless, the proxy access and majority vote provisions have continued to draw fire and it is possible that they may be changed in conference.

Majority Voting. Under Delaware law (and the laws of many other states), the default standard for uncontested elections of directors is a plurality vote, with the result that a director who receives a single favorable vote is elected even if a majority of the shares are withheld from the nominee. A number of companies have voluntarily adopted different versions of majority voting standards, but most companies continue to follow plurality voting. The Report notes the views of a number of commenters indicating that a plurality vote standard is inherently unfair and undemocratic and that a majority vote standard is necessary to democratize the voting process and make boards more representative. Some commenters, however, expressed the concern that some directors should continue to serve on the board notwithstanding an unfavorable vote, for example, where the director is the board's only financial expert. The bill takes that concern into account.

The bill requires the SEC to direct the exchanges to prohibit (with appropriate opportunity to cure and exemptive authority based on issuer size or other factors) the listing of companies that do not require majority voting in uncontested elections of directors. A director who received a majority of votes in an uncontested election would be deemed to be elected, and a director who received less than a majority would be required to submit a resignation to the board. The board would then be required to accept the resignation and make the effective date public or, with a unanimous vote, decline to accept the resignation and make public the relevant analysis of that decision. (Obviously, issuers that are not exchange-listed would not be affected.)

Note that the corresponding House financial reform bill does not include a majority vote mandate, and it has been reported that Rep. Barney Frank, has indicated that he was "not sure" whether majority voting would appear in the final financial reform legislation. Reportedly, he added that the final bill might include authorization for the SEC to impose the requirement (as opposed to a mandate).

Proxy Access. As the Report indicates, the Committee believes that it is appropriate " for shareholders, as the owners of the corporation, to have the right to nominate candidates for the Board using the issuer's proxy under limited circumstances." The bill provides authorization for, but does not mandate, the SEC to require proxy access for shareholder nominees to the board. Specifically, under the bill, the SEC may adopt a requirement that solicitation of a proxy, consent or authorization by an issuer include a director nominee submitted by a shareholder, as well as a requirement that an issuer follow a certain procedure in connection with that solicitation, including a requirement permitting the use by shareholders of the issuer's proxy solicitation materials to make the nomination. The Report indicates that the bill deliberately "gives the SEC wide latitude in setting the terms of such proxy access. The Committee intentionally did not specify that shareholders must have held a certain number of shares or have held shares for a particular period of time to be eligible to use the proxy. If the SEC proposes rules, interested persons can offer their views on the appropriateness of proposed regulatory terms in the public comment process."

The bill retrenches slightly on the proxy access provisions in the initial version of the bill by authorizing the SEC to issue regulations but not mandating it. The House bill is only mildly different from the Senate bill, and it has been reported that Rep. Frank has confirmed that the final bill will include, in some form, authorization for the SEC to promulgate proxy access. The SEC planned to adopt proxy access rules on its own initiative, but it has encountered strong opposition in the business community, which has questioned the authority of the SEC to regulate matters traditionally the province of the states. If the bill is adopted, it would eliminate that issue and smooth the way for the SEC to act.

Say on Pay. According to the Report, the Banking Committee believes "that shareholders, as the owners of the corporation, have a right to express their opinion collectively on the appropriateness of executive pay." (And besides, as the Report points out, the UK has "say on pay" and, as we all know, everything has turned out really well over there.) This provision requires any consent or proxy for an annual or other shareholder meeting that requires compensation disclosure to also include a separate resolution for non-binding shareholder approval of executive compensation as disclosed under Reg S-K 402. Although the vote is nonbinding, it must still be tabulated and reported, according to the Report. (So a merger proxy that includes compensation disclosure must have a separate vote on compensation? Hopefully, ultimately not the case.) The vote is expressly not to be construed to overrule a decision by the issuer or its board, to create or imply any new, or any change to, the fiduciary duties of the issuer or its board or to restrict or limit the ability of shareholders to make proposals for inclusion in proxy materials related to executive compensation. 

Although ultimately the requirement will be at least annual, the Report makes clear that there was consideration of alternative time intervals, such as votes every three years, and of whether votes after the first year should be triggered only by a failure to receive a minimum percentage of votes in support of the compensation plan. The Report also makes clear that issuers are not precluded from also seeking more specific shareholder opinion through separate votes on cash compensation, golden parachute policy, severance or other aspects of compensation. The provisions that would have required shareholder votes on golden parachutes and on classified boards that were in earlier drafts do not appear to be in the current version of the bill (although the provision for say on golden parachutes is in the House bill and could be retained in conference).

Compensation Committees. The Report cites a letter from The Council of Institutional Investors, which expressed the concern that compensation committees and their external consultants "play a key role in the pay-setting process. Conflicts of interest contribute to a ratcheting up effect for executive pay, however, and should thus be minimized and disclosed." Accordingly, the bill would direct the national securities exchanges to prohibit listing of companies that do not maintain independent compensation committees. The definition of "independence" for compensation committee members is likely to be similar to that for audit committee members and must consider relevant factors, such as the source of compensation of a director, including any consulting, advisory or other compensatory fee paid by the issuer to the director, and whether the director is an affiliate. The rules may permit exemptions related to issuer size and other factors.

Compensation Consultants, Legal Counsel and Other Advisors. The bill would require the SEC, within 360 days after enactment, to direct the exchanges to prohibit listing of issuers that do not comply with the provisions below, although there will be a reasonable opportunity for cure and special consideration for small issuers. Under the bill, compensation committees must have authority to retain or obtain the advice of a compensation consultant, independent legal counsel and other advisors and must be directly responsible for the appointment, compensation and oversight of their work, although the issuer must fund their compensation. There is no requirement that the committee follow the advice of the consultant, counsel or advisor (or even engage one) or otherwise forego its own judgment. In selecting consultants, legal counsel and other advisors, the committee would be required to "take into consideration" the independence factors identified by the SEC, including the following:

• the provision of other services to the issuer by the consulting, legal or other advisory firm; 
•  the amount of fees received from the issuer as a percentage of the total revenue of the firm; 
•  the policies and procedures of the firm that are designed to prevent conflicts of interest;
• any business or personal relationship of the consultant, counsel or other advisor with a member of the compensation committee; and
• any stock of the issuer owned by the compensation consultant, legal counsel or other advisor.

Issuers will be required to include proxy disclosure regarding whether the committee retained or obtained the advice of a compensation consultant and whether the work of the consultant raised any conflict of interest and, if so, the nature of the conflict and how the conflict is being addressed.

Additional Proxy Disclosure Regarding Pay v. Performance. Because proxy statements are just not long enough, the bill will require additional proxy disclosure regarding executive pay. The Report notes that shareholders "are keenly interested when executive compensation is increasing sharply at the same time as financial performance is falling." (Let's see if the SEC might take the opportunity to remove some of the less relevant proxy provisions?) The SEC is required to issue rules mandating "a clear description" of any compensation required to be disclosed under Reg S-K 402 (should we be offended by the implication that our CD&As are not clear descriptions?), including information that shows, perhaps in graphic form, 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. The Report suggests a graph with a horizontal axis of a number of years and a vertical axis with two scales, one for executive compensation and a second for financial performance of the issuer for each year. This disclosure is not required by the House bill.

Internal Pay Equity. The SEC would be required to adopt amendments to Reg S-K 402 to require disclosure in SEC filings (not limited to proxy statements) regarding internal pay equity, that is (A) the median of the annual total compensation of all employees of the issuer, except the CEO, (B) the annual total compensation of the CEO, and (C) the ratio of the two (with the "total" being determined by the same method as total compensation in the Summary Compensation Table, including equity and other benefits, a calculation that should be a delightful full-employment opportunity for someone, or 20 someones, depending on the size of the company). While not discussed in the Report, the provision surely takes into account data previously introduced by Senator Durbin from the Economic Policy Institute indicating that, in 1965, U.S. CEOs at major companies made 24 times the pay of an average worker, while, by 2005, CEOs earned 262 times the pay of an average worker. (A report on The Today Show in May 2009 showed the ratio of average CEO pay at public companies relative to average employee pay at 400:1 in the U.S., while in Great Britain, the ratio is 22:1; in Canada, 20:1; and in Japan, 11:1.) This disclosure is not required by the House bill.

Clawbacks. The Report indicates that the Banking Committee believes it is unfair to shareholders for corporations to allow executives to retain compensation that they were awarded erroneously. The bill requires the SEC to direct the exchanges to prohibit listing of companies that do not develop, implement and disclose clawback policies. The policy must provide that, in the event that the issuer is required to restate its financial statements due to material noncompliance with any financial reporting requirement under the securities laws, the issuer will recover from any current or former executive officer who received incentive-based compensation (including stock options awarded as compensation) during the three-year period preceding the requirement to restate, the amount in excess of what would have been paid to the executive officer under the accounting restatement. This provision would put the onus on the issuer to collect and may open the door to derivative actions, while under SOX 304, forfeitures seem to be enforced by the SEC and the courts have not found any implied private right of action to enforce the provision. The House bill does not address clawbacks.

Broker Discretionary Voting. This provision imposes, through the exchanges, a prohibition on broker discretionary voting in connection with election of a member of the board of directors of an issuer, executive compensation or any other significant matter, as determined by the SEC. The Report indicates the Committee's desire that the final vote tallies reflect the wishes of the beneficial owners of the stock and not be affected by the wishes of the broker that holds the shares. This provision is not addressed in the House bill.

Hedging Disclosure. The bill would require the SEC to mandate annual proxy disclosure of whether any employee or director, or any of their designees, is permitted to engage in hedging transactions through the purchase of financial instruments (such as prepaid variable forward contracts, equity swaps, collars, and exchange funds) designed to offset decreases in the market value of equity securities granted as compensation to or held by the employee or director. The Report notes that this provision "will allow shareholders to know if executives are allowed to purchase financial instruments to effectively avoid compensation restrictions that they hold stock long-term, so that they will receive their compensation even in the case that their firm does not perform." The House bill does not require hedging disclosure.

Combined Chair/CEO Disclosure. This provision requires the SEC, not later than 180 days after the date of enactment of the provision, to issue rules that require proxy disclosure of the reasons why the issuer has one person serving as a combined CEO/Chair or two persons serving in those roles. (Will someone please tell the <br>Senate that the SEC already requires this disclosure?) According to the Report, the Committee received strong views on the merits of both models as well as on whether to prohibit a public company from having the same individual serve as Chair and as CEO. The Committee recognized that different public companies may have good reasons for following either model and therefore opted for the current disclosure provision, without endorsing or prohibiting either model. This provision is not included in the House bill, and it has been reported that Rep. Frank does not attribute much significance to separating the two positions, but that's all a big ho-hum given that the SEC already mandates disclosure.

Whistleblower Incentives. For individuals who provide certain information relating to a violation of the securities laws to the SEC, there are securities whistleblower protection and incentive payments of between 10% and 30% of the amount collected.

Section 13(d) and Section 16 Reporting. For purposes of beneficial ownership reporting under these sections, the bill would include security-based swaps, to the extent required by the SEC, as the acquisition of the equity security.

Committees and Studies. There are lots of committees established and studies and reports mandated:

• An Investor Advisory Committee would be established at the SEC to advise and consult with the SEC on regulatory priorities, regulation of securities products, the effectiveness of disclosure and initiatives to protect investor interests. promote investor confidence and the integrity of the securities marketplace and to recommend legislative changes.
• Establishes an Office of the Investor Advocate, among other things, to assist retail investors in resolving significant problems investors may have with the SEC or with SROs, to identify areas in which investors would benefit from changes in the regulations of the SEC or SROs and to propose changes that may be appropriate to mitigate problems.
• Requires the SEC to conduct a study to identify the existing level of financial literacy among retail investors, including various subgroups.
• Comptroller General to conduct a study to identify and examine potential conflicts of interest that exist between the staffs of the investment banking and equity and fixed income securities analyst functions within the same firm, especially the firms that were the subject of the Global Analyst Research Settlements in 2003 .

Exemption for SOX 404(b) is not in the Senate bill. But the House bill does contain a provision that would exempt smaller non-accelerated companies from SOX 404(b), the requirement that companies obtain an audit of their internal controls. It has been reported that Frank believes the provision will survive conference negotiations.