Dodd-Frank Wall Street Reform and Consumer Protection Act: What Public Companies Need to Know

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The law includes a wide range of new regulations that will affect a wide variety of businesses from Wall Street to Main Street, including financial institutions such as banks, credit unions, investment banks and student loan providers as well as other businesses, such as debt collection agencies, mortgage-related businesses, payday lenders and consumer protection agencies. A new Consumer Financial Protection Bureau within the Federal Reserve and chaired by a person to be appointed by the President and confirmed by the Senate will have authority over many of these businesses to enforce provisions of the Dodd-Frank Act and, where appropriate, adopt additional regulations. The new law also includes executive compensation, corporate governance and other disclosure reforms for public companies generally and mandates the Securities and Exchange Commission (the “SEC”) to take specific rulemaking action in certain areas. The following is a summary of those provisions of the Dodd-Frank Act that will affect corporate governance and disclosure obligations of public companies generally. This management alert does not cover the principal areas of the Dodd-Frank Act that seek to strengthen regulation of financial institutions.

Permanent 404 Relief for Smaller Reporting Companies

Section 404(b) of the Sarbanes-Oxley Act of 2002 requires the independent auditor of a public company to issue an attestation report on the company’s internal control over financial reporting and management’s assessment of those controls under Section 404(a). The SEC has acted each year to delay implementation of Section 404(b) with respect to smaller reporting companies with a public float of less than $75 million. The Dodd-Frank Act permanently exempts all such smaller reporting companies from the provisions of Section 404(b).

Shareholder Approval of Executive Compensation Matters

The new law includes a “say-on-pay” provision that requires a public company at least once every three years to seek a non-binding shareholder vote ratifying the executive compensation packages of the company’s named executive officers. The law requires such a vote with respect to all compensation of named executive officers that is subject to disclosure pursuant to Item 402 of Regulation S-K, and therefore would include base salary, bonus, both equity and non-equity compensation awards, perquisites and severance benefits. A company’s proxy statement relating to its first annual meeting of shareholders to be held on or after January 21, 2011 must include separate resolutions subject to shareholder approval of the following items:

• Non-binding ratification of the compensation packages for the named executive officers; and
• A determination whether the company will seek such shareholder ratification of executive compensation awards every one, two or three years.

After the initial shareholder vote on these items, a company must obtain shareholder ratification of executive compensation packages as frequently as is determined by shareholders in the initial vote. In addition, at least once every six years, the company must obtain shareholder approval with respect to how frequently it will seek shareholder ratification of executive compensation. Again, all such shareholder ratifications are on a non-binding basis.

The new law also requires a non-binding shareholder vote with respect to all compensation that would be triggered as a result of a business combination transaction, excluding compensation arrangements that were previously approved by shareholders. Under these new “golden parachute” rules, any proxy statement relating to a meeting scheduled to occur on or after January 21, 2011 and that relates to an acquisition, merger, consolidation, or proposed disposition of all or substantially all the assets of the company must include a separate, non-binding proposal approving all golden parachute payments. The law directs the SEC to adopt new rules describing the nature and scope of appropriate proxy disclosure that must be included in the proxy statement with respect to golden parachute payments.

Shareholder votes on say-on-pay or golden parachutes are non-binding on a company and therefore may not overrule any action by the board of directors with respect to executive compensation or contravene existing binding employment agreements. Moreover, the results of a shareholder vote on any executive compensation matter do not create or imply any new or modified fiduciary duties from board members.

The new law also permits, but does not require, the SEC to exempt one or more classes of companies from compliance with the new executive compensation provisions of the law. Although the most likely class of issuer that may be exempted from these new disclosure requirements would be smaller reporting companies, it is not yet known whether or how the SEC intends to act with respect to these provisions.

It is also important to note that under Rule 14a-6 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), any proxy statement containing a say-on-pay or golden parachutes proposal would have to be filed in preliminary form with the SEC at least ten calendar days prior to the date that a definitive proxy statement is mailed. Unless the SEC acts to amend Rule 14a-6 or waive its application to say-on-pay and golden parachute proposals (which the SEC did for TARP recipients that were subject to prior SEC say-on-pay rules), then the new rules would add approximately two weeks to most corporate proxy timelines.

The new legislation also requires an institutional investment manager exercising investment discretion with respect to $100 million or more of U.S. public company securities that is subject to regulation under Section 13(f) of the Exchange Act to disclose how it votes on executive compensation matters. This new transparency with respect to institutional investor voting may make it more difficult for management to obtain institutional support in circumstances where proxy voting firms such as RiskMetrics Group (formerly ISS) or Glass Lewis recommend a vote against executive compensation. In the past, management could engage in a dialogue with its institutional investors regarding a “no vote” recommendation to win support for the measure. Whereas this type of dialogue will still take place, these institutions may be unwilling to cast a vote as a matter of public record that will be contrary to such outside recommendations.

Other Executive Compensation Matters

New Disclosure Items

The Dodd-Frank Act creates several new disclosure items that public companies must include in their annual reports or proxy statements. These new disclosure provisions require the SEC to adopt rules to require disclosure of the following information:

• Enhanced “pay-for-performance” disclosure that provides a “clear description” of the relationship between named executive officer compensation and actual performance. This provisions applies to all forms of compensation subject to disclosure under Item 402 of Regulation S-K. The SEC rules will have to define the nature and scope of the types of disclosure that will comply with the new law.
• The total compensation of the CEO compared to the total median compensation of all employees of the company, including the ratio of total CEO compensation to the median total employee compensation.
• Whether employees or directors of the company are permitted to engage in any hedging activities with respect to the equity securities of the company that are directly or indirectly beneficially owned by them.

Compensation Committees should immediately begin to assess whether the company’s compensation philosophies include pay-for-performance goals and the extent to which the company’s compensation practices achieve those goals. Committees also should review existing Compensation Discussion & Analysis disclosure and begin to identify how such disclosure may be expanded under the new law.

In addition, a company should evaluate its existing insider trading and compliance programs to determine whether modifications or additions to the program are necessary or appropriate to either ensure proper and timely identification of hedging transactions or to prohibit such transactions by employees and directors so as to eliminate the risk of non-disclosure.

Compensation Clawbacks

Section 304 of the Sarbanes-Oxley Act created a mandatory clawback from the CEO and CFO of bonuses and incentivebased awards that were paid or earned in the 12-month period preceding an accounting restatement that resulted from material noncompliance as the result of misconduct. The Dodd-Frank Act includes a mandate for the SEC to adopt rules requiring national securities exchanges to require every listed company, as a condition of listing, to adopt a policy for the clawback of certain executive compensation. The clawback provisions of the Dodd-Frank Act are more expansive than the provisions under Section 304 of Sarbanes-Oxley as follows:

• The clawback must apply in the event of any material noncompliance regardless of whether there is misconduct.
• The clawback is not limited to the CEO, CFO or other named executive offers, but rather applies to all executive officers.
• The clawback extends the Section 304 look-back period from 12 months to three years and applies only to the excess amount paid to the executive officers based on the financial statements previously reported as compared to the amount they should have received after giving effect to the accounting restatement. SEC rulemaking will have to clarify how to calculate a clawback where the incentive based payments were not based on a specific formula or were discretionary in nature.

Companies should undertake a review of existing compensation policies and procedures to determine whether amended or new policies are necessary to comply with the new clawback provisions. This review should include an assessment of the Company’s compensation plans and executive employment and compensation award agreements as well.

Compensation Committee Matters

Committee Member Independence and Authority

The Dodd-Frank Act creates new rules for the composition, authority and function of compensation committees and requires the SEC to adopt rules by July 21, 2011 prohibiting the listing on a national securities exchange of any security of a company not in compliance with these standards.

First, the law requires that all members of the compensation committee be independent in accordance with rules to be established by the SEC. The law requires the SEC rules that will be adopted over the next year to require compensation committees to consider, at a minimum, a compensation committee member’s sources of compensation and affiliations with the company when considering independence. Under the new law, a compensation committee must have the authority to engage its own independent consultants, legal counsel or other advisers and be responsible for their appointment, compensation and oversight. The independence criteria and the authority with respect to independent consultants, advisers and counsel are substantially similar to the audit committee independence requirements and authority rules under Section 10A(m) and Rule 10A-3 of the Exchange Act which were adopted pursuant to Section 301 of the Sarbanes-Oxley Act.

Currently, the listing standards of the national securities exchanges provide that a director may perform consulting services for a company, generally up to $120,000 per year, and still be independent for purposes of service on the board of directors and any committee other than the audit committee. In addition, some of the national securities exchanges have adopted exceptions that permit one non-independent director to serve on a listed company’s compensation committee for a period not to exceed two years in exceptional and limited circumstances. Although the Dodd-Frank Act permits the SEC to create exemptions from the compensation committee member independence requirements or adopt rules permitting the national securities exchanges to provide for certain exceptions thereto, the SEC declined to do so with respect to the audit committee independence requirements adopted as part of Sarbanes-Oxley and is unlikely to do so for compensation committees. Accordingly, compensation committee members who are performing consulting services for the company or who are otherwise not independent and are serving pursuant to the exceptional and limited circumstances exception may have to resign from the compensation committee when the SEC adopts its rules implementing the provisions of the new law. What is unknown at this time is whether the SEC will provide a transition period to facilitate an orderly reorganization of compensation committees to comply with the new rules.

Consultants, Counsel and Advisors

When Congress considered corporate codes of ethics as part of Section 406 of Sarbanes-Oxley, it declined to require public companies to adopt such codes. Instead, Section 406, and Item 406 of Regulation S-K adopted by the SEC pursuant to Section 406, only requires a company to disclose whether or not it has such a code of ethics and if not, to disclose the reasons it has not adopted such a code. The basis for this regulatory approach was that the negative publicity that would result from such disclosure would be an adequate incentive for companies to adopt a code of ethics as substantially all public companies have done.

Congress has taken a similar approach as it relates to the independence of consultants, advisers and legal counsel engaged by a compensation committee. The new law does not require that compensation consultants, legal counsel or other advisers be independent of the company. However, a company must disclose how the compensation committee considered factors that affect the independence of such consultants, counsel or advisers in deciding to engage them to provide services for the committee. The law directs the SEC to adopt rules identifying the factors that affect independence, which at a minimum must include:

• The provision of other services to the company.
• The amount of fees paid by the company to the consultant, counsel or adviser and the percentage that such amount represents with respect to the total revenue of the consultant, counsel or adviser.
• The conflicts of interest policies and procedures of the consultant, counsel or adviser.
• Any other business or personal relationships between the consultant, counsel or adviser and a member of the compensation committee.
• Any ownership of the company’s stock by the consultant, counsel or adviser.

These requirements are similar to disclosure rules the SEC adopted on December 16, 2009 for the 2010 proxy season. As with the executive compensation provisions of the law, the SEC is permitted, but not required, to exempt one or more classes of issuers from compliance with the new compensation committee requirements.

Brokers

Elimination of Discretionary Voting

Consistent with the Amendments to NYSE Rule 452 that were adopted effective as of January 1, 2010, the new law requires national securities exchanges to prohibit brokers from casting discretionary votes without obtaining instructions from their clients in connection with any director elections. The new law also applies the same prohibition to non-binding shareholder votes relating to say-on-pay or golden parachutes.

Fiduciary Duties

The original House version of the Dodd-Frank Act included a provision that created a statutory fiduciary duty owned by broker-dealers to their clients. The final version of the bill that was enacted eliminated this statutory fiduciary duty, however it does include a mandate that the SEC conduct a six-month study of broker-dealer activities for the purpose of determining whether rulemaking or a statutory fiduciary duty is necessary or appropriate.

Board Leadership Structure

The new law requires the SEC to adopt appropriate disclosure rules relating to the roles of Chairman of the Board and CEO and whether and why a company has chosen to combine or separate these roles. The legislative provisions are substantially identical to the new disclosure rules that were adopted by the SEC on December 16, 2009 for the 2010 proxy season, so it is unclear what, if any, additional disclosure rules may be adopted by the SEC pursuant to this legislative mandate.

Proxy Access

In 2003, 2007 and 2009, the SEC published several rulemaking proposals that would have provided shareholders access to company proxy materials in connection with the nomination of candidates for election to the board of directors. However, a consensus never developed at the SEC as to which of the proposed shareholder access models was most appropriate, and none of these proposed rules were ever adopted. The new law authorizes, but does not require, the SEC to adopt rules that provide for shareholder access to company proxy materials for the nomination of directors. Although earlier versions of the Dodd-Frank Act included specific ownership thresholds for a shareholder to qualify to nominate a director in the company proxy statement and the number of shareholder nominated directors that a company would have to include in its proxy, none of these specific provisions survived in the final version of the bill that became law. The SEC has not acted on its most recent proposal from June 2009, and it is unclear whether it will consider new or modified proposals in light of the passage of the Dodd-Frank Act. However, given the legislative support and recent public statements from the SEC, it is likely that the SEC will take action to enact shareholder access rules for the 2011 proxy season.

Majority Vote and De-Staggered Board Provisions Not Approved

Earlier versions of the Dodd-Frank Act included a mandatory majority-vote standard. A majority vote standard requires a director who receives more votes against his election than for it to resign from the board of directors. The provisions that were initially part of the Dodd-Frank Act would have required all public companies to adopt a majority vote standard that was substantially consistent with the “meaningful alternative” to majority voting that was supported by RiskMetrics Group and which many public companies have adopted as the result of shareholder proposals in recent years. The meaningful alternative standard requires a director of a public company who receives more votes against his election than for it to immediately offer his resignation to the board of directors or its nominating committee. The board or nominating committee would then have 90 days to consider the vote results and the underlying causes and make a public disclosure of the determination of the board or committee to accept or reject the resignation.

The majority vote provisions of the Dodd-Frank Act were eliminated during negotiations by the joint House-Senate conference committee during the final days before the conference report was approved by the committee and passed by the House and Senate. Furthermore, provisions discussed much earlier in the Congressional process that have prohibited public companies from having staggered boards of directors were also not adopted.

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