Fall 2010 may usher in the most significant regulatory changes ever affecting U.S. businesses, from Wall Street to Main Street. With the worst of the financial crisis now behind them, Washington policymakers are turning their attention away from the financial sector and toward businesses in general.
With the signature of President Barack Obama on July 21st, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is now the law of the land. For boards in all industries, not just in banking, this broad new law has struck like a governance earthquake. There will be strong aftershocks as regulators work on implementation on a timeline that ranges from immediate to five years from now.
So what’s in the law? Thanks to ongoing coverage by NACD Alliance Partner Weil Gotshal and others, most directors are by now familiar with key provisions of this massive legislation. Still, hidden in the law are more governance shockers—such as a superclawback provision in Title II. Here’s a guide to key provisions of the law and what to do about them.
Title I: Financial Stability
Mandating risk committees for some financial institutions. The Board of Governors of the Federal Reserve System will require certain financial institutions to establish a risk committee. The provision applies to any publicly traded non-bank financial company supervised by the Board of Governors and to any publicly traded bank-holding company with consolidated assets of $10 billion or more. The board-level risk committee will be responsible for the oversight of the enterprise-wide risk management practices of the company; will include the number of independent directors the Board of Governors recommends (based on the nature of operations, size of assets and other appropriate criteria related to the company); and will include at least one risk management expert with experience in “identifying, assessing and managing risk exposures of large, complex firms.”
Next steps: Find a good risk committee charter and adapt it for your use. Take advantage of the work and documents of existing risk committees in successful institutions. Also, make sure the full board continues to oversee risk. This topic is too critical to delegate entirely to a committee.
Audit committees should continue their active oversight of financial reporting risk.
Title II: Orderly Liquidation Authority
Firing and superclawback power for the FDIC. Under this title, especially section 210, the Federal Deposit Insurance Corporation (FDIC) has the power to act as the receiver for insolvent financial companies, including publicly held bank holding companies and non-bank financial companies—a broad term that could conceivably cover any financial firm. The law states that the FDIC may “disaffirm or repudiate any contract or lease to which the covered financial institution is a party” if the Corporation finds it “burdensome.” Furthermore, the FDIC may recover “compensation” from “any current or former senior executive or director substantially responsible for the failed condition of the covered company.” There’s a two-year statute of limitations, except for fraud, where there is no time limit. The FDIC “shall promulgate regulations to implement the requirements of this subsection, including defining the term ‘compensation’ to mean any financial remuneration including salary, bonuses, incentives, benefits, severance, deferred compensation or golden parachute benefits and any profits realized from the sale of the securities” of the company. When NACD Directorship spoke to Weil Gotshal Counsel Heath P. Tarbert in Washington, D.C., he warned that almost any financial firm might be vulnerable to FDIC action under this broad provision—including hedge funds.
Next steps: Directors of financial institutions need to keep a close watch on the implementation of these provisions, bearing in mind that even if directors do everything in their power to avoid insolvency, failure can occur due to outside forces beyond their control. A combination of volatile markets, changed accounting rules and changed reserve requirements can lead to findings of insolvency despite adequate oversight by the board. Given the current aggressive stance of regulators, combined with the current weak economy, directors of financial institutions should consider the possibility of insolvency and a resulting loss of past compensation. As such, they would be prudent to consider their pay to be entirely at risk and should plan accordingly.
Title IX: Investor Protections and Improvements to the Regulation of Securities
Bounties for whistle-blowers. The whistle-blower provision goes well beyond the one in Sarbanes-Oxley (SOX), which merely protected whistle-blowers. This provision offers a reward of between 10 and 20 percent for a tip that leads to sanctions of $1 million or more. The tipster, who may be anonymous to the company and known only to the Securities and Exchange Commission (SEC), stands to receive at least $100,000.
Next steps: Use this provision as the catalyst for reinvigorating your company’s ethics training program. This can deter not only truly unethical behavior, but also frivolous complaints.
Mandated shareholder approval for compensation— “say on pay”—and golden parachutes. This provision goes into effect for companies at their next annual shareholder meetings. At least once every six years, shareholders must vote on the frequency of this pay referendum, which the law says must be held at least every three years. Moreover, in any proxy or consent solicitation material in which the shareholders are asked to approve M&A activity, the company must disclose any and all compensation (including the total value) expected to be paid to executive officers based on the proposed M&A activity. This proxy must also include a non-binding shareholder vote to approve these compensation agreements. The SEC may exempt small companies from these provisions.
Next steps: Work proactively with your corporate secretary to prepare for this issue at your next annual meeting. Address the subject of pay referendum frequency in your proxy materials. Consider the pros and cons of frequent vs. infrequent say-on-pay votes, bearing in mind that the most important part of executive pay is long-term incentive pay, which is often calibrated to pay out in three years or more. Remember, because the vote occurs after the launch of a plan, and because all it says is “no,” its value is more symbolic than informative. Effective shareholder communications remain extremely important.
Independent compensation committees. All companies listed on a national securities exchange must have a compensation committee composed entirely of directors deemed independent. The securities exchanges will set the guidelines for determining independence. The consultants selected by the compensation committees must be independent as well. The exchanges may choose to exempt companies from this requirement based on size and other factors.
Next steps: Boards can define independence stringently for their compensation committees now, without waiting for outside definitions. Most companies now use existing definitions from the exchanges (November 2003 listing rules implementing SOX) or from the Internal Revenue Service (implementing the $1 million cap on tax deductibility two decades ago). However, the SEC is likely to narrow the definition. In anticipation of the SEC’s rule, consider implementing the SOX Section 301 definition of audit committee independence. This rule assumes that the independent director is not an employee or related to an employee. But furthermore it states that the independent director must not accept consulting fees and must not be affiliated with the company or its subsidiaries.
Increased compensation disclosures. When disclosing executive compensation in the proxy, companies must also discuss the relationship between compensation already paid and the financial performance of the company, “taking into account any change in the value of the shares of stock and dividends of the issuer and any distributions.” Companies must also disclose the median annual compensation of all employees of the company, excluding the CEO, the total annual compensation of the CEO and the ratio between the two.
Next steps: Allocate agenda time to define corporate performance in a way that is meaningful to the company. As noted above, the law says boards must include stock price performance and dividend payments. However, boards would be unwise to limit their definition of corporate performance to these indicators.
One of the great lessons from the recent financial panic was that stock price is not always a fair indicator of value. Indeed, the most useful definitions of “financial performance” include additional factors, such as operating profits, cash flow and total shareholder return (TSR) during a stated investment period, according to recent surveys by NACD, Pearl Meyer & Partners and James F. Reda & Associates. Furthermore, boards should not let this regulatory emphasis on financial metrics distract them from other metrics, such as improvements in health, safety and the environment.
Guidance on both financial and non-financial metrics appears in the report of the NACD Blue Ribbon Commission on Performance Metrics to be released in October 2010 and featured in the next issue of NACD Directorship magazine.
As for the median compensation disclosure, boards should not wait to be surprised by the number come proxy time. If you are not already receiving this number now, ask for it. If the number suggests that the CEO is being overpaid in relation to employees, review pay plans, check peer numbers and ask: Is this perception or reality? If it is perception, explain it to your stockholders. If it is reality, work to change it.
Clawbacks. If a company is required to file an accounting restatement due to the material noncompliance with a financial reporting requirement, the company must recover all incentive-based compensation related to the incorrect statement paid to current or former executives within the three-year period before the restatement.
Next steps: Compensation committee members can study the balance of base salary to incentive compensation in light of this new provision and the other compensation provisions, such as say on pay and pay for performance, in the new law. Incentive pay—especially long-term incentive pay—is vitally important. But boards should avoid placing so much in at-risk incentive pay that it will have a demotivating rather than motivating effect: honest, hardworking managers should not experience rebuffs or repossession due to accounting technicalities.
Meanwhile, audit committee members should be more vigilant than ever when reviewing financial statements to make sure that the accounting treatments chosen are appropriate and that no red flags appear. This will reduce chances of restatements due to error or fraud. If there is a restatement, comply with the clawback provision but don’t stop there; work to restore trust in the board’s judgment and integrity.
Employee or director hedging. Proxy materials must disclose whether any employee or board member of the company holds or was granted any financial instrument to hedge against a decrease in the value of the company.
Next steps: Boards can go one step further and implement a policy banning this behavior. It is not good to allow a director or an employee to bet against the company by shorting stock (benefiting from a decrease in share price). They are there to foster prosperity, not to profit from decline.
Increased compensation oversight for the financial industry. Financial institutions must disclose all incentive-based compensation of their employees. Federal regulators can enact regulations or guidelines to prohibit any type of such incentives that they consider excessive or that could lead to financial loss to the institution.
Next steps: If you serve on the board of a publicly held bank, review the disclosures your bank made about compensation risk and the pay performance link (both already required under proxy rules). If you determine that the compensation awarded fails to motivate long-term value but instead motivates risky behavior then work to change it. If, on the other hand, the pay seems appropriate, be proactive in communicating its value to minimize the chance of a government ban.
Broker no-vote. The law also includes elimination of broker voting on say on pay—extending a previous ban on broker voting in director elections. Now a broker is prohibited from voting a proxy for director elections, executive compensation or any other significant matter without instructions from the beneficial owner.
Next steps: Build better relations with your retail investors. For guidance, see the materials of the Shareholder Communications Coalition (shareholdercoalition.com) and by Broadridge (shareholdereducation.com/proxy_process.asp).
Proxy access. The SEC is given the authority to create rules determining procedures pertaining to proxy access. The SEC may exempt small issuers from these rules.
Next steps: Keep current through your advisors and NACD on what the proxy access rules say. Currently, proposed standards range from 1–5 percent and one to five years. NACD’s comment letter on the pending rules suggest a 5 percent holding for two years. (A flash survey conducted at the time of the comment letter revealed that most NACD members supported a 5 percent percent threshold, but were less concerned about time held, with responses clustering at one, two and three years.)
Board leadership structure disclosures. Companies must disclose and explain their choice of board leadership structure, and whether the roles of the CEO and chair position are combined or separated.
Next steps: Companies are already making disclosures about their leadership structures in response to the proxy disclosure enhancement rules that became effective for spring proxy season 2010. Now, they can see the messages of other companies—not just peers, but any well-governed companies. Disclosures vary. Good governance is doing what is right for the company.
NACD has developed a template for enhanced governance disclosures, which can be requested via resources@NACDonline.org. For general governance guidance, the NACD’s Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Traded Companies can be accessed at NACDonline.org.
This article went to press in mid-August, before the SEC’s historic 3-2 vote to approve proxy access on August 25, 2010. For details see the SEC’s rule on Facilitating Shareholder Nominations, a.k.a. “proxy access” (Release No. 33-9136) at sec.gov, Final Rules. The final rule rule sets a threshold ownership minimum of 3 percent held for 3 years–a golden mean between the 1 and 5 percent range originally contemplated. ARL