Publications
Article

Implementing the Dodd Frank Act

Wall Street Lawyer

Preparing for the 2011 Proxy Season and Beyond… What the Dodd-Frank Act Will Mean for Public Companies

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act) signed into law on July 21, provides for the most extensive overhaul of U.S. financial market regulation since the Great Depression. Coming in at more than 2,300 pages, the Act easily surpasses the length of the Sarbanes-Oxley Act of 2002 in terms of sheer breadth and size, although unlike Sarbanes-Oxley, most of the Act’s provisions are aimed at fixing flaws in the financial sector that were blamed for causing the 2008 economic meltdown. Tucked away in those 2,300 pages are a number of changes that will significantly affect public companies, many of them in the areas of corporate governance, executive compensation and public disclosure.

The Act requires revisions to the regulatory landscape and establishes an enhanced regulatory scheme and requirements applicable to public companies and other market participants. Specifically, the Act adds several new corporate governance and disclosure requirements applicable to companies listed on U.S. stock exchanges and in some instances, all public companies.

In most instances, the foregoing regulatory requirements require additional rule making by the Securities and Exchange Commission (SEC) or the national securities exchanges to fully implement these changes. SEC Chairman Mary Schapiro has publicly indicated that the SEC is committed to having these requirements in place for the 2011 proxy season. This article describes action items that public companies should consider taking now to be prepared for the upcoming proxy season and beyond.

What Should Public Companies Be Doing Now?
Many suggestions for action will ordinarily depend on the content of the rules and regulations to be adopted by the SEC to effect the provisions of the Act. However, based on the Act’s current requirements, public companies should consider taking the following steps now, in light of the scope and breadth of changes to be ushered in as a result of the Act:

Avoid Potential Surprises at the 2011 Annual Meeting—The elimination of discretionary voting by brokers will undoubtedly create issues for some companies in obtaining a quorum for the annual shareholders meeting or the vote for specific proposals requiring majority or supermajority votes. The Act requires that the national securities exchanges adopt rules prohibiting exchange members from voting shares held in “street name” on the election of directors, executive compensation or any other “significant matter” as determined by the SEC by rule, unless the members have received voting instructions from the beneficial owner of the securities. Thus, it will be important to review the company’s charter and bylaws, as well as applicable state corporate law, well in advance of the meeting to determine what the quorum requirements will be for annual meetings and consult with counsel on making appropriate amendments to the charter or bylaws. In addition, companies should plan on allowing extra time between the date proxy materials are mailed and the date of the 2011 annual meeting or consider the retention of a proxy solicitor. Proxy solicitation services will likely be in high demand in 2011 as a result of the elimination of broker voting and the other shareholder proposals required by the Act. Subject to the provisions of the final rules, if a company is only electing directors, the company should also consider adding a proposal where directors have discretionary authority, such as a proposal to ratify the appointment of the company’s auditors. The addition of a proposal where discretionary voting is permitted will help the company meet its quorum requirements for the annual meeting.

Get Ready for Proxy Access—Companies should get ready now for “proxy access.” The Act provides the SEC with the authority to adopt rules permitting shareholders of a public company, under specified circumstances, to utilize the company’s proxy solicitation materials to nominate directors submitted by the shareholders.[1] The adoption by the SEC of definitive “proxy access” rules on Aug. 25 will only enhance the need for public companies to consider retaining a proxy solicitor and working with them to design an approval strategy in anticipation of shareholders proposing their director or directors and including them in the company’s proxy statement. Proxy access will add a further wrinkle to the 2011 proxy season particularly in light of the fact that the SEC has discretion in the rulemaking process to determine the eligibility requirements shareholders must meet.

Anticipate Mandatory “Say-on-Pay” Proposals and Other New Compensation Disclosures—Beginning six months after the enactment of the Act, public companies will be required to provide in their annual proxy statement, at least once every three years, a nonbinding shareholder vote approving executive compensation.[2] In addition, at the first shareholders’ meeting to which this requirement will apply, and at least once every six years thereafter, each public company must include in its proxy materials another shareholder proposal which permits shareholders to determine the frequency of the inclusion of a “say-on-pay” proposal in its proxy materials (i.e., every year, every two years, or every three years). In light of the mandatory “say-on-pay” proposals which will likely be effective for the 2011 proxy season and other new disclosures related to compensation, compensation committees will want to start to carefully consider how to address executive compensation disclosures in the company’s compensation discussion and analysis, or CD&A, or elsewhere in the proxy statement. These new requirements will likely require a careful review and likely a rewrite of last year’s CD&A. It is suggested that companies take this opportunity to streamline and clarify compensation policies for the benefit of shareholders reviewing this information. Since the vote on this proposal will likely set the stage for what will happen in future years, the presentation and content will be of critical importance this year. In addition, say-on-pay proposals will require companies with institutional shareholders to pay close attention to the voting policies of such shareholders as well as ISS (now a subsidiary of MSCI, Inc.), which advises many institutions on voting decisions.

This say-on-pay vote also will apply if the company’s shareholders are asked to vote on a merger or asset sale. In addition to the previously described say-on-pay proposals, whenever shareholders are asked to approve an acquisition, merger, consolidation or sale or other disposition of all or substantially all of a company’s assets at any shareholders’ meeting occurring six months after the enactment of the Act, the company or the person soliciting proxies must disclose in the related proxy statement or information statement any agreements or understandings concerning compensation payable to named executive officers as a result of such transaction. These arrangements are commonly referred to as “golden parachute payments.” The public company will now be required to provide shareholders with a separate nonbinding vote on such payments.[3] Disclosures regarding these arrangements must include the aggregate total of all such compensation and the conditions upon which it may be paid to, or on behalf of, an executive officer of the public company.

The Act also introduces new compensation related disclosures regarding the alignment of compensation with shareholder interests which companies should prepare for immediately. For example, disclosure of the relationship between compensation of executives and enhancing shareholder value (i.e., appreciation in the value of the company’s publicly traded equity) is now required. Shareholders will continue to pay particular attention to how successfully the company aligned executive compensation with increasing value for shareholders as well as the allocation of stock-based compensation and cash. It is anticipated that this disclosure will make executive compensation decision-making and the financial and other measures utilized to determine performance- based compensation more transparent. Companies should start early to prepare this new disclosure, and compensation committees should consider whether changes in the compensation mix are necessary. The financial crisis also focused attention on the compensation mix as contributing to the overall level of risk undertaken by executives. The Act also provides a need for compensation committees to review the interplay between risk and executive compensation and address any compensation policies or practices that encourage excessive risk-taking.

Since the Act does not require any particular method of disclosing this information, it will be important to see how the SEC decides to implement this requirement as well as what best practices develop with regard to this disclosure.

 Evaluate the Independence of Compensation Committee Members under New Criteria—The Act mandates changes to stock exchange rules to require that compensation committees consist only of independent directors.[4] “Independence” will be defined in the SEC’s adopting rules, but the Act requires that such definition take into consideration any consulting or other fees paid by the issuer to a committee member and whether the committee member is an affiliate of the issuer. Given the new requirements applicable to compensation committees under the Act, as well as the new considerations applicable to the independence determination, public companies and their boards of directors will need to consider now whether their compensation committees will meet the more stringent requirements of the Act. It should be noted that other requirements could be added by the SEC in the final rule when adopted. This review process should include an evaluation of the relationships that exist with compensation committee members based upon the new requirements articulated in the Act, as well as the other existing independence standards included in applicable stock exchange rules, § 16 of the Securities Exchange Act of 1934 (Exchange Act) and § 162(m) of the Internal Revenue Code, each of which has different standards to be satisfied for the independence of compensation committee members. If the board determines that there are not an adequate number of compensation committee members who will meet the new requirements as well as the existing requirements, it will be necessary to seek and add new board members to this critical committee. Although it may be premature to embark on the process of adding new directors prior to the adoption of the final rules on this topic, companies should have as a top priority the evaluation of the composition of this committee once these rules are released.

Reevaluate Clawback Provisions in Existing Compensation Arrangements—Public companies will now be required to adopt and disclose clawback policies requiring current and former executive officers to repay any incentive compensation (including options) received during the three-year period prior to an accounting restatement which is due to material noncompliance with financial reporting requirements, in excess of what they otherwise would have been paid. This provision significantly enhances the clawback provisions currently contained in § 304 of Sarbanes-Oxley, which provide for a one-year clawback of compensation in the event of the restatement of financial statements due to material noncompliance with the financial reporting requirements under the securities laws where the executive was engaged in misconduct which resulted in the erroneous financial statements.

The expanded clawback provisions of the Act will likely require the amendment of existing company policies and compensation arrangements. Companies should also amend plan documents and model agreements related to equity and other awards to reflect these requirements. Further, in amending these documents, companies must consider the enforcement of such policies. Review of existing clawback provisions will undoubtedly take some time to effect and may prove difficult to implement; for example, companies will need to determine how to apply the clawback to former officers. Prior to the adoption of SEC rules in this area, companies should include clawback provisions that are at least compliant with the Act in new arrangements.

Analyze the Use of Compensation Committee Consultants—The Act requires the stock exchanges to adopt rules giving compensation committees the authority to engage independent consultants and counsel at the issuer’s expense.[5] A key provision of this change is the independence of the consultant, which must include the following considerations: 

  • whether the person that employs the consultant provides other services to the public company; 
  • the amount of fees received from the public company by the person that employs the advisor and the percentage such fees represent of the person’s net total revenue; 
  • the policies and procedures of the person that employs the advisor, which are designed to prevent conflicts of interest; 
  • any business or personal relationships between the consultant and any member of the compensation committee; and 
  • any stock of the public company owned by the consultant.

Proxy statements for meetings occurring one year after enactment of the Act will have to disclose whether a compensation consultant was engaged, whether there were any conflicts of interest and how they were addressed. These new requirements will place more emphasis on independence and highlighting conflicts of interests involving compensation consultants.

These changes in the Act with respect to compensation committee consultants will require a thorough evaluation of the selection process as well as a review of existing relationships and policies related to the selection of compensation consultants. It may be necessary to develop and utilize a questionnaire for existing or new consultants so that the compensation committee can evaluate the consultants under the new requirements of the Act. Compensation committees should also consider adopting policies regarding the retention of consultants, counsel and advisors and the related procedures applicable to the retention of such advisors. In this regard, companies may need to implement policies similar to those used by audit committees with the retention of independent auditors, including preapproval policies.

Determine How to Disclose and Calculate the Median Compensation Numbers—Under the Act, public companies will now be required to disclose in annual proxy statements the relationship between executive compensation and financial performance, taking into account any change in stock value and dividends paid (which may be done in a graph), and also must disclose: (i) the median compensation of all employees (excluding the CEO); (ii) CEO compensation; and (iii) the ratio of median employee compensation to CEO compensation. This is one of the most troubling aspects of the Act, and based on anecdotal evidence it may be difficult (if not impossible) to calculate for many companies and will require the compilation of a significant amount of compensation data. Since the parameters for this disclosure rule are set forth in the law and the SEC rule cannot deviate from these parameters, this may ultimately prove to be a burdensome disclosure requirement, particularly for companies with employees outside the United States or to the extent they have a significant number of part-time employees. Many commentators hope the SEC will address or eliminate such difficulties in its final rules to the extent possible; however, it has been suggested that further amendment of this provision of the Act will need to be considered by Congress. In any event, companies will need to start now to determine how they will gather the necessary data and draft the required disclosures.

Amend the Insider Trading Policy to Address Hedging and Draft Related Proxy Statement Disclosures—Hedging activities by directors, officers and employees with respect to securities of a public company can often result in adverse effects to that company, and many companies have already implemented specific policies to address these activities. Many public companies limit or prohibit the ability of executive officers, directors and other employees to enter into hedging transactions with respect to the company’s securities, which are typically reflected in companies’ insider trading policies.[6] Under the Act, public companies will be required to disclose in their annual proxy statements whether any employee or director is permitted to purchase financial instruments that are designed to hedge or offset any decrease in the market value of the company’s securities (i) granted to the employee or director by the company as compensation or (ii) otherwise held directly or indirectly by the employee or director. For companies that do not have such policies, consideration should be given to the adoption of such policies following the issuance of disclosure rules on this topic by the SEC. In this regard, the board should consider whether these restrictions should apply only to directors and executive officers or to a broader group of employees. Additionally, consideration should be given as to whether hedging activities should be prohibited or subject to an established pre-approval policy.

Rationalize Board Management Structure—The Act requires that the SEC issue rules that require public companies to disclose in annual proxy materials the reasons why the company chose to have: (i) the same person serve as Chairman of the Board of Directors and CEO; or (ii) different individuals serve as Chairman of the Board of Directors and CEO.[7]

In 2009, the SEC promulgated substantially similar disclosure requirements related to board and company leadership[8] and many companies, whether through the disclosure or as part of adopting good governance practices, have already addressed this issue. Many companies have separated these two positions or have elected a lead director, as such reforms have long been considered best practices in corporate governance.

While the Act’s new requirements seem to mirror the substance of the existing SEC disclosure requirements on this topic, the SEC may adopt rules to require additional disclosures in this regard. Thus, companies should consider undertaking a review of the board leadership structure currently utilized and be prepared for further rulemaking on this subject. Companies with a combined chairman and CEO position will undoubtedly want to reassess the reasons for combining these roles and be prepared to disclose them in the proxy statement.

Review and Revise Key Corporate Governance Documents—As a result of the adoption of new whistleblower protections and other corporate governance changes in the Act, companies should begin to review and revise their whistleblower policies and procedures as well as other key corporate governance documents, such as the code of conduct and committee charters. At a minimum, existing whistleblower policies must be revised to include employees of the public company’s subsidiaries and affiliates whose financial information is included in the company’s consolidated financial statements (if such employees are not included already) to match the Act’s extension of the federal whistleblower protection provided by Sarbanes-Oxley. Under the Act, public companies, including their consolidated subsidiaries or affiliates, may not discharge, demote, suspend, threaten or otherwise discriminate against, a whistleblower covered by the Act.

Further, the adoption of the Act presents a good opportunity to review policies and procedures dealing with, among other things, conflicts of interest, compliance with applicable ethics rules, and compliance with applicable laws related thereto, such as the Foreign Corrupt Practices Act. Given the bounty that the SEC is now permitted to pay whistleblowers, companies may see an increase in whistleblower-type complaints, which will heighten the need to have effective policies and procedures in place to address these issues.

Take Action with Respect to New Swap Approval Requirements—The Act’s new swap approval provisions will require a company’s board of directors to designate a committee to review and approve swap transactions. Specifically, the Act requires that the appropriate committee of any public company that engages in derivative activities approve the decision to enter into covered “swap transactions” that rely upon commercial “end-user” exemptions from the new clearing requirements in the Exchange Act and the Commodity Exchange Act. The approval provision was effective upon enactment of the Act. This committee should also consider whether appropriate amendments to its charter will also be necessary. Finally, consideration should be given to the adoption of additional procedures to aid in the company’s compliance with the new requirements under the Act applicable to swap transactions.

Consider Establishing a Risk Committee—The Act requires nonbank financial companies and certain bank holding companies to establish risk committees, which will undoubtedly affect best practices in this area for these, and perhaps all, public companies. Under the Act, the Federal Reserve Board (FRB) must require publicly traded nonbank financial companies that it regulates, publicly-traded bank holding companies with assets in excess of $10 billion, and possibly smaller bank holding companies, to establish a risk committee responsible for the oversight of enterprise-wide risk. The committee must include such number of independent directors as the FRB determines appropriate (based on the nature of operations, size of assets, etc.), and at least one risk management expert.

Given the recent focus on risk-related issues particularly in light of the financial crisis, boards of public companies not subject to these requirements may want to consider establishing a risk committee having responsibility for the oversight of company-wide risk management practices. Risk committees should also consider the merits of including a “risk management expert” as will be required for nonbank financial companies and certain bank holding companies, depending upon the complexity of organization and the type and level of exposure to various elements of risk.

Educate the Board and Committees on the Act’s New Requirements—Given the myriad of changes required by the Act, it will be necessary to educate the board of directors and affected committees regarding the Act’s requirements as well as the changes impacting the board and specific committees. For example, the swap transaction approval obligations of the Act will also require the implementation of a new approval process for those transactions as well as the education of the Board and appropriate committees regarding the new approval requirements applicable to swap transactions.

Develop, Test and Implement Internal Controls to Demonstrate Compliance with the Act—In light of the numerous changes required by the Act, many of which will be implemented over a period of several years, it will be necessary for public companies to further develop, test and implement the appropriate internal controls and procedures to ensure compliance with the Act’s requirements on a timely basis. Of course, understanding what new control structures are needed will require a certain degree of flexibility given the manner in which the Act’s requirements are scheduled to be implemented. As has become accepted practice under Sarbanes-Oxley, compliance with the Act should be evidenced by reasonable documentation and support, which should be retained by the public company.

Reassess Filing Status for Purposes of Compliance with Section 404 Requirements—The Act provides relief for nonaccelerated filers[9] from §404(b) of the Sarbanes-Oxley Act, which requires a public company’s independent public accountants to attest to management’s assessment of the effectiveness of the company’s internal controls. Under the Act, each company that is not an accelerated filer will be exempt from the requirement to provide such an auditor attestation report in the company’s Form 10-K. Companies that may qualify as nonaccelerated filers should quickly assess this status as provided under existing SEC rules as it will affect whether an auditor’s attestation to management’s assessment of the company’s internal controls will be required.

Conclusion
The lesson learned from the passage of the Sarbanes-Oxley Act is that it is never too early to start digesting and considering the implementation ramifications of sweeping, reform-minded laws. The Dodd-Frank Act, at over 2,300 pages in length, is no exception to this rule. Given the myriad of changes required by the Act, companies must be ready to spring into action and address the reforms ushered in by the passage of the Act. While for some, there may be a delay until the SEC adopts rules which may not be final until late December 2010 or early January 2011, companies should commence the process now by starting to digest and understand the law. The next step would be to educate its board, relevant committees and other persons (such as the corporate secretary staff) about the changes reflected in the Act from a disclosure perspective as well as in policies and procedures. Finally, public companies and their relevant constituents should begin to consider what changes to disclosure, documentation and policies they should expect to implement no later than the beginning of next year.
While many of the precise rule formulations are not yet known and may not be for some time, if Sarbanes-Oxley was any indication, public companies will be busily engaged with implementation of the requirements of the Dodd-Frank Act over the next 12 months and beyond.

Notes
[1] See, generally, Section 971 of the Act.
[2] See, generally, Section 951 of the Act.
[3] This separate approval of the golden parachute payment is not applicable if the golden parachute payment was previously the subject of a prior “say-on-pay” vote.
[4] Generally does not apply to controlled companies or foreign private issuers.
[5] Generally does not apply to controlled companies.
[6] Certain hedging transactions are prohibited by Section 16(c) of the Exchange Act.
[7] See, generally, Section 972 of the Act.
[8] Proxy Disclosure Enhancements, Release No. 33- 9089, 74 FR 68,334 (Dec. 23, 2009), codified in Item 407(h) of Regulation S-K.
[9] A nonaccelerated filer generally is a defined to be a company with less than $75.0 million of worldwide public float held by nonaffiliates on the last business day of the second fiscal quarter of the company’s fiscal year.

Reprinted from the Wall Street Lawyer.  Copyright © 2010 Thomson Reuters/West.  For more information about this publication please visit www.west.thomson.com.