The Financial Reform Act and Executive Pay

Joseph Bachelder is founder and senior partner of the Bachelder Law Firm. This post is based on an article by Mr. Bachelder that first appeared in the New York Law Journal. Additional posts relating to the Dodd-Frank Act are available here.

The House and Senate conferees on H.R. 4173, the Restoring American Financial Stability Act of 2010 (RAFSA), have been reviewing and reconciling differences between the House and Senate versions of RAFSA since early June. [1] The conference is based on the Senate version passed May 20. RAFSA covers, among other things, a broad range of issues relating to the financial industry as well as issues relating to publicly traded companies not limited to the financial industry. Within this broad range are, among others, issues concerning so-called systemic risk for our financial system, regulatory supervision, derivatives, hedging, consumer protections, credit rating agencies, corporate governance and executive compensation.

The following discussion is limited to the executive compensation provisions in RAFSA Title IX, Subtitle E. Since passage is expected to be based largely on the Senate version, the following discussion is based on that version (references at the beginning of each part are to the Senate version).

At the time the column was submitted, changes to the Senate version of the bill were being proposed by the House and were in active debate. A later column will note substantive changes in the legislation that passes from those provisions noted in today’s column.

Say on Pay (Section 951). The Senate version would require publicly traded companies to provide their shareholders, in connection with the annual meeting, the right to a nonbinding vote on “the compensation of executives” of the company. [2]

Say on Pay has been developing gradually as a corporate governance practice for a number of years. [3] Excluding those companies required by TARP to provide shareholders with Say on Pay, approximately 80 companies had adopted some form of Say on Pay as of June 4, 2010. Approximately 650 companies were required to adopt Say on Pay as TARP recipients. Very few of the companies providing Say on Pay have had a shareholder vote in which a majority of shareholders voted against the issuer’s executive compensation practices. [4]

Comment. If enacted, the Senate version of RAFSA would require that a Say on Pay resolution be included in any proxy statement filed for a meeting for which compensation disclosure is required occurring “after the end of the 6-month period beginning on the date of enactment of this section.” The Say on Pay provisions reflect a continuing expansion in the role of the Federal government in executive compensation matters. [5]

Independence of Compensation Committees (Section 952). The Senate version would require that in evaluating independence of committee members the national securities exchanges (and national securities associations) consider (i) sources of compensation of each member and (ii) whether any member is “affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer.” [6] These new provisions, if enacted, will expand the attention required of the compensation committee (and, presumably, of the Board and the management of the issuer as well) to the independence of each committee member. [7]

Independence of Advisers, including Consultants and Legal Counsel, to the Compensation Committee (Section 952). The Securities and Exchange Commission (SEC) is directed to prescribe criteria to be considered in determining independence of an adviser to the compensation committee, including provision of services to the issuer and the amount of fees paid by the issuer to the adviser (or the adviser’s employer), policies of the adviser (or the adviser’s employer) that are designed to prevent conflicts of interest, business or personal relationships between compensation committee members and the adviser and stock of the issuer owned by the adviser.

RAFSA (as provided in the Senate version) also would provide as follows:

  • (i) Hiring of Adviser. The committee must be directly responsible for the hiring of an adviser. The statute also requires the committee to exercise its own judgment and take action as it decides appropriate, independently of the advice received by the committee from the adviser.
  • (ii) Funding. Issuers must provide appropriate funding for the compensation of the advisers selected by the compensation committee.

The above provisions regarding independence, hiring and compensating of advisers go substantially beyond the current SEC proxy statement disclosure requirements. [8]

Comment. No later than 360 days after the new law’s enactment, the SEC must direct exchanges to de-list any issuer not in compliance with the provisions as to independence of compensation committees and provisions as to hiring and funding costs of advisers to the committee contained in §952 (new §10C of the Securities Exchange Act of 1934 (Exchange Act)).

The proposed changes will impact on the attention given by compensation committees to the independence of each member (an evaluation frequently not a clear-cut issue) and to the independence of those they select as their advisers. As just one example, compensation committees historically have accepted recommendations of management (e.g., a head of human resources or general counsel) in selecting their advisers notwithstanding that these advisers may be performing other services (often very substantial services) for the company.

Two New Disclosure Requirements (Section 953).

(a) Pay versus Financial Performance. The SEC is directed to issue rules requiring disclosure in the proxy statement of the relationship between executive compensation required to be disclosed under Item 402 and financial performance of the company. Financial performance, as described in the Senate version, takes into account “any change in the value of the shares of stock and dividends of the issuer and any distributions.” The bill provides that an issuer “may include a graphic representation of the information required to be disclosed.”

Comment. This new rule would apply to all proxy statements requiring compensation disclosure. The effect of this new rule would be to emphasize the correlation or lack of correlation between changes in Summary Compensation Table pay and in financial performance for the fiscal year being reported.

Due to the nature of compensation (a mix of short and long-term, fixed and incentive) and the unpredictable behavior of the stock market (often independently of company operating performance in a given year), the meaningfulness of such a disclosure is at least subject to question and, at worst, (a) it may result in unreasonable media criticism of executive compensation in a year in which short-term stock performance is not good and (b) it may inhibit compensation committees in awarding outstanding executive performance in a given year. Also, as noted, it will tend to focus shareholders’ attention on short-term rather than long-term financial performance.

(b) Ratio of CEO Total Pay to Median Total Pay of All Other Employees. This proposal would require disclosure in one place of (i) the total pay for the CEO as shown in the Summary Compensation Table, (ii) the median total pay, similarly determined, for all employees except the CEO and (iii) the ratio of (i) to (ii).

Comment. This new rule would “require each issuer to disclose in any filing of the issuer described in §229.10(a) of title 17, Code of Federal Regulations” the information described above as to CEO total pay and median total pay of all employees except the CEO. For most major U.S. corporations, this new rule would mean assembling compensation information on employees not only in the U.S. but in foreign countries as well (for the very largest, it would mean many thousands of employees spread over dozens of countries).

It would pose substantial difficulties in assembling data and it could be very distorting. For example, a CEO can have a year (for example, a first year of employment or a year in which a one-time award is made) that is not representative of the ongoing CEO pay relationship with other employees’ pay at the issuer.

Also, pay levels in foreign countries often are affected by cost-of-living differences, frequently changing exchange rates, etc. A further problem for employers likely will be that many employees will find themselves in an “unhappy” situation (that is, the discovery by the particular employee of his or her pay in relationship to the median for all employees).

Clawbacks (Section 954). This provision would apply to any issuer listed on a national securities exchange (or with a national securities association). It would require, among other things, that if such an issuer is required to restate its financial statements due to a “material noncompliance of the issuer with any financial reporting requirement under the securities laws,” then any executive officer (current or former) of such an issuer would have to repay any “excess” compensation the executive received “during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on the erroneous data….” [9] The amount required to be repaid would be the excess of the incentive compensation received by such executive over what the executive would have received if the financial statements had been correctly stated.

Comment. Clawback under RAFSA is limited to that portion attributable to the financial misstatement, but it could be very difficult in some cases to determine the portions of incentive awards that are affected by the financial misstatement versus those that are not.

Section 304 of Sarbanes-Oxley provides a clawback provision applicable to the CEO and the CFO. Such clawback is applicable only if such misstatement was “as a result of misconduct.” (It is not entirely clear whether, under Sarbanes-Oxley, the misconduct involved must be ascribed to the CEO or CFO in question. [10])

Disclosure of Hedging Activities (Section 955). This section of the proposed law would require disclosure in the proxy statement of the issuer’s policy regarding hedging by employees or directors. For this purpose, hedging includes financial arrangements such as short sales, equity swaps and other derivative arrangements intended to protect the investor from market price changes affecting the equity securities held by such person (i.e., an employee or director of the issuer). [11]

Additional Regulations regarding Compensation of Employees at Bank Holding Companies (Section 956). The proposed legislation would prohibit payment to any “executive officer, employee, director, or principal shareholder” of a bank holding company of (i) “excessive compensation, fees, or benefits” or (ii) compensation that “could lead to material financial loss to the bank holding company.” [12] The proposed new rule would require the Federal Reserve Board of Governors, in establishing standards for compensation plans at bank holding companies, to take into account compensation standards as described in §39(c) of the Federal Deposit Insurance Act (FDIA) as well as the views and recommendations of the Comptroller of the Currency and the Federal Deposit Insurance Corporation (FDIC). [13]

Comment. As noted above, the proposed rule would apply to an “executive officer, employee, director, or principal shareholder” of a bank holding company. The bill does not elaborate on the meaning of “excessive compensation,” as described in §39(c) of the FDIA. Section 39(c), which applies to “insured depository institutions,” [14] requires that “each appropriate Federal banking agency” prescribe, among other things, the compensation standards that will prohibit an “executive officer, employee, director, or principal shareholder” of a bank holding company from receiving “excessive compensation, fees or benefits.” Section 39(c) sets out factors to be taken into account in determining whether the compensation is “excessive.” [15]

A compensation committee of a banking organization that is subject, in part, to the Final Guidance on Sound Incentive Compensation Policies issued on June 21 jointly by the Federal Reserve, the FDIC, the Office of the Comptroller of the Currency and the Office of Thrift Supervision (Final Guidance) and, now, the new rule prescribed under RAFSA (that is, the amendment of the Bank Holding Company Act) may be faced with more than one definition of appropriate compensation for purposes of compliance with the various applicable statutes and regulations as just noted.

It may comply as to compensation requirements for purposes of TARP (if applicable) and even for purposes of the Final Guidance but not for purposes of the proposed new rule under RAFSA §956 if it is a bank holding company. (See discussion in footnote 13 with regard to current efforts of the House/Senate conferees on RAFSA to mitigate this confusion.)

Broker Voting (Section 957). Under this proposal, brokers would not be allowed discretionary proxy authority without specific designation by the beneficial owner of the securities involved. Presumably this restriction will cover Say on Pay votes as well as binding votes on the authorization of executive pay plans.


[1] The House of Representatives passed H.R. 4173 on Dec. 11, 2009. On May 20, 2010, the Senate, having passed its own version (S. 3217), re-designated its version H.R. 4173. This procedure provided the House and Senate conferees the Senate version as the basis for discussions. There are numerous differences between the House-passed and Senate-passed versions, including differences in the executive compensation provisions and many of these are the subject of the debate going on in the conference as this column was being written.
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[2] The bill applies to “any proxy or consent or authorization for an annual or other meeting of shareholders…for which the proxy solicitation rules of the [SEC] require compensation disclosure….” Proposed §14A of the Exchange Act as added by §951 of RAFSA. While the bill does not define “the compensation of executives,” it does refer to such compensation “as disclosed pursuant to §229.402 of title 17, Code of Federal Regulations.” The term also is used in the American Recovery and Reinvestment Act of 2009 (ARRA), which references “the compensation disclosure rules of the [SEC].”
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[3] For previous discussion on Say on Pay developments, see this column (NYLJ, June 19, 2009 and Aug. 26, 2009).
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[4] Motorola and Occidental failed in 2010 in connection with their annual meetings to achieve a majority vote in support of the company’s executive compensation program (approximately 46 percent approval in the case of Motorola and approximately 46 percent approval in the case of Occidental); in one case under TARP, KeyCorp, there also was a failure in 2010 in connection with its annual meeting to obtain a majority approval (approximately 43 percent voted approval).
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[5] See this column (NYLJ, March 22, 2010).
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[6] Rule 12b-2 adopted by the SEC under the Exchange Act defines “affiliate” as follows: “An ‘affiliate’ of, or a person ‘affiliated’ with, a specified person, is a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the person specified.” 17 C.F.R. 240.12b-2.
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[7] Current SEC rules regarding the independence of compensation committee members are contained in Item 407(a) of Regulation S-K (17 C.F.R. 229.407(a)). For NYSE rules regarding compensation committee independence, see Rule 303A.05 of the NYSE Listed Company Manual.
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[8] Current SEC rules regarding the circumstances under which the consultant’s fees must be disclosed as well as requirements for description of the compensation consultant’s role in advising as to compensation are contained in Item 407(e)(3)(iii) of Regulation S-K (17 C.F.R. 229.407(e)(3)(iii)). For NYSE statement in this respect, see Commentary to §303A.05 of the NYSE Listed Company Manual.
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[9] For definition of “executive officer,” see Rule 3b-7 adopted by the SEC under the Exchange Act (17 C.F.R. 240.3b-7).
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[10] In certain other respects as well, §304 of Sarbanes-Oxley is less harsh on executives than the proposed §954 of RAFSA: §304 only applies during the 12- month period following the filing in question and is limited to the CEO and CFO. (On the other hand, §304 claws back, in addition to any bonus (or other incentive based or equity based compensation) received during such 12-month period, “any profits realized from the sale of securities of the issuer during that 12-month period.”)
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[11] There is an ambiguity in RAFSA’s addition of proposed §14(j)(1)-(2) as to whether the equity securities referred to are limited to equity securities of the issuer. Presumably, the ambiguity will be cleared up in the final version if §955 of RAFSA is enacted. For existing restrictions on insiders’ short-swing trading, see §16(b) of the Exchange Act. In addition to §16(b), there are restrictions on insider trading under §10(b) of the Exchange Act. Securities transactions, including hedging transactions, are subject to reporting requirements with the SEC, including Form 4 reporting. In addition to the SEC requirements, many companies have their own policies with regard to employee and director hedging.
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[12] The definition of “bank holding company” is contained in §2(a)(1) of the Bank Holding Company Act (12 U.S.C. 1841(a)), which provides a “‘bank holding company’ means any company which has control over any bank or over any company that is or becomes a bank holding company by virtue of this Act.” Further explanation on the definition is contained in §2(a)(2)-(6) of the Act.
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[13] At the time the column was written, a proposal was under consideration by the House/Senate conferees that would direct that the applicable regulatory agencies such as the Federal Reserve, the FDIC and the Comptroller of the Currency coordinate in producing consistent regulations regarding executive compensation for financial institutions.
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[14] An “insured depository institution” is defined in §3(c)(2)-(3) of FDIA (12 U.S.C. 1813(c)(2)-(3)). Generally speaking, it means “any bank or savings association the deposits of which are insured by the Corporation pursuant to this Act.” The supervising agencies, each an “appropriate Federal banking agency,” as noted in the text, include the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the FDIC and the Director of the Office of Thrift Supervision.
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[15] The “excessive compensation” provisions of FDIA §39(c) were added by legislation enacted in 1991. “Excessive compensation” does not appear in the terminology used in ARRA or in the Final Guidance regarding incentive compensation issued June 21, as noted in the text, by several Federal banking regulatory agencies. TARP refers to compensation that encourages “excessive risk” (much like the second part of the provision, quoted above, in §956) and the Final Guidance refers to compensation that encourages “imprudent risk” but neither on of them refers to “excessive compensation.” It should be noted, however, that in reviewing compensation of top executives at those institutions that are subject, under TARP, to direct supervision of their compensation levels (i.e., salaries, bonuses and long-term incentives), the Special Master for TARP Executive Compensation, as part of his approval authority, has forced a reduction in the compensation levels of such executives from the compensation levels that had been put into effect, or were proposed to be put into effect, by those institutions.
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  1. […] The Financial Reform Act and Executive Pay — The Harvard Law … […]

  2. By Shaming Corporate Cheapskates | Dirt Diggers Digest on Thursday, July 15, 2010 at 10:41 pm

    […] Section 953 of the Dodd-Frank bill deals with disclosures relating to executive compensation, not only at banks but at all publicly traded companies. One of the ways it seeks to rein in out-of-control CEO pay is by requiring firms to reveal how the amount paid to the head of the company compares to that received by the typical employee. The theory is that having this information made public would give pause to grasping CEOs and soft-touch board compensation committees. […]