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Say-on-Pay and Frequency of Say-on-Pay Votes

Approval of Say-on-Pay and Frequency of Say-on-Pay Resolutions

Under new Rule 14a-21(a), a public company is required, not less frequently than once every three calendar years, to provide for a separate shareholder advisory vote to approve the compensation of its named executive officers, as disclosed pursuant to Item 402 of Regulation S-K, including the Compensation Discussion and Analysis ("CD&A"), compensation tables and narrative discussion3.

The final SEC rule does not require companies to use any specific language or form of resolution to be voted on by shareholders. The resolution should indicate that the shareholder advisory vote is to approve the compensation of the company's named executive officers as disclosed pursuant to Item 402 of Regulation S-K. A vote to approve a proposal on a different subject matter, such as a vote to approve only compensation policies and procedures, would not satisfy this requirement. The instruction to Rule 14a-21(a) provides the following non-exclusive example of a resolution that would satisfy Rule 14a-21(a):

RESOLVED, that the compensation paid to the company's named executive officers, as disclosed pursuant to Item 402 of Regulation S-K, including the Compensation Discussion and Analysis, compensation tables and narrative discussion, is hereby APPROVED.4
The compensation of directors is not subject to the shareholder advisory vote. In addition, if a company includes disclosure about its compensation policies and practices as they relate to risk management and risk-taking incentives, these policies and practices will not be subject to the shareholder advisory vote. However, to the extent that risk considerations are a material aspect of the public company's compensation policies or decisions for its named executive officers, then the public company is required to discuss these policies in its CD&A. If this is the case, such disclosure would be considered by shareholders when voting on executive compensation. Finally, in addition to the required say-on-pay and frequency of say-on-pay votes, companies may solicit shareholder votes on a range of compensation matters to obtain more specific feedback on the company's compensation policies and programs.

In addition, under new Rule 14a-21(b), public companies are required, not less frequently than once every six calendar years, to include a separate resolution, subject to shareholder advisory vote, to determine whether the shareholder vote on the compensation of the company's executives should occur every 1, 2, or 3 years. The separate shareholder vote on executive compensation and frequency of say-on-pay votes are required only when proxies are solicited for an annual or other meeting of security holders at which directors will be elected and for which the SEC rules require the disclosure of executive compensation pursuant to Item 402 of Regulation S-K.

Public companies are required to disclose in a proxy statement for an annual meeting (or other meeting of shareholders at which directors will be elected and for which the SEC rules require executive compensation disclosure) that they are providing a separate shareholder say-on-pay and the frequency of say-on-pay votes pursuant to the Dodd-Frank Act and to briefly explain the general effect of the vote, such as whether the vote is non-binding. Companies should also provide disclosure of the current frequency of say-on-pay votes and when the next scheduled say-on-pay vote will occur in their proxy materials. Public companies are not expected to disclose either the current frequency or when the next scheduled say-on-pay vote will occur in proxy materials for the meeting where a company initially conducts the say-on-pay and frequency votes.

The SEC rules also provide requirements as to the form of proxy that public companies are required to include with their proxy materials with respect to the frequency vote. The amended rules require proxy cards to reflect the choice of 1, 2, or 3 years (or every year, every other year or every three years), or abstain, for the frequency of say-on-pay vote.

Amendments to Compensation Discussion and Analysis Requirements

The SEC amended the CD&A requirements to clarify that one of mandatory principles-based topics to be discussed in the CD&A should be the company's consideration of the most recent say-on-pay vote. Such mandatory topic should focus on whether, and if so, how the public company has considered the results of the most recent say-on-pay vote in determining compensation policies and decisions, and how that consideration has affected the company's executive compensation policies and decisions. Public companies should address their consideration of the results of earlier say-on-pay votes to the extent such consideration is material to the company's compensation policies and decisions discussed.

Smaller reporting companies are subject to scaled disclosure requirements in Item 402 of Regulation S-K and are not required to include a CD&A. Smaller reporting companies are required to provide a narrative description of any material factors necessary to an understanding of the information disclosed in the Summary Compensation Table. If the consideration of prior say-on-pay votes is such a factor for a particular public company, disclosure of this fact would be required in the narrative description accompanying the Summary Compensation Table.

Shareholder Proposals

Rule 14a-8(i)(10) permits a public company to exclude a shareholder's proposal if the company has already substantially implemented the proposal. Under certain conditions, a public company may exclude subsequent shareholder proposals that seek a vote on the same matters as the shareholder advisory votes on say-on-pay and frequency of say-on-pay. The SEC added a note to Rule 14a-8(i)(10) to permit the exclusion of a shareholder proposal that would provide a say-on-pay vote, seeks future say-on-pay votes, or relates to the frequency of say-on-pay votes if, in the most recent shareholder vote on frequency of say-on-pay votes, a single frequency (i.e., one, two or three years) received the support of a majority of the votes cast5 on the matter and the company adopted a policy on the frequency of say-on-pay votes that is consistent with the shareholders' choice. For example, if in the first vote under Rule 14a-21(b) a majority of votes were cast for a two-year frequency for future shareholder votes on executive compensation, and the public company adopts a policy to hold the vote every two years, a shareholder proposal seeking a different frequency could be excluded so long as the company seeks votes on executive compensation every two years.

A shareholder proposal that would provide an advisory vote or seek future advisory votes on executive compensation with substantially the same scope as the say-on-pay vote should also be subject to exclusion if the company adopts a policy that is consistent with the majority of votes cast. Like additional frequency votes, the note to Rule 14a-8(i)(10) conditions exclusion on the public company implementing the frequency favored by a majority of shareholders.

Amendment to Form 8-K

Item 5.07 of Form 8-K currently requires a public company to disclose the results of its shareholders' meeting and to indicate the number of votes cast for, against, or withheld, as well as the number of abstentions and broker non-votes as to each matter on which shareholders voted at the meeting. Under the amended Item 5.07, with respect to the vote on the frequency of say-on-pay votes, the company is required to disclose the number of votes cast for each of 1 year, 2 years, and 3 years options, as well as the number of abstentions.

Amended Item 5.07 of Form 8-K also requires each public company to disclose its decision regarding how frequently it will conduct shareholder advisory votes on executive compensation. To comply with this new requirement related to the Board's decision regarding the frequency of the shareholder vote on executive compensation, a public company will have to file an amendment to its prior Form 8-K filing under Item 5.07 that disclosed the results of the shareholder vote on frequency no later than 150 calendar days after the date of the end of the annual or other meeting at which such vote took place, but in no event later than 60 calendar days prior to the deadline for the submission of shareholder proposals under Rule 14a-8 for the coming annual meeting.

Item 5.07 is not among the list of items subject to the safe harbor from liability under the Exchange Act. Companies that fail to file a timely report required by Item 5.07 will lose their eligibility to file Form S-3 registration statements.

Filing a Preliminary Proxy Statement for Say-on-Pay and Frequency Votes is Not Required

The SEC amended its rules to exclude shareholder votes to approve executive compensation and the frequency of shareholder votes on executive compensation, from the preliminary proxy statement filing requirement.

Approval and Disclosure of Golden Parachute Arrangements

Approval of Golden Parachute Arrangements

The SEC adopted new Rule 14a-21(c), pursuant to which a public company is required to include a separate resolution, subject to shareholder advisory vote, in a proxy statement for a meeting at which shareholders are asked to approve an acquisition, merger, consolidation, or proposed sale or other disposition of all or substantially all assets of the company, to approve any agreements or understandings and compensation disclosed pursuant to Item 402(t) of Regulation S-K (referred to as golden parachute arrangements). Any agreements or understandings between an acquiring company and the named executive officers of the registrant, where the registrant is not the acquiring company, are not required to be subject to the separate shareholder advisory vote.

Generally, the disclosure of golden parachute arrangements under Item 402(t) is not required to be included in annual meeting proxy statements. However, some public companies may choose to include this information because such companies will not be required to include in the merger proxy a separate shareholder vote on the golden parachute compensation if the same golden parachute compensation was included in the executive compensation disclosure that was subject to a prior say-on-pay vote.6

New golden parachute arrangements and any revisions to golden parachute arrangements that were subject to a prior say-on-pay vote require a separate merger proxy shareholder vote.7 However, changes that result only in a reduction in value of the total compensation payable would not require a new shareholder vote. Examples of changes requiring a new vote include: changes in compensation because of a new named executive officer, additional grants of equity compensation in the ordinary course, and increases in salary.

Companies providing for a shareholder vote on new arrangements or revised terms will need to provide two separate tables in merger proxy statements. One table will disclose all golden parachute compensation, including both arrangements and amounts previously disclosed and the new arrangements or revised terms. The second table will disclose only the new arrangements or revised terms subject to the vote, so that shareholders can clearly see what is subject to the shareholder vote. Similarly, in cases where Item 402(t) requires disclosure of arrangements between an acquiring company and the named executive officers of the soliciting target company, companies will need to clarify whether these agreements are included in the shareholder advisory vote by providing a separate table of all agreements and understandings subject to the shareholder advisory vote, if different from the full scope of golden parachute arrangements disclosed under Item 402(t).

Disclosure of Golden Parachute Arrangements

The SEC adopted the new Item 402(t) of Regulation S-K to require disclosure of named executive officers' golden parachute arrangements in both tabular and narrative formats. The required table is included as Exhibit A hereto. In the event uncertainties exist as to the provision of payments and benefits, or the amounts involved, a public company is required to make a reasonable estimate applicable to the payment or benefit and disclose material assumptions underlying such estimate in its disclosure. Item 402(t) does not permit the disclosure of an estimated range of payments.

The tabular disclosure required by Item 402(t) requires quantification with respect to any agreements or understandings, whether written or unwritten, between each named executive officer and the acquiring company or the target company, concerning any type of compensation, whether present, deferred or contingent, that is based on or otherwise relates to an acquisition, merger, consolidation, sale or other disposition of all or substantially all assets.

Item 402(t) also requires companies to describe any material conditions or obligations applicable to the receipt of payment, including but not limited to non-compete, non-solicitation, non-disparagement or confidentiality agreements, their duration, and provisions regarding waiver or breach. Public companies are also required to provide a description of the specific circumstances that would trigger payment, whether the payments would be lump sum, or annual, and their duration, and by whom the payments would be provided, and any material factors regarding each agreement. Such material factors would include, provisions regarding modifications of outstanding options to extend the vesting period or the post-termination exercise period, or to lower the exercise price.

Item 402(t) does not require disclosure or quantification of previously vested equity awards because these award amounts are vested without regard to the transaction. Also, the SEC rules do not require tabular disclosure and quantification of compensation from bona fide post-transaction employment agreements to be entered into in connection with the merger or acquisition transaction. However, information regarding such future employment agreements is subject to disclosure pursuant to Item 5 of Schedule 14A to the extent that such agreements constitute a "substantial interest" in the matter to be acted upon.

A public company may choose to include the disclosure in the annual meeting proxy statement to qualify for the exception from the separate merger proxy vote. If the golden parachute disclosure is included in an annual meeting proxy statement, the price per share amount will be calculated based on the closing market price per share of the company's securities on the last business day of the public company's last completed fiscal year. In a proxy statement soliciting shareholder approval of a merger or similar transaction, the tabular quantification of dollar amounts based on the company's stock price will be based on the consideration per share, if such value is a fixed dollar amount, or otherwise on the average closing price per share over the first five business days following the first public announcement of the transaction.

In addition, a company seeking to satisfy the exception from the separate merger proxy shareholder vote by including Item 402(t) disclosure in an annual meeting proxy statement soliciting the say-on-pay vote will be able to satisfy Item 402(j) disclosure requirements8 with respect to a change-in-control of the public company by providing the disclosure required by Item 402(t). The public company must still include in its annual meeting proxy statement disclosure in accordance with Item 402(j) about payments that may be made to the named executive officers upon termination of employment.

EXHIBIT A: Golden Parachute Compensation

1. See SEC Release No. 34-63768, Shareholder Approval of Executive Compensation and Golden Parachute Compensation (Jan. 25, 2011) at http://www.sec.gov/rules/final.shtml and SEC Compliance and Disclosure Interpretations dated February 11, 2011 at http://www.sec.gov/divisions/corpfin/cfguidance.shtml.
2. A smaller reporting company is generally a company that had a public float of less than $75 million as of the last business day of its most recently completed second fiscal quarter.
3. Smaller reporting companies are not required to provide a CD&A in order to comply with this requirement. Smaller reporting companies may include supplemental disclosure to facilitate an understanding of their compensation arrangements in connection with say-on-pay vote.
4. The SEC has provided guidance that the following plain English version of the resolution is also permissible:   RESOLVED, that the compensation paid to the company's named executive officers, pursuant to the compensation disclosure rules of the Securities and Exchange Commission, including the compensation discussion and analysis, the compensation tables and any related material disclosed in the proxy statement, is hereby APPROVED.
5. In light of the nature of the vote—with three substantive choices—it is possible that no single choice will receive a majority of votes and that, as a result, there may be companies that may not be able to exclude subsequent shareholder proposals regarding say-on-pay matters even if they adopt a policy on frequency that is consistent with plurality of votes cast. In addition, for the purposes of this analysis, an abstention would not count as a vote cast. This voting standard applies only to determine whether the exclusion of the proposal is appropriate under Rule 14a-8(i)(10) and not to determine whether a particular voting frequency was adopted pursuant to state law.
6. The exception will be available only to the extent the same golden parachute arrangements previously subject to an annual meeting shareholder vote remain in effect, and the terms of those arrangements have not been modified subsequent to the say-on-pay shareholder vote.
7. If the disclosure pursuant to Item 402(t) has been updated to change only the value of the items in the Golden Parachute Compensation Table to reflect price movements in the company's securities, no new shareholder advisory vote will be required. Any change that would result in an IRC Section 280G tax gross-up becoming payable would be viewed as a change in terms triggering such separate vote, even if such tax gross-up becomes payable only because of an increase in the company's share price.
8. Item 402(j) requires this disclosure of potential payments upon termination of executive's employment or change-in-control of the company.

In most instances, the foregoing regulatory requirements, which are discussed in greater detail below, require additional rule making by the SEC or the national securities exchanges to fully implement these changes.

The Act imposes enhanced regulation on the derivatives market, and the participants in this market, including public companies and requires approval of the appropriate committee for derivative activities will be required. The Act also provides for additional changes impacting public companies, including new benefits for whistleblowers, expanded liability for securities violations, increased restrictions on short sales, relief for non-accelerated filers and smaller reporting companies from obtaining auditor attestation of internal controls, disclosure of votes by institutional managers, requirements related to credit rating agencies and committee approval for derivative activities.

This post highlights certain of the more significant changes resulting from the new legislation generally applicable to public companies. These changes will impact disclosure and other requirements, many of which will be applicable for the 2011 proxy season. This post does not cover changes in banking law, hedge fund requirements and requirements applicable to derivatives and credit unions affected by the Act that may indirectly impact public companies. Changes to SEC Regulation D which impact private offerings of securities by public companies are discussed in more detail in our previous post on July 26.

Regulatory Changes Impacting Proxy Statement Disclosures and the Annual Meeting Process

Say-on-Pay and Golden Parachute Proposals. 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 non-binding shareholder vote approving executive compensation. The non-binding shareholder vote on this proposal, which has been called a “say-on-pay” proposal, does not override board decisions in this regard, does not create or imply any change to fiduciary duties of the board of directors, and will not preclude shareholder compensation proposals1. In addition, at the first shareholders’ meeting to which this requirement will apply, each public company must include another shareholder proposal in its proxy materials 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). Companies must also provide a vote, at least every six years, on whether the “say-on-pay” vote will occur every one, two or three years.

In addition to the say-on-pay proposal, 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 a 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, referred to as a “golden parachute payment,” and shareholders will have a separate non-binding vote to approve such payments2. The disclosure 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. Similar to the “say-on-pay” proposal previously described, the results of this vote do not override board action or affect the board’s fiduciary duties under state law.

New Compensation Committee Requirements. Within 360 days of enactment of the Act, the SEC is required to instruct the exchanges to adopt rules that, in effect, mandate that compensation committees consist only of independent directors3. “Independence” is to be defined, but such definition must 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. Compensation committees will also have the authority to engage independent consultants and counsel at the issuer’s expense, but must first consider factors to be identified by the SEC affecting independence4. These factors must include the following:

• the provision of other services to the public company by the person that employs the advisor;
• 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 advisor and any member of the compensation committee; and
• any stock of the public company owned by the advisor.

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 director independence and highlight conflicts of interests occurring with compensation consultants.

Additional Executive Compensation Disclosures. Public companies will 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) median compensation of all employees (excluding the CEO); (ii) CEO compensation; and (iii) the ratio of median employee compensation to CEO compensation. This provision will be implemented by amendment to the SEC’s rules but the Act does not specify any timeframe required for the SEC’s adoption of such amendments.

Disclosure Related to the CEO/Chairman Structure. The SEC must issue rules that require public companies to disclose in annual proxy materials sent to shareholders the reasons why the company chose:

• to have the same person serve as Chairman of the Board of Directors and CEO; or
• different individuals to serve as Chairman of the Board of Directors and CEO5.

The SEC previously promulgated similar disclosure requirements related to this issue and many companies have already addressed this disclosure. Other companies separated these two positions or have elected a lead director as this has long been considered a best practice in corporate governance.

Limits on Discretionary Voting by Brokers. The Act requires that the national securities exchanges adopt rules prohibiting brokers 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 brokers have received voting instructions from the beneficial owner of the securities. The Act does not specify a timeframe for the adoption of rules related to this requirement, however, it is anticipated that these rules will be adopted and effective for the 2011 proxy season.

Proxy Access. The Act provided 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.6 The SEC has the discretion to determine the eligibility requirements shareholders must meet to utilize the company’s proxy statement to nominate directors. Given that the shareholder proxy access debate has raged for years, this requirement of the new law should come as no surprise as the SEC, on several occasions, has previously proposed rules addressing this issue, including proxy access rules proposed as recently as June 2009. Accordingly, SEC Chairman Mary Schapiro has indicated in a recent speech that the SEC intends to adopt rules related to proxy access that will be in effect for the 2011 proxy season.

New Hedging Disclosure. 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. Although the Act requires the SEC to adopt rules on hedging disclosures, no timeframe for the adoption of such rules was specified in the Act.

Additional Changes Impacting Public Companies

Amendments to Regulation D Governing Private Offerings. Rules under the Securities Act of 1933, as amended (the “Securities Act”), provide for a series of tests to determine whether an investor is an “accredited investor.” The legislation requires the SEC to amend any of the net worth standards to exclude the value of the investor’s primary residence from the calculation of net worth7 and to provide for a periodic adjustment of the $1 million threshold beginning four years after the date of the legislation’s enactment. These changes which are effective immediately are discussed in detail in Blank Rome Corporate and Securities Alert No. 4.

The law also authorizes the SEC to undertake a review of the accredited investor tests that apply to natural persons, other than the net worth standard, to determine whether the requirements of the definition should be adjusted in light of the public interest, the protection of investors and the economy. The SEC may make changes to the rule, other than the net worth standard, as it deems appropriate, taking these considerations into account.

Beginning four years after the date of the Act’s enactment, and at least every four years thereafter, the SEC must review the definition of “accredited investor” set forth in Rule 215 under the Securities Act (or any successor rule) to determine whether the definition in its entirety should be amended for the protection of investors, in the public interest or in light of the economy. While the accredited investor test set forth in Rule 215 is identical in all material respects to the definition applicable to Rule 506 offerings, it is unclear whether the amendment of Rule 215 pursuant to the Act will affect the definition of accredited investor that is applicable to Rule 506 offerings.

Within one year after the law is enacted, the SEC must amend Rule 506 to include specified “bad boy” disqualifications for offerings exempt under that rule. First, the SEC must enact rules that provide for disqualifications under Rule 506 that are “substantially similar to” the provisions under Rule 262 of the Securities Act. Under Rule 262, an issuer is disqualified from relying upon that exemption if the issuer (or its predecessors or affiliated issuers), or its officers, directors, promoters, 10% or greater stockholders, or underwriters (and their affiliates) meet any one of several “bad boy” disqualifications.

In addition to these disqualifications, the legislation will require the SEC to adopt rules disqualifying an offering or sale of securities under Rule 506 if a person is subject to a final order of a state securities commission; a state insurance commission; or a state or federal authority supervising banks, savings associations or credit unions, including the National Credit Union Administration, that is issued within 10 years of the filing of the offer or sale and is based upon a violation of any law or regulation prohibiting fraudulent, manipulative or deceptive conduct, or that bars the person from:

• associating with any regulated entity;
• engaging in the business of securities, insurance or banking; or
• engaging in savings association or credit union activities.

Reliance on Rule 506 would be prohibited for any person that has been convicted of any felony or misdemeanor in connection with the purchase or sale of any security or involving the making of a false filing with the SEC, no matter when the conduct occurred.

While Rule 262’s “bad boy” provisions had been currently applicable to offerings of securities under rarely-used Rule 505, the imposition of these requirements to Rule 506 offerings will serve to lessen the ability of some issuers to rely upon this widely-used exemption to raise capital. This amendment will also require an additional layer of due diligence for issuers relying upon Rule 506 in these transactions, especially necessitating deeper scrutiny into the background of the issuer’s controlling persons, 10% or greater beneficial owners, promoters, underwriters and related persons.

Enhanced Clawback Requirements for Executives. Public companies will 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, due to material non-compliance with financial reporting requirements, in excess of what they otherwise would have been paid. This provision significantly increases the clawback provisions currently contained in Section 304 of the Sarbanes-Oxley Act of 2002 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. These requirements will be implemented through the adoption of rules by the national securities exchanges which will prohibit the listing of the securities of any company which does not adopt such clawback policies.

Benefit for Whistleblowers. The Act adds a new benefit for whistleblowers8. Under this new provision, subject to certain exceptions, the SEC will have the authority to pay to a whistleblower who provides “original” information leading to an enforcement of a judicial or administrative action where the monetary sanctions recovered exceed $1.0 million, 10–30% of any monetary sanctions the SEC or other agency collects. Such payments will be in the SEC’s sole discretion. This provision does not apply to whistleblowers that are members or employees of a self-regulatory organization (for example, a securities exchange), the Department of Justice, the Public Company Accounting Oversight Board or a regulatory or law enforcement agency. Additionally, a whistleblower will be denied an award if such whistleblower is convicted of a criminal violation related to the judicial or administrative action for which the whistleblower provided original information, or if the whistleblower gained the original information through the performance of the audit of the company’s financial statements. Whistleblowers will also receive payments if their information leads to a successful related action by another governmental agency. Additionally, the federal whistleblower protection provided by the Sarbanes-Oxley Act was extended to prohibit retaliation or discrimination by subsidiaries or affiliates of a public company. Under the Act, public companies, including their consolidated subsidiaries or affiliates, may not discharge, demote, suspend, threaten or otherwise discriminate against a whistleblower.

Expanded Liability for Securities Violations. The legislation also expanded the Securities Act which governs securities offerings to add “aiding and abetting liability” for any person that “knowingly or recklessly” provides substantial assistance to another person in violation of the Securities Act. Section 20(e) of the Securities Exchange Act of 1934 was amended to enhance the current “aiding and abetting” liability to include “reckless” acts.

Increased Restrictions on Short Sales. The Act also requires the SEC to adopt rules requiring financial institutions to disclose information regarding short sales. Brokers will also be required to notify customers that such customers may elect not to allow their shares to be lent to third parties by the broker. Brokers are also required to notify their customers if the customers’ securities are used in short sales and indicate that the broker may receive a fee in connection with lending the customers’ shares. These are helpful provisions in that they enable retail brokerage customers to be put on notice of their rights with respect to the short sale of their securities held in brokerage accounts. Given the excessive and prolonged short sales have the effect of decreasing the market value of the affected publicly traded securities, investors in the affected securities, have an interest in limiting these activities as opposed to facilitating these short sales. The new SEC rules will likely reduce short selling problems plaguing certain public companies.

Enhanced Regulation of Swap Transactions and Committee Approval for Swap Transactions. The Act imposes enhanced regulatory requirements on the derivative market and its participants as well as public companies. Such enhancements include a broader definition of regulated financial instruments included as derivative instruments, and new requirements applicable to exchange trading and central clearing of derivative instruments. In addition, more stringent margin and capital requirements will be required for derivative market participants The Act also 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 Securities Exchange Act of 1934 and the Commodity Exchange Act. The approval provision was effective upon enactment of the Act.

Relief from Section 404’s Requirement for Independent Auditor Attestation of Internal Controls for Small Public Companies. One of the positive elements of the Act for public companies was the relief provided for non-accelerated filers9 from Section 404(b)10 of the Sarbanes-Oxley Act which requires the company’s independent public accountants to attest to management’s assessment of the effectiveness of the company’s internal controls. Under the Act, companies that are not large accelerated filers or accelerated filers will be exempt from the requirement to provide such auditor attestation report. The SEC is also required to conduct a study on reducing the burden on companies with market capitalization between $75 million and $250 million of complying with Section 404(b) of the Sarbanes-Oxley Act.

Disclosure of Votes by Institutional Managers. The Act requires institutional investment managers to disclose at least annually how they voted on say-on-pay proposals and golden parachute proposals. It is anticipated that the SEC will issue rules related to the location and timing of this disclosure.

Credit Rating Agencies’ Consent and Disclosures. Many issuers refer to the ratings of their debt and preferred securities in their registration statements and in other SEC filings which are incorporated by reference into their registration statements. Rule 436(g) of the Securities Act historically allowed issuers to include or incorporate such credit ratings into their registration statements without obtaining the rating agencies’ consent. The Act repeals Rule 436(g). As a result of the provisions of the Act, certain rating agencies have said that they will not furnish consents for the time being. The SEC has set forth the following guidelines with respect to the disclosure of ratings information for non-asset backed securities offerings:

• no consent is required where an issuer includes disclosure about its credit ratings in a filing with the SEC in the context of a discussion of changes to a credit rating, the liquidity of the registrant, the cost of funds for a registrant or the terms of agreements that refer to credit ratings (collectively, “disclosure-related ratings information”);
• no consent is required where an issuer includes disclosure about its credit ratings in a free writing prospectus that complies with Rule 433 or in term sheets or press releases that comply with Rule 134;
• except as provided below, issuers may continue to use currently effective registration statements without the credit agency’s consent to any information regarding ratings included or incorporated by reference therein until the next post-effective amendment to such registration statement;
• a consent must be filed in connection with a prospectus or prospectus supplement that is first filed on or after July 22, 2010 that includes ratings information (other than disclosure-related ratings information as noted in the first bullet above);
• a consent must be filed if a subsequently incorporated periodic or current report contains ratings information (other than disclosure-related ratings information as noted in the first bullet above); and
• registration statements and post-effective amendments to registration statements (note that the filing of the issuer’s next annual report is deemed to be the post-effective amendment of a registration statement) that become effective on or after July 22, 2010 must include an appropriate consent if the registration statement includes or incorporates by reference any ratings information (other than disclosure-related ratings information as noted in the first bullet above).

Amendments to Regulation FD regarding Disclosure to Credit Rating Agencies. The Act requires the SEC to amend Regulation FD within 90 days of enactment of the Act to remove the exemption for communications with entities whose primary business is the issuance of credit ratings. Therefore, unless another exemption applies, public companies will not be able to provide material non-public information to credit rating agencies.

Establishment of a Risk Committee by Certain Publicly-Traded Bank Holding Companies. The FRB must require publicly traded nonbank financial companies that it regulates and publicly-traded bank holding companies with assets in excess of $10 billion, and may require 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. The FRB is required to issue final rules regarding this requirement not later than two years after the enactment of the Act, to take effect not later than 15 months after the one year anniversary of the enactment of the Act.

Application of the Act to Foreign Private Issuers. Although a majority of the provisions of the Act do not apply to foreign private issuers11, there are a couple of provisions that will impact foreign private issuers. For instance, a foreign private issuer with a security listed on an exchange will be required to adhere to the new compensation committee requirements unless the foreign private issuer provides in its annual report on Form 20-F the reasons why the foreign private issuer is not in compliance. In addition, as the enhanced clawback provisions for executives applies to all public companies with a security listed on an exchange, the clawback provisions for executives will apply to foreign private issuers unless the SEC in implementing regulations regarding the clawback provisions provides for a foreign private issuer exemption. The Act itself provides for no such exemption. As is the case with U.S. public companies, foreign private issuers that are non-accelerated filers will not be required to have the company’s independent public accountants attest to management’s assessment of the effectiveness of the company’s internal controls. Finally, the added whistleblower benefits and expanded liability for securities violations have the potential to impact foreign private issuers.

Action Items for Public Companies—Preparing for the 2011 Proxy Season and Beyond

In light of the Act’s new disclosure and corporate governance requirements, many of which take effect six months after enactment of the Act, public companies should consider taking the following actions prior to the 2011 proxy season:

1.  Plan Ahead for the 2011 Annual Meeting. The elimination of discretionary voting by brokers will undoubtedly create issues for companies with obtaining a quorum for the annual shareholders meeting or the vote for specific proposals requiring majority or super-majority votes. As a result, it will be important to review the company’s charter document or bylaws well in advance of the meeting to determine what the quorum requirements are for annual meetings and consult with counsel regarding whether amendments to modify these requirements are recommended. In addition, companies should plan on allowing extra time between the meeting and mail dates for the 2011 annual meeting or consider the retention of a proxy solicitor. These 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 by a plurality vote, the company should also consider adding a proposal where directors have discretionary authority, such as the ratification of auditors. Thus, the addition of a proposal where discretionary voting is permitted will ensure the company meets its quorum requirements for the annual meeting.

2.  Anticipate Mandatory “Say-on-Pay” Proposal and Other New Compensation Disclosures. Given the mandatory “say-on-pay” proposal which will be effective for the first meeting of shareholders occurring six months after the enactment of the Act and other new disclosures related to compensation, the compensation committees will want to carefully consider how to address executive compensation disclosures in the company’s compensation discussion and analysis (“CD&A”) or elsewhere in the proxy statement. This will likely require a careful review and a potential rewrite of last year’s CD&A. It is suggested that companies attempt 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.

Given the Act also requires 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), shareholders will continue to pay particular attention to how successfully the company aligned executive compensation with increasing value for shareholders as well as the combination of stock-based compensation and cash. It is anticipated that this disclosure will have to be more transparent with respect to executive compensation decision-making and the financial and other measures utilized to determine performance-based compensation. The financial crisis also focused attention on the compensation mix as contributing to the overall level of risk undertaken by executives. This Act provides incentive for compensation committees to review the interplay between risk and executive compensation and address any compensation policies or practices that encourage excessive risk-taking.

3. Evaluate Independence of Compensation Committee Members Under New Criteria. Given the new requirements applicable to compensation committees under the Act, as well as the new considerations applicable to the independence determination, the board should consider whether the composition of the compensation committee will meet the more stringent requirements of the Act and it should be noted that other requirements could be added by the SEC in the final rule when adopted. This review process should include the board’s evaluation of the relationships that exist with compensation committee members based upon these new requirements articulated in the Act. If the board determines that there are not an adequate number of compensation committee members that will meet the new requirements, it will be necessary to 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 review of the SEC proposal, the company should have as a top priority the evaluation of the existing composition of this committee.

4. Reevaluate Clawback Provisions in Existing Compensation Arrangements. The expanded clawback provisions of the Act will likely require the amendment of existing company policies, as well as changes to compensation arrangements as well as plan documents and model agreements related to equity and other awards. This exercise will undoubtedly take some time to effect and may prove difficult with respect to implementation related to former officers. Prior to the adoption of SEC rules in this area, companies should include language compliant with the Act in new arrangements.

5. Analyze the Use of Compensation Committee Consultants. The 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 solicitation of compensation consultants. It may be necessary to utilize a questionnaire for existing or new consultants for gathering the information necessary for the compensation committee to evaluate the consultants under the requirements of the Act. These requirements may also necessitate the implementation of policies similar to those used with the retention of a company’s independent auditors, including pre-approval policies. Companies should also consider adopting policy regarding the retention of consultants, counsel and advisors and the related procedures applicable to the retention of such advisors.

6. Determine How to Disclose and Calculate the Median Compensation Numbers. One of the most troubling aspects of the Act is clearly the disclosure of the ratio of the median of total annual compensation of all employees to the total annual compensation of the CEO. This requirement will be difficult (if not impossible) to calculate for many companies. Since the parameters are set forth in the law and the SEC rule cannot deviate from these parameters, companies will need an early start to gather the necessary data and draft disclosure to quantify and explain these numbers.

7. Amend Insider Trading Policy to Address Hedging. Hedging activities can often result in adverse effects and require specific policies to address these activities. Many public companies have policies addressing hedging, which are typically reflected in companies’ insider trading policies12. For companies that do not have such policies, consideration should be given to the adoption of such policies in anticipation of 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 to whether hedging activities should be prohibited or subject to an established pre-approval policy.

8. Rationalize Board Management Structure. The Act’s requirements regarding disclosure of the rationale for the company’s board management structure, as well as existing SEC disclosure requirements on this topic, will necessitate a review of the structure currently utilized. Companies with a combined chairman and CEO position will undoubtedly have to rethink this combination or provide additional support for continuing the combination of these two critical roles.

9. Review and Revise Key Corporate Governance Documents. Changes to the whistleblower provisions of the Sarbanes-Oxley Act as well as other corporate governance requirements of the Act necessitate the review and revision of the company’s whistleblower policies and procedures as well as other key corporate governance documents such as the code of conduct and committee charters. At a minimum, the whistleblower policy 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. Further, this presents a good opportunity to review other documents as part of the company’s compliance review and assess the effectiveness of these documents.

10. Take Action with Respect to New Swap Approval Requirements. The Act’s new Swap approval requirements will require the Board to designate a committee to review and approve Swap transactions. An appropriate amendment to the selected committee’s charter will also be necessary. Finally, consideration needs to be given to what procedures need to be put in place to insure compliance with the new requirements applicable to Swap transactions.

11. Consider Establishing a Risk Committee. The requirement of the Act related to risk committees for non-bank financial companies and certain bank holding companies will undoubtedly affect best practices in this area for all public companies. Given the recent focus on risk-related issues particularly in light of the financial crisis, boards of public companies may consider establishing a risk committee to be responsible for the oversight of company-wide risk management practices. Whether this committee has a “risk management expert” as required for nonbank financial companies and certain bank holding companies will depend upon the complexity of organization, as well as other factors.

12. 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 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 requirements of the Act will also require the implementation of a new approval process as well as the education of the Board and the appropriate committees regarding the new approval requirements applicable to Swap transactions.

13. Develop and Implement Internal Controls to Ensure Compliance with the Act. In light of the numerous changes required by the Act, many of which will be implemented over a several year period, it will be necessary for public companies to develop and implement the appropriate internal controls and procedures to ensure compliance with the Act’s requirements on a timely basis. These controls will require a certain degree of flexibility given the manner in which the Act’s requirements will be implemented
 

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1. See generally section 951 of the Act
2. 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.
3. Generally does not apply to controlled companies.
4. Generally does not apply to controlled companies.
5. See generally, Section 972 of the Act.
6. See generally, Section 971 of the Act.
7. The SEC has indicated in a recent Compliance & Disclosure Interpretation that the amount of any indebtedness secured by the primary residence may be excluded from the value of the residence (where the amount of the debt exceeds the fair market value of the residence and the lender has recourse to the investor personally for such excess, such excess liability should be deducted from net worth calculation).
8. See generally, Section 922 of the Act.
9. A non-accelerated filer is a company with less than $75.0 million of public float held by non-affiliates on the last business day of the second fiscal quarter of the company’s fiscal year.
10. See generally, Section 989G of the Act.
11. Since the SEC’s proxy rules do not apply to foreign private issuers, provisions of the Act requiring additional proxy statement disclosure are not applicable.
12. Certain hedging transactions are prohibited by Section 16(c) of the Securities Exchange Act.

The Treasury Department subsequently released draft legislation in mid-July that would require all public companies to hold annual, non-binding shareholder votes on executive compensation packages as well as impose stricter standards to ensure the independence of corporate compensation committees. Treasury’s say on pay proposal is modeled after a rule the United Kingdom adopted in 2002. Starting December 15, 2009, proxy materials would have to include tables summarizing the salary, bonus, stock option awards, and total compensation package for senior executives and also narrative explanations of any golden parachute and pension compensation packages. In the event of a merger or acquisition, companies would need to hold separate votes on golden parachutes and lay out simply and clearly what the departing executives would receive.

To ensure the independence of corporate compensation committee members, the legislation calls for "exacting new standards" modeled on how Sarbanes Oxley established the independence of audit committees. The provisions would require a compensation committee to be granted the funding and authority necessary to hire compensation consultants, legal counsel, and other advisers—all of whom should be independent of the company's management—to help the committee negotiate pay packages that are "in the best interests of shareholders."

Immediately following the release of the Treasury legislative draft, House Financial Services Committee Chairman Barney Frank (D-MA) issued a “discussion draft” virtually identical to the administration’s proposal, except for the addition of a section applying only to covered financial institutions that would require their regulators to evaluate and prohibit compensation practices that would:

• encourage inappropriate risks
• threaten an institution’s safety and soundness, or
• “have serious adverse effects on economic conditions or financial stability.”

The House Financial Services Committee intends to take up the say on pay measure next week. Senators Charles Schumer (D-NY) and Richard Durbin (D-IL) have both introduced say on pay legislation, but the Senate is expected to take up in the fall the version the House is likely to pass in the next few weeks.

Say on pay has bipartisan appeal in Congress, evidenced by a 2007 House vote on a Chairman Frank-sponsored bill that mirrored his current draft. Easily passing the House by a vote of 269-134— yet stalling in the Senate—Frank’s bill garnered the support of over 50 Republicans, including prominent GOP members such as Ranking Member of the Ways and Means Committee Dave Camp (MI) and Ranking Member of the Budget Committee Paul Ryan (WI). In light of this 2007 vote and current public opinion over corporate executive compensation practices, the prospects for enacting say on pay rules as part of a broader financial regulatory reform bill have significantly improved.

Arguments For and Against

Say On Pay Is Non-Binding

• While the legislation calls for non-binding say on pay, most business observers agree that corporate boards will face enormous pressure to accept the shareholder votes.
• Other countries and companies are doing it.
• Britain, Australia, Norway, Spain and France have say on pay rules similar to those currently proposed here. Roughly 25 U.S. Companies have voluntarily implemented say on pay, and the administration has pointed to AFLAC as an example of the policy’s success.

Pay Not Related to Performance

Proponents of say on pay cite research indicating that executive compensation is increasingly unrelated to company performance. Last year the Securities and Exchange Commission (SEC) revised its rules to require public companies to disclose more information about their executive compensation plans, including C-level executives and board members. However, many believe the rules did not go far enough to inform shareholders of the totality of compensation packages. The draft legislation specifically addresses conflict of interest concerns regarding CEOs negotiating their own pay arrangements during merger and acquisition negotiations.

Increases in CEO Pay Disproportionate to Worker Pay Increases

The Institute for Policy Studies and the Center for Corporate Policy determined that the CEO to worker pay gap was 42 to 1 in 1980, but by 2007, it was 411 to 1.

CEOs Caution Against Congressional Intervention

USA Today recently polled 31 large company CEOs on say on pay and 77 percent were against the government mandating the policy. The U.S. Chamber of Commerce and the Business Roundtable, an association representing large company CEOs, both assert that shareholders could demand say on pay today, without Congress passing any new laws. Business executives have raised concerns that say on pay could lead to shareholder micromanagement and government intervention and could likely drive talented executives into privately held firms. There is also the concern that large, institutional shareholders could abuse the say on pay policy to coerce management into making certain decisions that might drive up profits in the short term but would not be in the company’s best long-term interests.

• Tie compensation to performance—condition performance-based pay on internal and external metrics, not just stock prices.
• Structure compensation “to account for the time horizon of risks”—condition compensation on and align incentives according to longer term performance.
• Align compensation with sound risk management—because some compensation packages “unintentionally encouraged excessive risks” and because risk managers often do not have enough authority to stop such practices, “compensation committees should conduct and publish risk assessment of pay packages” to avoid “imprudent risk-taking”
• Scrutinize golden parachutes and supplemental retirement packages—question whether such packages align with shareholders’ interests, enhance companies’ long-term value, provide incentives for stronger performance, and reward executives even when shareholders lose value.
• Promote transparency and accountability in setting compensation—encourage Congress to pass “Say on Pay” legislation giving shareholders non-binding votes on executive compensation and legislation giving the SEC authority to require companies to establish independent compensation committees along the lines of the independent audit committees established under the Sarbanes-Oxley Act

In addition to proposed legislation, Treasury said bank regulators, led by the Federal Reserve, will integrate the administration’s compensation principles into bank supervision. Indicating a recognition of the fears that the administration would be over-reaching with its proposals, Secretary Geithner said clearly what the administration is not doing 

“We are not capping pay. We are not setting forth precise prescriptions for how companies should set compensation, which can also be counterproductive.”

Instead, the Secretary hopes for standards that “reward innovation and prudent risk-taking . ”

Later today, the Administration announced the appointment of Kenneth Feinberg, a Washington lawyer and former staffer to Senator Kennedy, as the White House "pay czar." His primary authority is to review the compensation levels at firms receiving "extraordinary assistance" under the TARP program and to take steps to ensure their compensation practices are "sound and appropriate."

News reports indicate that seven firms fall into this category—AIG, Citigroup, Bank of America, General Motors, GMAC, Chrysler, and Chrysler Financial.  We are also hearing that Feinberg will be looking at the pay policies affecting the top 100 executives at each of the companies—not just the top 25 as mandated by the provisions in the stimulus legislation passed earlier this year. This deepening of the federal involvement in these firms is likely to cause some consternation in executive suites beyond just those directly affected.

Today's announcements set in motion regulatory, legislative and policymaking processes that will take several months to unfold. As details are discussed, additional issues are sure to arise.  Financial Reform Watch will be tracking them closely.

Treasury: 'Providing Compensation Committees With New Independence' Fact Sheet (PDF)

Treasury: 'Ensuring Investors Have A "Say on Pay"' Fact Sheet (PDF)