The Curtain Falls On Act One
On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. This caps over a year of intense activity by the House and Senate to address the causes of the financial crisis and reform the regulatory system. Dodd-Frank (named after Senator Christopher Dodd D-CT and Representative Barney Frank D-MA) is a complex bill spanning 2,323 pages and by our count it will lead to 520 rulemakings, 81 studies and 93 reports. By contrast Sarbanes-Oxley required 16 rulemakings and 6 studies.The bill not only deals with financial issues, but it runs the gamut from Congo conflict materials to corporate governance. We will leave the Congo off to the side and concentrate on corporate governance.
As I have written before, Proxy Access was one of the most controversial issues in the entire bill. There was intense debate if it should be included and at certain points led to an impasse that scuttled the bi-partisan discussions to create a consensus bill. The conference committee was no different, and there was a robust debate on the language that should be included in the bill.
The House and Senate both passed financial regulatory bills that gave the Securities and Exchange Commission ("SEC") the authority to issue proxy access rules. After the Senate passed its bill in late May, the House and Senate appointed members to a conference committee to reconcile the two bills into one piece of legislation to be considered by both legislative chambers. Negotiations among conference committee members normally only involve provisions that differ between the bills. The negotiation process provides for an offer by House conferees and an offer by Senate conferees with an effort to reach agreement. If there is an agreement by the House and Senate conferees, then that provision becomes part of the final bill.
Despite the fact that House and Senate did not differ on the grant of authority on proxy access, the Senate presented an offer that was prescriptive. The Senate conferees offer mandated the SEC to issue proxy access rules with thresholds of five percent ownership for a two-year period. The borrowing of shares would not be allowed to achieve the ownership requirements. The Senate offer also included a new concept known as a tail. The tail would require a shareholder, who gained access to the proxy and elected directors to the board, to hold those shares for a two-year period.
The House conferees rejected this offer. While there was some discussion regarding a compromise on thresholds of three percent and three years, the conference committee eventually agreed to a grant of authority to the SEC, allowing them to issue proxy access rules if they choose to do so. Senator Mike Crapo (R-ID) offered an amendment, that was accepted, granting the SEC the authority to exempt issuers or a class of issuers from the proxy access provisions. The SEC can take the size of the issuer or class of issuers into account if they choose to use that exemptive authority.
The SEC has had a proposal on proxy access rules for over a year. Some have speculated that this legislative grant of authority was given to try and inoculate the SEC from a legal challenge. It is anticipated that the SEC will move quickly and finalize the rulemaking in order to implement proxy access for the 2011 proxy season.
Other Governance Issues In The Dodd-Frank Bill
There were a number of other corporate governance provisions in the Dodd-Frank Bill that will need the attention of regulators and governance professionals.
Say on Pay - Shareholders are given the right to an advisory non-binding vote on executive compensation. This provision was modified by another amendment by Senator Crapo, allowing shareholders to determine once every six years if that vote should happen on an annual, biannual or triennial basis. Such votes have been required for TARP companies, and it is not expected that Say on Pay will be difficult to implement.
Independent Compensation Committees - Compensation committees must be composed of independent directors and allow the committee to hire lawyers and advisors without any oversight from the rest of the board or management. Compensation consultants will also be required to disclose and be free of conflicts of interest. While the legislation creates a goal, much of the implementation will be left to the discretion of the regulators. These provisions will also be part of listing standards and those exchanges will have the ability to exempt companies.
Pay versus Performance - The SEC will require issuers to disclose in proxy solicitations information linking the annual relationship between paid executive compensation and the financial performance of an issuer.
Pay Ratios -Disclosures will also have to be made in the form of a ratio between the compensation paid to the CEO of a company and the median of all compensation paid to all worldwide employees of a company.
Clawbacks - Companies will have to develop policies for the recovery of compensation erroneously awarded based upon materially misstated financial reports.
Hedging - In proxy solicitation materials, companies will have to disclose hedging by directors or employees.
Enhanced Compensation Structure Reporting - Originally, the House bill required federal regulators to approve or disapprove incentive compensation for all employees in the financial sector. This has been modified somewhat and limited to a financial firm's executives and employees who may place firms at a material risk. The Federal Reserve is already working with other banking regulators to develop guidance along these lines.
Broker Vote - Last year's action by the SEC to strip the broker vote was codified.
Leadership Disclosures - This provision codifies rules adopted by the SEC last year requiring the disclosure of the leadership structure of a company.
Whistleblower Protections - Several provisions of the bill require enhanced protections and awards for whistleblowers.
Management Interlocks - For financial companies some forms of management interlocks will be prohibited.
These corporate governance requirements present a full spectrum of potential regulatory implementation. Some requirements such as Say on Pay will be relatively easy and quick to implement. Other provisions will be controversial, such as whistleblower protections, and, of course, some will be very difficult to implement such as pay for performance and pay ratios. We have seen over the past eight years how some of the SOX provisions, notably 404 (b), were difficult if not impossible for regulators to implement. We should expect that some of these provisions may fall into that category. Indeed Rep. Barney Frank (D-Mass.), the chairman of the House Financial Services Committee, has already stated that there will be a second bill to deal with areas of substantive confusion that may lead to uncertainty.
On July 14, 2010 the SEC issued a concept release on the U.S. proxy voting system. The concept release has a 90-day comment period.
The concept release has been highly anticipated. Because of the changing nature of voting in corporate elections, structural modifications, such as the repeal of the broker vote and future changes such as proxy access, many parties have called for a review and potential overhaul of the proxy voting systems.
Commonly known as proxy plumbing issues, this SEC review is the first serious look at potential changes to the proxy voting system in almost 30 years. Generally, the SEC is seeking comment on the accuracy, transparency and efficiency of the system, shareholder communications and the relationship of certain entities within the proxy plumbing system. Specifically, the SEC is seeking to address issues such as vote counting and confirmation, the role of institutional investors, shareholder participation and the role of proxy advisory firms.
If this is a serious undertaking by the SEC, many issues can come to the forefront and allow for a serious debate and consideration of solutions. The precipitous drop in retail shareholder participation and the rise of influence of proxy advisory firms coupled with the increased prominence of institutional investors have placed many stresses and strains on a system that may need to be overhauled in some areas.
However, with the anticipated 200-plus rulemakings the SEC may need to undertake as part of the Dodd-Frank bill, it is unclear if the SEC can give this process the due consideration that it deserves and the follow-up on actions that may need to be taken. This is concerning since the corporate governance changes in the Dodd-Frank bill codify some important changes to the proxy plumbing, such as the repeal of the broker vote, while pushing to the center stage other regulatory changes, such as proxy access, that can accelerate strains on the system. Additionally, it is unclear if the Dodd-Frank regulatory tsunami will give market participants the time or energy to fully analyze and comment on these important issues.
Proxy plumbing provides a forum to identify issues and present solutions, however, the regulatory landscape may present difficulty in allowing this process to play itself out.
The passage of the Dodd-Frank bill and the circulation of a concept release on proxy plumbing demonstrate that the corporate governance aspects of regulatory reform are not over, but that the curtain has fallen on only the first act. A round of regulatory implementation is just starting and more rounds of legislative action should be expected. While many corporate governance reforms have happened over the past several years, such as majority voting and ending classified boards, through the shareholder-director relationship, it is clear that we are entering a new phase of government activism. This activism coupled with a larger federal role could present shareholders and directors with new governance structures that are more geared to a check-the-box mentality, rather than the flexible discussion that has allowed for dynamic change. Time will tell if this leads to better governance or if we need to fix the solution that is currently being proffered.