ALERT - What You Need to Know About the Dodd-Frank Act

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August 6, 2010

The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law on July 21, 2010, includes provisions related to executive compensation and corporate governance that will ultimately affect all reporting companies, as well as companies that conduct private placements under Regulation D.  These provisions will require companies to provide enhanced disclosures in proxy statements, give shareholders an advisory vote on executive compensation, and review and likely adjust compensation committee practices and policies.  In some instances these provisions are applicable immediately or with the coming year’s proxy statements, and in other instances they will not become applicable until after rulemaking by the Securities and Exchange Commission and/or the national securities exchanges (e.g., NYSE and NASDAQ).  In any event, companies should be aware of these provisions and take action now to ensure compliance with these significant changes to executive compensation and corporate governance.

Overview
The following chart identifies the new executive compensation and corporate governance topics addressed in the Dodd-Frank Act, notes which topic may apply to your company, and when it becomes applicable.  A brief description of each topic follows the chart.  The information provided is as of July 30, 2010.

Topic:

Applies to:

Applicable when:

All reporting companies

Exchange-listed companies

Smaller reporting companies (1)

Say-on-Pay

X

X

X(2)

In proxy for first shareholder meeting after Jan. 21, 2011

Compensation Clawback Policies

 

X

 

After SEC and exchange rulemaking

Compensation Comparisons

X

X

X

After SEC rulemaking

Hedging Disclosure

X

X

X

After SEC rulemaking

Compensation Committee Independence

X(3)

X

X(3)

After SEC and exchange rulemaking

Compensation Committee Consultants

X

X

X(2)

After SEC rulemaking

Proxy Access

X

X

X(2)

After SEC rulemaking

Broker Discretionary Voting

X(4)

X

X(4)

Changes now effective

SOX 404 Exemption

   

X

Exemption now effective

(1) Smaller reporting companies, as defined by the SEC, are generally companies with less than $75 million in public float.  Smaller reporting companies listed on an exchange should refer to that column as well.

(2) The Dodd-Frank Act permits the SEC to exempt smaller reporting companies (or other classes of issuers) from these requirements. Such companies should watch for further information as the SEC promulgates its rules.

(3) The SEC or the exchanges may exempt a group of issuers, such as smaller reporting companies, from this requirement.  In addition, “controlled companies,” as defined by the applicable exchange, are exempted.  However, because the SEC currently requires non-listed issuers to disclose compensation committee independence with reference to exchange or other standards, even non-listed issuers will want to follow developments on this front.

(4) The exchanges will be required to prohibit their members from voting on certain matters unless the beneficial owner of the issuer’s shares has given the broker instructions on how to vote on such matters; however, all issuers will likely wish to take this change into account as they seek to achieve a quorum and obtain passage of the proposals they present at their own shareholder meetings.

In addition, the changes to the “accredited investor” definition and the “bad boy” disqualification are now effective for all companies involved in a private placement under Regulation D.

Say on Pay
The Dodd-Frank Act requires public companies to ask shareholders to approve, in a non-binding advisory vote, its executive compensation program.  This requirement, commonly referred to as “say on pay,” has three components.  First, at least once every six years, each public company must present a resolution to its shareholders in its proxy statement to determine whether this say on pay vote will occur every one, two or three years.  Second, at the level of frequency so determined, the company must include a resolution in its proxy statement requesting that its shareholders approve its executive compensation program.  These resolutions are non-binding.  Finally, shareholders will have a similar non-binding advisory vote on the executive compensation to be paid in connection with a change-in-control transaction (such as “golden parachute” payments).

What to do Now:  Public companies should plan to include the first and second resolutions in their proxy statement for their first annual shareholders meeting held after January 21, 2011.  In addition, companies should take this opportunity to review their executive compensation programs against evolving best practices in anticipation of increased shareholder scrutiny.

Compensation Clawback Policies
The Dodd-Frank Act requires the SEC to adopt rules directing the national securities exchanges to require each listed company to develop and disclose compensation clawback policies.  These policies must provide for the recovery of incentive compensation paid to current and former executive officers in connection with an accounting restatement due to material noncompliance with financial reporting requirements for the three-year period preceding the date of the restatement.  The Dodd-Frank Act directive on compensation clawback policies is broader than that contained in the Sarbanes-Oxley Act, which required that such policies apply only to the CEO and CFO, be triggered by misconduct, and reached back only to the preceding 12 months.

What to do Now:  Companies should review their existing compensation clawback policy and revise it as necessary to comply with the provisions in the Dodd-Frank Act.  Companies without a compensation clawback policy in place should adopt one now. 

Compensation Comparisons:  Pay for Performance and Internal Pay Equity
The Dodd-Frank Act requires the SEC to adopt rules requiring each public company to disclose in its proxy statement the relationship of the compensation that it actually paid its executives compared to the company’s actual performance.  The Dodd-Frank Act also requires the SEC to adopt rules requiring each public company to disclose in its proxy statement a comparison between the Chief Executive Officer’s total annual compensation and the median annual total compensation of all its employees except for the CEO.

What to do Now:  It is anticipated that the SEC rules will contain guidance on how to disclose these compensation comparisons.  Until then, companies should be mindful of the disclosure of these comparisons when reviewing and adjusting executive compensation.

Hedging Disclosure
The Dodd-Frank Act requires the SEC to adopt rules requiring each public company to disclose in its proxy statement whether any of its employees or directors are permitted to hedge against the company’s stock.  Hedging activities are broadly defined to include any financial instrument designed to hedge or offset a decrease in the market value of equity securities granted as compensation or held by the employee or director.

What to do Now:  Companies should review their existing policy on hedging.  Companies without a policy on hedging should consider adopting one now.

Compensation Committee Independence and Consultants
The Dodd-Frank Act requires the national securities exchanges to adopt listing standards that subject directors on the compensation committee to heightened independence standards.  These standards will take into account the source of a director’s compensation, such as any consulting, advisory or compensatory fees from the company, as well as whether the director is affiliated with the company or with a subsidiary of the company or its affiliates.  Listing standards must also prescribe that the compensation committee has the sole discretion to hire its own consultants, legal counsel and other advisors, has the appropriate funding to do so, and considers the independence of such advisors.  Companies will also be required to disclose whether the compensation committee retained compensation consultants and how any conflicts of interest were addressed.

What to do Now:  Companies should review the relationships between compensation committee members and the company.  Boards with few independent directors may need to increase board size and recruit additional independent directors likely to fit the coming standards.  Compensation committees should continue to scrutinize relationships and activities between compensation consultants and the company to avoid situations that could create a conflict of interest.

Proxy Access
The Dodd-Frank Act authorizes the SEC to adopt rules requiring public companies to place director nominees submitted by shareholders on their proxy ballots, which is commonly referred to as “proxy access.”  The SEC proposed proxy access rules in May 2009, but its authority to adopt them had been debated.  The Dodd-Frank Act settles this issue by giving the SEC the clear power to adopt proxy access rules, and to determine the ownership thresholds and other details.  The SEC’s May 2009 proposal would have allowed the nomination by shareholders of up to 25% of the directors being elected, and required a nominating shareholder to own 1-5% of a company’s stock (depending on the size of the company) for more than one year.

What to do Now:  Companies should be prepared to comply with proxy access rules, which may be adopted by the SEC in time for the 2011 proxy season.

Broker Discretionary Voting
The Dodd-Frank Act requires the SEC to adopt rules directing the national securities exchanges to prohibit discretionary voting by brokers on most significant matters, including the election of directors and executive compensation.

What to do Now:  The NYSE already took this step as to the election of directors, but companies should be aware that this change could make it harder to pass other shareholder proposals, including the new say-on-pay proposals.

SOX 404 Exemption
The Dodd-Frank Act grants a permanent exception to smaller reporting companies from the auditor attestation requirement of Section 404(b) of Sarbanes-Oxley.  The SEC had deferred the application of this requirement a number of times, and many commentators had argued it was an unfair burden on smaller reporting companies.

What to do Now:  Smaller reporting companies will still be required to submit management’s annual report on internal controls and procedures, as they have for the past several years, so the development and maintenance of strong controls remains important. 

Regulation D Offerings
The Dodd-Frank Act amended the net worth prong of the definition of an “accredited investor” under Regulation D to exclude the value of the person’s primary residence from the calculation of their net worth. The SEC has also issued an interpretation of this provision on July 23, 2010, which stated that the indebtedness secured by the residence, up to its fair market value, may also be excluded.   It further clarified that indebtedness secured by the residence in excess of the home’s value should be deducted from the home’s net worth.  This change narrows the accredited investor definition significantly, especially in light of the recent housing market bubble and collapse.  In addition, the SEC is to promulgate further rules adjusting the definition of an accredited investor by July 2011 and every four years.

In addition, so-called “bad boy” disqualification provisions were added for Regulation D offerings akin to those already applicable to offerings made under Regulation A.  The SEC has been directed to issue rules to disqualify offerings made by persons with a record of securities violations.   

What to do Now:  The accredited investor definition change was effective immediately, so issuers conducting ongoing Regulation D private placements should edit their form of subscription agreement or otherwise get a representation that each investor is accredited, as now defined, at the time of sale.  No changes were made to the other prongs of the definition of an accredited investor, including to Rule 501(a)(6), which looks to an individual’s income.  In addition, brokers involved in Regulation D private placements should be mindful of the bad boy disqualification rules as part of their due diligence in future offerings.

For Further Information

For further information on the Dodd-Frank Act and the changes your company may need to make to comply, please contact your Briggs and Morgan attorney or any member of our securities, executive compensation and corporate governance practice groups.