Dodd-Frank

A federal district court in Texas recently upheld the right of the SEC to seek clawbacks of bonus and other compensation under Section 304 of Sarbanes-Oxley from executives who have not been accused of any wrongdoing, by denying the executives’ motion for summary judgment. In the case, SEC v. Baker, the SEC is seeking reimbursement of bonuses, incentives and compensation from the CEO and CFO of Arthrocare in connection with the company’s restatement of its financial statements. The restatements were due to alleged fraud by two senior vice presidents of Arthrocare. The SEC did not allege that the CEO and CFO committed any conscious wrongdoing.

As we have discussed, the SEC had previously sought clawbacks under Section 304 from executives not charged with personal wrongdoing. The current case in Texas is apparently only the second time that a federal court has upheld the right of the SEC to seek clawbacks where the SEC has not alleged that the executives in question participated in the wrongful conduct. (The first case, SEC v. Jenkins, was decided by a federal district court in Arizona.) The court in Baker rejected the argument that the language of Section 304 required the misconduct of the officer from whom the reimbursement was being sought and found that Section 304 “require[s] only the misconduct of the issuer”. The court also rejected arguments by the defendants that Section 304 is unconstitutional and that they are protected by the Civil Asset Forfeiture Reform Act. In addition to cases where courts have upheld the right to clawbacks, the SEC has previously reached settlements to clawback compensation under Section 304 with executives not charged with personal misconduct.

Prior to these cases, it had been generally viewed that the clawback provisions of the Dodd-Frank Act, which provide for disgorgement regardless of whether misconduct has occurred, are broader than those of Sarbanes-Oxley. While the Dodd-Frank provision remains broader in many respects, this court case brings Section 304 one step closer to the Dodd-Frank provision.

The NYSE has published an updated rule filing submitted to the SEC on the recent proposed listing standards related to compensation committees. The rule filing notes that “Amendment No. 1 corrects a single error in the rule text in Exhibit 5 as originally filed. The error was in Section 303A.00 under the heading ‘Transition Periods for Compensation Committee Requirements.’”

To be clear, listed companies will have until the earlier of their first annual meeting after January 15, 2014, or October 31, 2014, to comply with the new director independence standards with respect to compensation committees. Other proposed changes, including those related to compensation committee advisers, will become operative on July 1, 2013. 

We previously discussed these rules and a detailed memorandum is in the works.

We just discussed the NYSE's proposed standards applicable to compensation committee members and their advisers, which closely follow the SEC final rules. Nasdaq has posted its proposed version, which contains some differences worth mentioning. Details will follow in a client memorandum, but headline items include:

Compensation Committee Requirement

Nasdaq currently permits CEO and executive officer compensation to be determined by an independent compensation committee or independent directors constituting a majority of the board's independent directors, but has proposed to eliminate the latter alternative and to require companies to have a standing compensation committee, with a minimum of at least two members. Nasdaq also proposed to retain its existing exception that allows a company to have a non-independent director serve on the compensation committee under exceptional and limited circumstances if the committee consists of three members, and the non-independent director is not an executive. 

Compensation Committee Member Independence

Unlike the NYSE, Nasdaq proposed that it follow the same standards for audit committees with respect to the prohibition on accepting directly or indirectly any consulting, advisory or other compensatory fee from the listed company, rather than making this a factor for boards to consider in assessing independence. However, unlike for audit committees and similar to the NYSE, Nasdaq-listed company boards can consider affiliated relationships without such relationships being a strict bar to service, and evaluate whether the director’s affiliation would impair the director’s judgment as a member of the compensation committee.

In fact, Nasdaq reiterates that, similar to the NYSE, it does not believe that ownership of company stock by itself, or possession of a controlling interest through ownership of company stock by itself, precludes a board finding that it is appropriate for a director to serve on the compensation committee. The proposed standards affirmatively state that it may be appropriate for certain affiliates, such as representatives of significant stockholders, to serve on compensation committees since their interests are likely aligned with those of other stockholders in seeking an appropriate executive compensation program.

Compensation Committee Charter

Similar to its requirement for audit committees, Nasdaq's proposal requires companies to certify as to the adoption of formal written compensation committee charters and the review and reassessment of the adequacy of such charters, with specific requirements for the scope of the committee’s responsibilities.

Compensation Committee Adviser Independence

Like the NYSE, Nasdaq's proposal only adopts the six factors that are in the SEC’s final rules for compensation committees’ assessment of advisers’ independence.

Effective Date

Nasdaq proposed that rules relating to compensation committee responsibilities and authority, be effective immediately, including the (a) authority to retain compensation consultants, independent legal counsel and other compensation advisers; (b) authority to fund such advisers; and (c) responsibility to consider certain independence factors before selecting such advisers, other than in-house legal counsel. The remaining provisions (including the compensation committee independence and charter requirements) must be complied with by the earlier of either the second annual meeting held after the date of approval of Nasdaq’s amended listing rules or December 31, 2014. Nasdaq will require a certification as to compliance.

The NYSE has posted its proposed filing with the SEC to implement the SEC rules for compensation committees and advisers. We are preparing a client memorandum to describe the standards in more detail shortly, but headline items include:

Compensation Committee Independence

The NYSE has not added any additional bright-line prohibitions to its independence standards.  Rather, it has followed the SEC final rules in giving a board discretion to determine how consulting, advisory and other compensatory fees and affiliate status may affect a compensation committee member's independence. The standards make clear that these factors should be considered, as part of its affirmative determination of all factors, specifically relevant to determining whether a director has a relationship to the company which is material to that director's ability to be independent from management in connection with the duties of a compensation committee member.

In making the independence assessments for compensation committee members, the board will need to consider whether (a) the director receives compensation from any person or entity or (b) an affiliate relationship places the director under control of the company or management, or creates a relationship between the director and management, in each case in a way that would impair independent judgment about the company’s executive compensation.

Compensation Committee Advisers

The NYSE retained, and did not add to, the six independence factors that compensation committees must consider, with respect to the person's independence from management, when selecting a compensation consultant, legal counsel or other adviser to the committee. The committee is required to conduct this assessment with respect to those advisers that provide advice to the committee, other than in-house legal counsel.

Effective Dates

In terms of timing, the proposed changes will take effect on July 1, 2013.  However, additional time is being granted to comply with the two key provisions described above. NYSE-listed companies have until their first annual meeting after January 15, 2014, or October 31, 2014, to comply with the new standards with respect to compensation committee independence factors and compensation adviser independence.

As we discussed, however, that separate and apart from the listing standards, the SEC rules require all companies subject to proxy disclosure rules to describe if the work of a compensation consultant gives rise to a conflict of interest, the nature of any conflict of interest and how the conflict is being addressed, in the proxy statement for the meeting at which directors will be elected on or after January 1, 2013. The six adviser independence factors are among the factors to be considered in determining whether disclosure is necessary. 

We are pleased to announce the publication of Getting The Deal Through – Corporate Governance 2012. Davis Polk lawyers Arthur Golden, Thomas Reid and Sapna Dutta authored the “Global Overview” chapter. 

We note this year that, as the wave of post-financial crisis corporate governance reform continues across the globe, the impact of the significant burdens on the regulators that are responsible for implementing these reforms is becoming increasingly visible. That said, we are also seeing a subtle divergence in the nature of these regulatory efforts in different parts of the world.  In the United States, regulatory efforts have focused primarily on implementation of the Dodd-Frank Act, which continues to require significant time and has resulted in delays in the rulemaking schedule. In contrast, Europe has seen more in the way of new initiatives, including the publication of the European Commission’s Green Paper on a future EU-wide corporate governance framework and the U.K. government’s significant proposals intended to curb executive compensation.

As the year goes on, we expect that U.S. and European companies will continue to experience intense pressure from regulators and shareholder advocacy groups in respect of their corporate governance practices on a number of fronts. It is inevitable that the reaction to the financial crisis of 2008 and the ongoing Eurozone crisis should provoke such severe and prolonged reaction.  What remains to be seen, if, as and when global economic conditions stabilize, is whether or not these ongoing governance reforms ultimately do anything to improve the competitiveness or actual governance of individual companies or the North American or Western European economies, or whether they are simply a series of responses – ranging in nature from remedy to retribution – that may be understandable, but perhaps not efficient in the long term. 

Read the “Global Overview” chapter >

Cognitive bias leads to faulty decisionmaking, warned Vice Chancellor J. Travis Laster at the National Conference of the Society of Corporate Secretaries and Governance Professionals. In his address, he used an example of a Delaware case to demonstrate the collective desire to develop information to support a preconceived goal rather than reach independent conclusions, the fallacy of groupthink that avoids hard questions, the tendency to prefer data that confirms a prior belief and the likelihood of taking immense risks to avoid losses, noting that the Court looks for the presence of those biases in examining cases. We also heard from the leaders of two influential proxy advisers, ISS and Glass Lewis, that each firm will change to new methodologies in the coming proxy season for constructing the all-important peer group against which they assess CEO compensation and form say-on-pay recommendations, making predictability an ever elusive goal for now.

Such were the examples of the range of discussions focused on effective corporate governance, from thoughtful debates on the relationship between companies and their shareholders to practical advice on the nuts and bolts for board functions, all centered around the conference theme – The Shape of Things to Come. Over 800 attendees gathered to hear from an impressive roster of experts, including investors, regulators, academics, consultants and counsel, and also to learn from each other given the unique opportunity to gather with other like-minded professionals whose primary role is to support boards. Since one regret is that it was not possible to attend all the sessions and take advantage of everything being offered, the following is a somewhat random selection of highlights arranged around the theme of anticipating what may be in store in the near future:

Regulators.  In his speech, Commissioner Troy Parades underscored SEC efforts toward rigorous rulemaking, including quality cost-benefit analysis based on solid economics. He stressed the need for pragmatic regulation that avoids being overly burdensome for companies in terms of compliance, but also informs investors without engulfing them in too much unnecessary information. SEC staff from the Division of Corporation Finance were present to discuss their hard work writing rules as mandated by first Dodd-Frank, and now the JOBS Act. Rules with deadlines have clear priority, but otherwise both sets of legislation are being tackled simultaneously. The staff specifically declined to address the timing for when we will see proposals on the remaining executive compensation rules under Dodd-Frank, affectionately known as the “gang of four” (pay-for-performance, hedging policy, clawback and internal pay ratio). During this past proxy season, 332 Rule 14a-8 no-action letter requests were processed, a 5% increase from last year, with average response periods of 38 days. The SEC whistleblower program is receiving about 8 complaints a day, with a significant number of those reports also being made to companies at the same time. The staff is keenly aware of the anti-retaliation provisions and may even ask companies for personnel files to confirm the absence of negative actions toward employees who came forward.

Active, or Activist, Investors.  In his keynote, Ralph Whitworth, founder of Relational Investors and a board member at Hewlett-Packard, stressed the importance of not letting the emphasis on board collegiality suppress directors from asking tough questions.  He captured it succinctly with a statement about the need for a director to be likeable, without having others believe that the director wants to be liked. There was active and vigorous debate at another session on whether the Section 13D 10-day reporting period should be shortened, during which a representative from Pershing Square argued that all shareholders benefit from the increased liquidity and stock price brought on by activist actions, and claimed that the available data shows that it is quite rare that investors who are required to file 13Ds ultimately accumulate more than a 10% ownership stake. 

Shareholder Engagement.  BlackRock’s willingness to devote 20 people to their engagement effort on a global basis is due in part to its inability to merely walk away from a vast majority of its investments that are made on an indexed basis. The firm talks to companies privately when they perceive issues, and expect directors to be available for discussions when there are significant say-on-pay problems. They recommend that off-season engagement focus primarily on the effectiveness of company boards, with executive pay being only a part, but not the key point, of the discussion. Engagement this year has increased exponentially, CalSTRS indicated, while the AFL-CIO announced that over half of the shareholder proposals it submits are withdrawn after negotiations with companies. One example of the divide between companies and proponents appears in the wide ranging views of which information should be captured when companies decide to adopt a policy to disclose political spending. 

Board Dynamics and Elections.  The need for directors to be willing to challenge what they are being told, even at the cost of being perceived as disruptive, was discussed in more than one session. The recent emphasis on individual director qualifications raised the concern that other directors may place over-reliance on board members who are labeled as having functional expertise, obscuring the need for all directors to have a general understanding of the company. Director elections (and as a byproduct, proxy access) continue to be a hot topic. While only a few directors receive a majority lack of support, those tend to be at companies that have plurality voting and thereby able to fully ignore shareholder sentiment. Some investors have developed a short list of problem directors and will vote against those directors at every company where the directors serve. 

Executive Compensation.  Speculation abounds over the rising number of companies that are disclosing realizable, or realized, pay, with some 40% of large-caps including this element in their proxy statements. But others lamented the lack of a cohesive and recognized method that would allow for comparability. Over 100 companies filed supplemental materials this season.  While most investors thought they were somewhat helpful, they generally do not change investor voting and in some situations triggered criticism when new information was presented that was not found in proxy statements. There was widespread agreement among investors that those filings, and subsequent investor discussions, should avoid being merely, or even largely, an attack on the proxy advisory firms’ recommendations. 

These brief highlights represent only a small portion of the active dialogue and discourse that made the conference a valuable resource as governance matters continues to gain prominence and affect both the workings and reputations of companies, in particular, as Chancellor Laster indicated, the underlying state law itself has changed very little while there has been enormous shift in the reality of the power balance between shareholders and companies. These are suitable times to have author Bethany McLean, known for her writing on Enron and the financial crisis, provide the closing address. She explored the causes of one financial scandal after another, questioning whether company leadership were willing to engage in candid assessments of their organizations’ risks and problems. 

Doug Chia, the Chairman of this 66th national conference and Assistant General Counsel and Corporate Secretary at Johnson & Johnson, reiterated his support for providing a forum where complex governance issues can be aired and understood, “We wanted to give governance professionals who support management and boards an opportunity to hear from and discuss the perspectives of the numerous constituents who influence the debate on effective corporate governance, and also a chance to engage with and learn from each other.“

As we remarked back in August 2011, the SEC website with its rulemaking schedule on Dodd-Frank initiatives is changed with little notice, as it has been again.  Back in August 2011 we even speculated whether the corporate governance rules would apply to the 2012 proxy season, but the SEC did not meet most of its previously stated timeline with the exception of the rules on mine safety.  The current schedule for January to June 2012 is as follows:

Final rules:  (a) disclosure by institutional investor managers on how they voted on executive compensation; (b) listing standards on compensation committee independence and compensation advisers; and (c) disclosure on conflict minerals and by resource extraction issuers.

Proposed rules:  (a) disclosure of pay-for-performance, pay ratios, and hedging by employees and directors; and (b) recovery of executive compensation.

For the July - December 2012 period, the SEC calendar currently indicates it plans to adopt final rules on (a) these executive compensation disclosures and clawback policy; and (b) end-user exception to mandatory clearing of security-based swaps. 

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Although the SEC staff has publicly stated that the clawback provision is the most complex of the remaining Dodd-Frank governance rulemaking, the most controversial provision appears to be the requirement to disclose the ratio between the CEO total compensation and the employee median.  Given the specific and prescriptive nature of the legislation, interested parties have been struggling for some time to come up with a workable solution, while some continue to argue for outright repeal.   

In August, the AFL-CIO suggested that the SEC could permit issuers to comply through the use of statistical sampling, with SEC guidance on how to construct the sample methodology, such as sample size and specific confidence levels, as well as allowing issuers to identify the median employee based solely on cash compensation.  Certain SEC staff members have publicly declared the idea "interesting" and worth considering as they develop proposed rules.  The SEC website still indicates that proposed rules are planned before the end of 2011. 

Now the Center for Executive Compensation, which represents the senior HR representatives of more than 325 of the largest US corporations, has responded with its own letter to the SEC.  After conducting a survey of its members, the Center concluded that statistical sampling would be extremely difficult for most global companies to implement, primarily due to the wide variability in pay practices and recordkeeping.  More than three-quarters of respondents have over 10,000 employees globally, with significant populations located in more than 10 countries.  Almost half said that manual calculations would be the predominant approach and that it would take at least three months to calculate the ratio, so that proxy deadlines may not be met. 

The primary concerns stem from the complexity of data aggregation given the fact that most companies, especially large multinationals, do not maintain a centralized list of employees that is linked to their compensation information.  Rather, since information about each employee is maintained in the separate country and business unit, statistical sampling would not avoid the need to develop a list that first identified all employees and then identified and calculated all elements of compensation needed for sampling purposes.  Some of the specific issuer responses noted that sampling would require examining local payrolls in over 30 countries or as many as 100 different payroll systems, and countless vendors.  Other concerns raised included the implications of currency values, tax impacts and privacy laws.  Issuers also questioned whether total cash compensation is an appropriate proxy for total compensation for non-US employees, as "in kind" contributions make up a substantial part of compensation in certain parts of the world for tax and cultural reasons. 

"Issuers appreciate the SEC staff's efforts to find a flexible approach for a very challenging requirement, but unfortunately statistical sampling would neither eliminate, nor reduce the significant difficulties associated with gathering the data necessary to accurately identify the median employee based on compensation.  For large multinational companies with multiple operating units like J&J, we can already see that this data gathering exercise will present major administrative burdens.  What we need is a practical solution that does not place additional strains on companies' resources in these tough economic times," commented Doug Chia, Corporate Secretary at Johnson & Johnson, which has 117,000 employees working in over 250 operating companies worldwide.

The Center concludes its letter by recommending that the SEC consider the use of estimates similar to median employee pay that are already publicly available, such as to employee earnings maintained by the Department of Labor's Bureau of Labor Statistics, which can be customized for a company's primary industries. 

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Section 951(b)(2) of Dodd-Frank requires companies to hold a non-binding shareholder vote on executive severance packages (golden parachutes) in connection with M&A transactions that are presented for shareholder approval.  Shareholder votes on golden parachutes have been required since April 25, 2011.  Pearl Meyer & Partners recently completed a study on the outcomes of such shareholder votes held between April 25, 2011 and September 26, 2011. 

According to the Pearl Meyer study, during this period, 37 companies included golden parachute disclosure and votes in their merger proxies, 24 of which to date have publicly disclosed the results of the golden parachute vote.  Each golden parachute vote received support of a majority of shareholders, with the median vote equal to 91% approval.  Interestingly, Pearl Meyer noted that the median support for the related merger transactions was 99%.  The study shows that shareholders are generally voting in favor of golden parachutes where the shareholders approve of the related merger transaction, but at slightly lower rates.

Pearl Meyer also noted that ISS issued reports on 32 of the 37 transactions.  Four of ISS’s reports contained a negative recommendation for the golden parachute votes.  Of the golden parachute votes that did not receive ISS support, according to the Form 8-Ks filed reporting the results of such votes, a majority of shareholders still approved each golden parachute vote (albeit by a percentage somewhat below the median – approval votes ranged from 57% to 95%).  Based on this early data, it appears that while ISS may have the ability to sway shareholder votes to some extent, the shareholders’ votes on golden parachutes are closely linked with shareholders’ views regarding the related merger transaction.  The “say on golden parachutes” vote therefore may not greatly affect a company’s decision(s) with respect to the golden parachute payments offered to executives and officers.

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We've been discussing with a number of clients whether it is appropriate to require employees to certify periodically that they are not aware of violations of the company's code of conduct or, put another way, that they have reported to the company all violations of which they are aware.  Some companies believe that this requirement can be a useful complement to a compliance program in that it requires employees to focus on the issue.  Others have been concerned that it could generate a lot of noise in the form of false leads, creating an investigative burden that could actually complicate the record.

There's another dimension to consider in this context: whether the very existence of such a requirement (independent of whether and how it is enforced) could be seen as interfering with an employee's statutorily-protected right to complain to the government.  If this seems to you like a tortured, thinking-too-hard argument, it's worth considering that a senior SEC official has recently advanced this very idea.

In a webcast on the invaluable corporatecounsel.net on September 13, Sean McKessy, the chief of the Office of the Whistleblower in the Division of Enforcement, had the following to say:

I would hate to have employers, with all the right intentions, craft language that could end up with unfortunate consequences.  For example, if the certification were drafted to say something like, “After six months I affirm that, to the extent that I was aware of any fraud, I came to the company to report it,”  an individual who had come to us might not feel comfortable signing the certification because he hadn’t gone to the company.  There could be some tension between trying to set up a structure like that and the statutory requirement of allowing the possibility for individuals to come directly to law enforcement or regulatory agencies.

Put aside that this objection on its face doesn't make a lot of sense, since (i) it addresses the case of someone who has already blown the whistle to the government, and (ii) there is in any case no inconsistency between going to the government and reporting internally.  What's disquieting is the prospect that a straightforward certification, of the type that many companies already use for the purpose of Sarbanes-Oxley compliance, could be twisted into an attempt by the company to suppress reporting to the government.

I'm inclined not to overreact to this; on some level it's the sort of thing you would expect the head of the Office of the Whistleblower to say, and it carries the standard disclaimer that it doesn't necessarily represent an official view of the SEC.  But it's a useful reminder that a certification policy should be drafted judiciously.  Just as you would generally be unwise to sanction a whistleblowing employee for failing to make an internal report first, you should avoid adopting a certification policy that even implicitly threatens such sanctions.  It's a fine line, and the details of drafting can matter.

Contact Bill Kelly.

Section 953(b) of Dodd-Frank requires companies to disclose the internal pay ratio between the total annual compensation of their CEO and the median total annual compensation of their employees.  Effectiveness of the requirement has been delayed until the SEC promulgates implementing rules.  Meanwhile, companies have complained that the calculations required to comply with the disclosure requirement are burdensome and unfeasible, and proposals for Section 953(b)’s repeal have been introduced in Congress. 

Against this background, it is somewhat surprising that shareholder proposals seeking disclosure of the internal pay ratio decreased in 2011, and average shareholder support for this disclosure has remained low (although it increased slightly in 2011).  According to an executive compensation bulletin published by Towers Watson in June 2011, shareholder proposals with respect to internal pay ratio disclosure dropped from 9 in 2010 to 3 in 2011 (through mid-June), while average shareholder support increased from 6.2% to 9.1%.

One such example of a failed shareholder proposal is the 2011 proposal by the International Brotherhood of DuPont Workers calling for the board of directors of E. I. du Pont De Nemours to compare the “compensation packages for senior executives with that provided to the lowest paid employees.”  The proposal received just 5.8% in shareholder support.

Some companies already address concerns regarding internal pay equity.  Examples of such “proactive” companies include Whole Foods Market, which places a cap (expressed as a multiple of the company’s average wage) on executive cash compensation, NorthWestern Corporation, which voluntarily disclosed in its 2011 proxy that its targeted compensation for its CEO in 2010, excluding benefits, was 18 times the median pay of all its employees, and Goldman Sachs, which released supplemental proxy materials dedicated exclusively to its compensation practices.

A possible reason for this lack of activism may be that shareholders as a whole are less concerned with internal pay ratio disclosure than with other areas of compensation policy, such as linking pay to performance and requiring executives to retain a significant percentage of their equity.

As we wait to see where the SEC and Congress will come out on mandatory internal pay ratio disclosure, it is difficult to predict where we will end up, but one thing looks certain – shareholder proposals are not currently leading the charge. 

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Earlier this week, the SEC announced a settlement with the former CFO of Beazer Homes USA to clawback incentive compensation and profits from the sale of Beazer stock of more than $1.4 million pursuant to the Sarbanes-Oxley Act.  Neither the CFO nor Beazer’s CEO, who reached a similar settlement with the SEC earlier this year for almost $6.5 million, was charged with personal misconduct.  Notably, the SEC blames Beazer’s chief accounting officer as the main perpetrator of the fraudulent actions that led to accounting restatements, but in accordance with the Sarbanes-Oxley Act, the SEC could not seek recoupment from any officers other than the CEO and CFO.  The SEC complaint against the chief accounting officer only included traditional cease-and-desist and disgorgement relief.

Section 304 of the Sarbanes-Oxley Act authorizes the SEC to seek recoupment of certain incentive compensation if an issuer must prepare an accounting restatement due to material noncompliance of the issuer with financial reporting requirements “as a result of misconduct.”  The SEC actions against Beazer’s CEO and CFO were criticized for taking an expansive reading of “misconduct” under the statute.  In contrast, the new rules the SEC is expected to promulgate in the coming months to implement the clawback requirements under Dodd-Frank will subject current and former officers to clawbacks, without reference to misconduct by anyone.  Under Dodd-Frank, companies must develop and implement policies with respect to (1) disclosure of incentive-based compensation that is based on publicly reported financial information and (2) clawback of incentive-based compensation from current or former executive officers following a restatement triggered by material noncompliance with any financial reporting requirements under securities laws.  The amount subject to the clawback is the amount in excess of what would have been paid under the restated results during the 3-year period preceding the date on which a company is required to prepare the restatement.

In a number of respects as noted below, the requirements of Dodd-Frank are broader than those of SOX.  Due to its expansive nature, in particular the absence of any misconduct as a trigger, there will likely be more clawback actions under Dodd-Frank than we have seen so far under SOX.  The Dodd-Frank provisions raise a number of interpretative questions, including whether SEC actions against officers will make it difficult for companies not to seek compensation reimbursements under Dodd-Frank if available.

Dodd-Frank	SOX
Requires clawbacks without regard to whether any misconduct has occurred	Requires misconduct, but according to the Beazer action, the misconduct does not need to be by the individual charged with clawback
3-year look-back	12-month look-back
Applies to current and former executive officers	Applies only to CEO and CFO
Enforceable by the issuer, as well as the SEC	Enforceable only by the SEC

 

For more information on open issues regarding the clawback under Dodd-Frank and its impact on foreign private issuers, see Compensation Clawback under Dodd Frank: Impact on Foreign Issuers from our Tokyo Office Blog.

The SEC news release regarding the clawback of compensation from Beazer Homes’ former CFO, as well as the related SEC complaint, can be found here.

Contact Ning Chiu. Contact Gillian Emmett Moldowan.

The SEC website contains a schedule of Dodd-Frank rulemaking, which has been helpful but at times confusing when the schedule is updated with little notice.  Currently, the schedule for the next five months of August - December includes:

Final rules:  (a) disclosure by institutional investor managers on how they voted on executive compensation; (b) listing standards on compensation committee independence and compensation advisers; (c) disclosure on conflict minerals, mine safety and by resource extraction issuers; and (d) end-user exception to mandatory clearing of security-based swaps.

Proposed rules:  (a) disclosure of pay-for-performance, pay ratios; and hedging by employees and directors and (b) recovery of executive compensation. 

The SEC calendar currently indicates it plans to adopt final rules on these executive compensation disclosures and clawback policy in the January - June 2012 time period.  In addition, during this period the SEC also intends to adopt rules (jointly with others) on the disclosure and prohibition of executive compensation structure and arrangements for financial institutions.

The real question is whether any of the executive compensation disclosure rules will apply to the 2012 proxy season.  While it seems unlikely that all of them will, and it will also depend on the nature of the comments received on the proposals, companies may recall that the final say-on-pay rules were adopted in late January 2011.  We may be in for a repeat of the same last-minute developments this upcoming season. 

Contact Ning Chiu. Contact Kyoko Takahashi Lin.

The DC Circuit's vacating of the SEC's proxy access rule has wider applications for the possible challenge of regulations under the Dodd Frank Act on the grounds that they fail to analyze the economic impact.  Even though we all know that the DC circuit is especially hard on the SEC,  other agencies could also find themselves in a similar position given the fact that the speed of deadlines under the Dodd Frank Act has essentially forced a very minimal economic review of hundreds of regulations.  The court's view that the SEC  "inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commenters" is a warning shot across the bow of Dodd Frank implementation.

Contact Margaret Tahyar.

A unanimous D.C. Circuit panel this morning invalidated Rule 14a-11 as "arbitrary and capricious", ruling that the SEC had failed to consider the potential costs and other impacts of the rule.  This outcome was fairly predictable given the composition of the panel that decided the case, but even so the scathing and dismissive tone of the opinion is remarkable.  The panel essentially swallowed the Business Roundtable and Chamber of Commerce arguments hook, line and sinker, even to the point of second guessing which academic studies the Commission should have relied upon and which it should have disregarded.

Where do we go from here?  Barring intervention from the Supreme Court, the decision sends the SEC back to square one: a dispiriting prospect, given that the subtext of the opinion is that this panel at least would have thrown out pretty much anything that the SEC might have put forth.  It's also hard to imagine the current Congress coming up with a statutory solution.  This means that the initiative on this subject may be back with companies and shareholders, where it arguably should have been all along.

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Some shareholders are using lawsuits as a new tactic to fight what they perceive as an escalation in executive compensation.  Shareholders are likely to find these suits difficult to push through the courts on their merits, but the suits can cost subject companies time and money, not to mention reputational harm brought on by negative media attention.

Last year, we saw shareholder derivative suits filed on behalf of KeyCorp (in Ohio state court) and Occidental Petroleum (in California state court) in connection with failed say-on-pay votes during the 2010 proxy season.  KeyCorp agreed, according to Reuters, to pay $1.75 million in attorneys’ fees and expenses to settle related suits and Occidental Petroleum, faced with three suits, settled one for an undisclosed amount and had two dismissed.  Both KeyCorp and Occidental announced significant changes to their executive compensation practices following the shareholder suits.

Similar lawsuits have been filed during the 2011 proxy season.  Earlier this month, a shareholder derivative suit Hercules Offshore, Inc. against the company’s directors, named executive officers and compensation consultant.  This suit represents the fourth shareholder derivative suit following a failed say-on-pay vote during the 2011 proxy season.  Suits have been filed on behalf of Umpqua Holdings (in Oregon), Jacobs Engineering Group (in California) and Beazer Homes USA (in Georgia) – all of which held meetings early in the proxy season.

In the suits on behalf of all six companies, the plaintiffs assert a disconnect between pay and performance, because of weakening corporate financial performance and increasing executive compensation.  However, unlike the suits filed in 2010, in which the plaintiffs claimed a multi-year history of excessive compensation at the respective companies, the suits filed this year focus on 2010 compensation relative to company performance.

The suits each claim that the directors breached their fiduciary duties, generally arguing that approving an increase in executive compensation not in line with the company’s disclosed pay-for-performance policy was an invalid exercise of the directors’ business judgment.  The plaintiffs argue that the failed say-on-pay votes rebut the presumption that the directors’ acted in the best interests of the company.  The validity of this argument is questionable in the case of the 2011 suits in light of the specific Dodd-Frank provision that the say-on-pay votes mandated by the Act do not create or imply any change to or addition to the fiduciary duties of directors.

Even so, if the cases get beyond a motion to dismiss, the outcome may be affected by the record (recall the Disney case from a few years ago).  Companies should consider what the background documents will show (including any compensation committee minutes) and be conscious of reviewing the record as closely as in, say, M&A matters.

Contact Kyoko Takahashi Lin. Contact Gillian Emmett Moldowan.

Earlier this month, the SEC readopted rules to ensure that its current definition of "beneficial ownership" would continue to apply to persons who purchase or sell security-based swaps ("SBS") on and after July 16, 2011.  The reproposal was prompted by Dodd-Frank's addition of Section 13(o) to the Exchange Act, which would have otherwise excluded security-based swaps from the disclosure and short-swing profit rules.  The SEC did not give any guidance as to when SBS constitute beneficial ownership for Section 13.  However, the SEC staff is evaluating possible changes to the Section 13 reporting requirements but the outcome and timing of that evaluation remains uncertain.  Here's a copy of the Davis Polk memo describing the new rule.

Contact Phillip Mills.

We presented a webcast today discussing the final Dodd-Frank whistleblower rules that the SEC adopted a couple of weeks ago.  It was a good discussion covering the range of challenges that companies are facing and expecting to face.  Based on questions raised by listeners both during and after the podcast it's apparent that many are struggling with how to continue to motivate employees to submit information internally through existing compliance systems, such as hotlines, rather than starting with the government.  Lots of variations on the theme:

• Can I provide by policy that employees are required to provide the company with information concerning suspected noncompliance? (yes)
• Can I enforce this policy by disciplining employees who take their complaints to the government first? (no)
• Can my policy state that employees should raise issues internally before going to the government? (generally not advisable, and in any case most companies have decided it's better not even to allude to the whistleblower bounty program)
• Can I have my own reward system for employees who submit information internally? (generally not advisable)

Bottom line is that the incentives for reporting internally in compliance with a corporate policy are inherently soft; we may celebrate you as a good citizen, may treat this favorably as part of your performance review, but we can't discourage you from going to the government first, and we can't realistically compete with the money that the bounty program could pay.  It's frustrating, but these limitations are to a great extent hardwired into Dodd-Frank and will be difficult to address through rulemaking.

Contact Bill Kelly.

The SEC held an open meeting today at which it adopted final rules implementing the whistleblower provisions in the Dodd-Frank Act. As expected, the final rules do not require employees to first report allegations through a company’s corporate compliance system before coming to the SEC, despite numerous comments by members of the corporate community urging the SEC to do so. The rules do contain additional provisions that purport to incentivize whistleblowers to report their concerns internally first although it is unclear what practical effect these provisions can reasonably be expected to have. Our Client Newsflash summarizing the final rules is available here. We also expect to hold a webcast on the final rules in the coming weeks.

Contact Richard Sandler.

As was rumored, the SEC has announced that it will hold an open meeting at 9:30 a.m. EDT on May 25, 2011 to consider the adoption of final rules implementing the Dodd-Frank whistleblower provisions. The SEC's announcement is here.  We'll be focusing on the open meeting with great interest.

Our memo from last November on the proposed rules is here. Our webcast on the proposed rules is here.

Contact .  Contact . 

When the SEC decided to eliminate the ability of brokers to vote on a discretionary basis without specific client instruction for director elections in July 2009, many predicted that it would seriously affect the ability of directors to obtain majority support.  The concern proved to be a false alarm.  As a result, when the Dodd-Frank Act required the elimination of broker discretionary voting for executive compensation matters, including say-on-pay, there wasn't nearly the same chatter. 

But it turns out that given the closeness of many of the failed say-on-pay votes, the reported broker non-votes would have made a real difference.  We calculated that 7 of the 21 companies reporting failed votes so far would have passed, in some cases by a decent margin, if the non-votes had actually been counted as "for" say-on-pay, which is not an unreasonable assumption given these discretionary votes generally favored management.  For one company, there were more broker non-votes reported than "for" votes. 

Currently for most companies the only proxy item that brokers can continue to vote on without client direction is auditor ratification.  In addition, many are not aware that the NYSE usually permits brokers to vote at their discretion on most management proposals to amend charters, including to declassify boards, eliminate supermajority provisions or allow special meetings of shareholders.  Since NYSE Rule 452 governing discretionary voting has a specific list of "cannot vote" items, items not on the list, and not viewed as contested, can be marked as a broker-may-vote matter by the NYSE.

Contact .

The debate on the Dodd-Frank whistleblower provisions is continuing on several fronts, with the SEC rumored to be close to finalizing its rule proposals and Congress considering proposals to address some of the (perhaps) unintended consequences of the original legislation.  A link to this week's House hearings is here.  At this stage of the legislative debate the parties seem mostly to be staking out extreme positions, from the Chamber of Commerce on one side to the AFL-CIO on the other.  Our memo from last November on the SEC proposal is here. Our webcast is here.  If you'd like to order a genuine Davis Polk whistle, well, you're out of luck.

 

It seems fair to assume that the SEC rules will take effect before Congress will be able to act.  The hope is that the SEC will pay attention to the host of comments it received (including from Davis Polk), particularly with respect to preserving the central role of corporate compliance systems.  The challenge, though, is that some of the worst features of the system are to some extent hardwired into the statute.

 

Contact Bill Kelly.

 

The SEC has just extended the deadline for comments in response to its proposed rules directing the national securities exchanges to adopt listing standards regarding the independence of compensation committees and advisers, as required by Dodd-Frank . The original deadline was today, and we had submitted our comments yesterday in anticipation, but commenters now have until May 19, 2011.

Our comments generally applaud the SEC for giving the exchanges the flexibility to develop applicable independence considerations. We’ve also made suggestions for technical changes and clarifications, such as that the independence rules for compensation committee members should not apply to committees that are responsible for broad-based plans (e.g., 401(k) plans), that the independence rules for consultants and advisers should not apply to in-house or outside counsel retained by management and that IPOing companies should be permitted a transition period, as they currently have under existing listing standards.

The SEC will consider the comments that it receives and will then propose its final rules. Ultimately, it will be up to the exchanges to determine how to implement those rules, subject to SEC approval. Exchanges must have their final listing standards within one year after the SEC publishes its final rules in the Federal Register.

Contact Kyoko Takahashi Lin.
 

Perhaps the onset of warmer weather has made us aware of the approach of July 21st, an auspicious date representing the one-year anniversary of the Dodd-Frank Act and also the statutory deadline for hundreds of provisions in the Act. The SEC doesn’t seem concerned, as it has announced a delay until August for final rulemaking on conflict minerals, resource extraction and mining disclosure, although those rules were required to be issued this month. The deadline to issue whistleblower rules also passed recently with Chairman Schapiro indicating that it’s coming soon. Now Congressman Barney Frank, the Act’s co-author, has publicly stated that the deadlines are not set in stone. According to this article, Mr. Frank remarked, “there is no penalty for not meeting the deadline. There’s no gun at their heads. Nobody gets fired.”

Contact Ning Chiu.

There continue to be multiple areas of legislative activity to repeal or amend certain provisions of Dodd-Frank, including draft legislation to require employees to communicate internally before making whistleblower claims to the SEC. In March House Republicans announced a bill to eliminate the provision to disclose the ratio between the CEO’s compensation and the median annual total of all employees. Recently the AFL-CIO denounced this attempt to “water-down” Dodd-Frank, expressing their belief that this disclosure would have a “profound impact.” on executive compensation. According to their data, the average total compensation for S&P 500 CEOs is now about 343 times that of the average American worker, up from 42 times in 1980.

Contact Ning Chiu.

Last week House Republicans announced that they are drafting five bills to eliminate or change parts of the Dodd-Frank Act.  One of the five is the elimination of the provision to disclose the ratio between the CEO’s compensation and the median annual total of all employees.  Could this possibly come to fruition?  Unlikely given the hurdles of getting any kind action out of Congress lately, but it’s a space to watch.  The latest SEC timeline aims for proposing and adopting final rules on the pay ratio disclosure in the August-December timeframe.  

Contact Ning Chiu. 

The SEC just issued a proposal to clarify that there will be no changes to the “beneficial ownership” rules for security-based swaps.  The concern was that language in the Dodd-Frank Act implied that if the SEC failed to enact new beneficial ownership rules for reporting security-based swaps by July 16, 2011, the SEC’s existing rules relating to derivatives reporting would no longer apply.  Yesterday’s proposal will dispel that notion (assuming the rule is made effective before July 16) by preserving the status quo for now.  Although this clarification is intended as a stopgap measure— the SEC is under pressure to reexamine its sections 13 and 16 rules in light of perceived abuses— I expect any rethink of sections 13 and 16 will be delayed by the overwhelming rule-making agenda arising out of Dodd-Frank.  Here’s the Davis Polk memo on the proposal.

 

Contact Phillip Mills.