The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act), which has cleared the House and Senate and is headed for President Obama’s signature, includes a number of provisions regarding executive compensation and corporate governance that are applicable to all public companies, not just financial institutions. These include giving shareholders a “say on pay,” requirements for independence of compensation committees and their consultants, and various new disclosure requirements relating to executive compensation. The Act also gives the Securities and Exchange Commission (SEC) authority to adopt rules providing shareholders access to management’s proxy and requires listed companies to adopt “claw-back” policies to recover compensation based on inaccurate financial information. In addition, the Act exempts companies with market capitalizations of less than $75 million from the Sarbanes-Oxley Act requirement to obtain an independent audit of their internal control over financial reporting.

“Say On Pay”—Advisory Shareholder Vote on Executive Compensation

The Act requires all public companies to give shareholders a non-binding vote to approve executive compensation (commonly known as “say on pay”) at least once every three years. At least once every six years, shareholders must be given the opportunity to vote on how often they want to vote on executive compensation—every year, every two years or every three years—with the first vote to occur next year. The Act closely follows the provision of the American Recovery and Reinvestment Act that requires all participants in the Treasury Department’s Troubled Asset Relief Program (TARP) to give shareholders an annual say on pay.

Shareholders must be asked to approve compensation as disclosed pursuant to the SEC’s compensation disclosure rules, which generally require disclosure regarding the compensation paid to the chief executive officer, chief financial officer and the three other most highly compensated officers. This means that shareholders will cast a single vote to approve the compensation for all five executive officers named in the proxy statement. The vote will not be binding on the company and, as provided in the Act, will not be construed as overruling a decision by the board of directors. The Act specifically provides that the shareholder vote does not create or imply any change in the fiduciary duties of directors. The shareholder vote will not restrict the ability of shareholders to make proposals for inclusion in management’s proxy statement related to executive compensation.

The say-on-pay requirement will apply to any annual meeting, or other meeting, of shareholders that occurs more than six months after enactment for which SEC proxy solicitation rules require compensation disclosure. Although SEC rule-making is not required for the say-on-pay requirement to be effective, it is likely that the SEC will revise its proxy rules to address whether the inclusion of a say-on-pay proposal requires the filing of a preliminary proxy statement. Under current rules, TARP participants must file their proxy materials in preliminary form. With all public companies subject to a say-on-pay requirement, it seems unlikely that the SEC will continue to require the filing of a preliminary proxy statement solely as a result of a say-on-pay proposal being on the agenda.

Golden Parachute Compensation in Business Combinations

The Act requires disclosure, in a clear and simple form in accordance with regulations to be adopted by the SEC, of any agreements or understandings with any named executive officers regarding any type of compensation that is based on or relates to a business combination being undertaken by the company. This disclosure must appear in the proxy solicitation material for a meeting of shareholders to approve the business combination. The required disclosure must include a total dollar amount of all compensation that may be paid to the executive officer.

Unless the agreements or understandings with the named executive officers have been subject to a prior say-on-pay vote, the proxy solicitation material for the business combination must include a separate resolution to approve the golden parachute compensation as disclosed. As with the say-on-pay proposal, the shareholder vote is non-binding.

New Compensation Committee Independence Standards

The Act extends to compensation committees of listed companies independence requirements similar to those established under the Sarbanes-Oxley Act for audit committees. As with audit committees, the compensation committee independence requirements will not apply to companies that are not listed on a national securities exchange, such as those that are traded on the OTC-Bulletin Board or the Pink Sheets. In addition, the independence requirements will not apply to controlled companies (companies with a 50% or greater shareholder) and certain other special situations.

The SEC rules must require that, in determining the definition of independence for compensation committee purposes, the exchange consider the source of compensation of the director, any consulting, advisory or other compensatory fee from the company, and whether the director is an affiliated person of the company or any subsidiary of the company. By providing the exchanges some flexibility in defining independence, these requirements appear to relax slightly those applicable to audit committees under the Sarbanes-Oxley Act, which make a director who accepts any consulting, advisory or other compensatory fee not independent for purposes of the audit committee.

The New York Stock Exchange and Nasdaq already require that listed companies maintain an independent compensation committee (or that executive compensation be determined by independent directors). However, the exchanges’ definition of independence generally applicable to directors requires payments to exceed specified dollar amounts before they impair a director’s independence. The new independence requirements for compensation committee members would be in addition to the existing stock exchange requirements. As a result, companies may find that some directors who currently serve on the compensation committee under existing stock exchange standards will be unable to serve because they, or their firms, receive compensation for services to the company.

The SEC has one year to adopt rules to address the listing requirements relating to compensation committees. Those rules will provide a reasonable opportunity for a listed company to come into compliance with the new listing requirements. The SEC may permit the exchanges to exempt a category of companies from the listing rules regarding compensation committees, taking into account the impact of the new requirements on smaller reporting companies.

Compensation Consultants

The Act permits a compensation committee to select a compensation consultant, legal counsel or other adviser to the compensation committee only after taking into consideration certain factors specified in rules to be adopted by the SEC. The Act does not expressly prohibit a compensation committee from engaging a consultant, counsel or adviser who is not independent, but the SEC’s rules may do so. The SEC’s rules must identify factors that affect independence, including (i) the provision of other services to the company by the firm that employs the consultant, counsel or adviser, (ii) the amount of fees received from the company as a percentage of total revenue of the firm that employs the consultant, counsel or adviser, (iii) the policies and procedures of the firm that are designed to prevent conflicts, (iv) any business or personal relationship that the consultant, counsel or adviser has with a member of the compensation committee, and (v) any stock of the company owned by the consultant, counsel or adviser.

Although the Act provides some guidance for the SEC, it leaves open important questions about when work relating to compensation matters constitutes providing consulting or advisory services to the compensation committee and when firms would be disqualified from providing services to the compensation committee.

The Act provides the compensation committee the authority to engage compensation consultants, independent legal counsel and other advisers, gives the committee responsibility for appointing, compensating and overseeing the work of such advisers, and requires the company to provide the committee with appropriate funding.

Claw-back Policies

The Act requires listed companies to adopt a “claw-back” policy for the recovery of incentive-based compensation that is based on financial information that is required to be reported under the securities laws. The claw-back policy must provide that if the company is required to prepare an accounting restatement due to material noncompliance with any financial reporting requirement, the company will recover any excess compensation from any current or former executive officer who received incentive-based compensation (including stock options) based on the erroneous data during the three-year period preceding the restatement.

Disclosure Requirements

The Act imposes several new disclosure requirements relating to compensation consultants, compensation matters and corporate governance.

Use of Compensation Consultants.  Companies will be required to disclose whether the compensation committee retained and obtained the advice of a compensation consultant and whether the work of the compensation consultant raised any conflict of interest and, if so, how the conflict was addressed. This disclosure must appear in any proxy materials for an annual meeting occurring more than one year after enactment. This new disclosure requirement significantly overlaps the disclosure requirements regarding compensation consultants that were added for the 2010 proxy season.

Pay vs. Performance.  Companies will be required to provide information that shows the relationship between executive compensation actually paid and the financial performance of the company, taking into account changes in the value of the company’s stock and any dividends or other distributions. The disclosure may include a graphic presentation. SEC rule making will be required to implement this disclosure requirement—and to clarify what is meant to be disclosed.

Relative Pay.  Companies will be required to disclose the median of annual total compensation of all employees, excluding the CEO, the annual total compensation of the CEO and the ratio of the two. The annual total compensation of employees must be determined by reference to the SEC compensation disclosure rules. Because total compensation for SEC disclosure purposes includes a variety of items beyond salary—such as the value of option grants and stock awards, bonuses earned for the year but paid in the following year and changes in pension value—calculating median total compensation for all employees could be a significant burden. This disclosure will be required in registration statements, proxy statements and other documents in which disclosure regarding executive compensation is required. SEC rule making will be required to implement this disclosure requirement.

Hedging.  Companies will be required to disclose in any proxy statement for an annual meeting of shareholders 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 equity securities that are granted to the employee or director as compensation or that are held, directly or indirectly, by the employee or director. The Act does not prohibit hedging and does not require disclosure of whether or not an employee or director has actually hedged his or her ownership of company stock. Currently, executive officers and directors are obligated to disclose transactions in derivative securities (such as puts, calls and securities futures contracts) under the beneficial reporting requirements of Section 16 of the Securities Exchange Act. In light of the required disclosure, companies should consider whether to adopt a policy that expressly permits or prohibits hedging of company stock. SEC rule making will be required to implement this disclosure requirement.

Chairman and CEO Structure.  Companies will be required to disclose in their annual meeting proxy statement why the company has chosen to have the same person serve as chairman of the board of directors and CEO or why the company has chosen to have different individuals serve in these positions. This provision adds little, as the SEC recently adopted a substantially identical disclosure requirement that was effective for the 2010 proxy season.

Corporate Governance Matters

Voting by Brokers.  The Act requires all national securities exchanges to prohibit brokers from exercising discretionary voting—i.e., voting shares of stock beneficially owned by their customers without receiving instructions from those customers—on the election of directors, executive compensation and any other significant matter that the SEC identifies by rule. Brokers that are members of the NYSE are already prohibited from voting on the election of directors or the approval of new compensation plans without receiving customer instructions. The primary significance of this provision of the Act, therefore, is that it makes a say-on-pay proposal a non-routine matter.

Proxy Access.  The Act amends the Securities Exchange Act to give the SEC authority to adopt rules and regulations regarding the obligation of a company to include in the company’s proxy materials a shareholder’s, or group of shareholders’, nominees for director (commonly referred to as “proxy access”). The SEC has on several occasions, most recently in 2009, taken up the issue of proxy access. One of the criticisms of this effort has been that the SEC lacks statutory authority to grant shareholders access to the company’s proxy in connection with the election of directors. Under current law, shareholders wishing to solicit proxies for their own nominees for director must use their own proxy statement. This provision of the Act paves the way for the SEC to complete its rule making on proxy access, which it had expressed the intent to do in time for the 2011 proxy season.

Smaller Companies Exempted from Sarbanes-Oxley Requirement for Independent Audit of Internal Control Over Financial Reporting

The Act permanently exempts companies with less than $75 million in market capitalization (called “non-accelerated filers”) from complying with the Sarbanes-Oxley Act’s Section 404(b) requirement that independent accountants audit a company’s internal control over financial reporting.

Pursuant to the Sarbanes-Oxley Act, the SEC currently requires companies to include in their annual reports a report of management, and an accompanying auditor’s report, on the effectiveness of the company’s internal control over financial reporting. Under the Act, non-accelerated filers would continue to have to provide management’s report, but would not need to obtain an audit of internal control over financial reporting from an independent accountant.

The obligation of non-accelerated filers to obtain an independent audit of internal control has been deferred a number of times, to more than five years after the date on which compliance was required of larger filers, out of concerns regarding the cost of compliance to these smaller companies. Under current rules, a non-accelerated filer must first obtain an independent audit of internal control over financial reporting when it files an annual report for a fiscal year ending on or after June 15, 2010. The Act provides a last minute reprieve from this compliance obligation.

Promisingly, the Act requires the SEC to prepare a study on how Sarbanes-Oxley Section 404(b) compliance burdens on companies with market capitalizations between $75 million and $250 million could be reduced (including considering whether such companies should also be completed exempted from Section 404(b)), and submit such study to Congress within nine months after the Act’s enactment.

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