Today’s column focuses on several of the provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203 (July 21, 2010) affecting executive compensation. These are (i) Say on Pay (including discussion of Proxy Access as it relates to Say on Pay), (ii) the so-called “clawback” provisions and (iii) the new requirement that a ratio of CEO pay to the median of the pay of all other employees be disclosed in the proxy statement. (These are only some of the provisions of Dodd-Frank that will impact on the executive pay process; a longer list of provisions relating to executive pay is noted separately below.)
Taken together, the provisions in Dodd-Frank that affect the executive pay process quite arguably will have the broadest and most significant impact on that pay process of any set of new rules ever contained in one law. The federal government, of course, has impacted for a long time on executive pay through tax and securities laws (and through temporary rulemaking such as that under Pay Controls (1971) and the Troubled Asset Relief Program (TARP) (2008)). But it is unlikely that there has ever been a single law that contains the potential long-term consequences for the process of setting executive pay that are contained in these provisions of Dodd-Frank.
For these reasons, Dodd-Frank may be described as a significant further step in the “federalization” of executive pay. “Federalization” for this purpose is intended to mean the use of federal law as a source of rulemaking and of governance on executive pay issues in contrast to the use of state law in deciding such issues.
Among the consequences of this federalization process will be a shift in the ultimate decision-making on important executive compensation issues from Boards of Directors to other “stakeholders” (or creation of a capacity to influence that decision-making). For example, shareholders (by Say on Pay votes and Proxy Access), regulators in Washington (by regulating on the meaning of excessive compensation at financial institutions) and, in some cases, a combination of federal regulators and SROs (in implementing “clawback” rules) will become more involved in the executive compensation process.
Boards of Directors will become increasingly concerned with compliance with rules and directives of these “stakeholders” (even when nonbinding in the case of Say on Pay votes). Boards’ historic role of having primary responsibility, under state law, for making important (often subjective) independent judgments on these significant executive pay issues will now be shared with (in some cases supplanted by) the authority of these other stakeholders under Dodd-Frank.
Dodd-Frank imposes new rules relating to executive compensation in the following areas:
- Shareholder voting (nonbinding) on executive pay (§951),
- Compensation committee independence (§952),
- Disclosures as to (i) executive pay in comparison with financial performance of the issuer and (ii) the ratio of the CEO’s pay to the median pay of all other employees of the issuer (§953),
- In the case of certain financial restatements, required recovery by the issuer of amounts paid to its executive officers (so-called “clawbacks”) (§954) and
- Standards and limitations on executive pay at financial institutions (§956).
Another provision, Proxy Access (§971), will likely have an impact, in some cases, in conjunction with some of the foregoing provisions (e.g., Say on Pay).
Two other provisions apply to executive pay but are not likely to affect significantly the executive pay process:
- Disclosures regarding employee and director hedging (including hedging as to grants under compensation arrangements) (§955) and
- New requirements as to voting by brokers on, among other matters, executive pay (§957).
All but one of these new Dodd-Frank provisions affects public companies generally. One provision (§956) establishes rules regarding “excessive compensation” at “covered financial institutions.” 
Corporate Governance Rules
Say on Pay and Proxy Access will impact significantly on actions of Boards of Directors, and particularly Compensation Committees, in their deliberations on executive pay. (Say on Pay and Proxy Access each has separate significance for the executive pay process, but their most significant impact may occur when the two are employed together in connection with a dispute over executive pay at a given issuer.)
1. Say on Pay. Say on Pay has been a part of corporate governance in the United States for a number of years.  Section 951 of Dodd-Frank now imposes on public companies generally the requirement of providing a nonbinding Say on Pay vote by share-holders.  The requirement to include a Say on Pay resolution in the proxy statement will apply starting with a covered company’s first shareholder meeting occurring after Jan. 21, 2011 (the six-month anniversary of the enactment of Dodd-Frank).
The new rule requires that at intervals no greater than three years shareholders must be given the opportunity for a nonbinding vote on the company’s executive compensation program. (That proxy statement for the first shareholders’ meeting occurring after Jan. 21, 2011, must give shareholders the right to vote on the frequency of the Say on Pay vote: it may be one, two or three years. At least once every six years, shareholders must be provided the opportunity for this separate vote as to the frequency of the Say on Pay vote.)
In addition to the Say on Pay vote, Dodd-Frank also requires that a nonbinding vote opportunity be given to shareholders, by separate resolution, in connection with a vote on a merger, consolidation, sale of assets or similar transaction, to approve so-called “golden parachute compensation” unless the agreements and understandings relating to such compensation have been the subject of prior Say on Pay votes within the meaning of §951. 
2. Proxy Access. Section 971 of Dodd-Frank authorized the Securities and Exchange Commission’s adoption of rules regarding Proxy Access. In Rule 14a-11 of Regulation 14A under the 1934 Act (as amended by §971 of Dodd-Frank), the SEC adopted a new Proxy Access rule effective Nov. 15, 2010. 75 Fed. Reg. 56668 (Sept. 16, 2010). Before the enactment of Dodd-Frank, the SEC already had been in the process of rulemaking on Proxy Access (See SEC Release No. 33-9046 (June 10, 2009).)
Under Rule 14a-11, if a shareholder has owned (and continues to own) 3 percent or more of the issuer’s voting securities for three or more years, that shareholder is eligible to include in the issuer’s proxy statement (at the issuer’s expense) a list of candidates (together with a statement of up to 500 words in support of each such candidate), which list may include a number of nominees representing up to 25 percent of the number of board seats.  (This means all board seats, not just those up for election in the case of a staggered board.) If more than one eligible shareholder proposes a list of candidates, the shareholder with the largest number of shares (and only that shareholder) will have the right to include a list of candidates. 
Comment. The combination of Say on Pay rules and the new SEC proxy access rules will put significant pressure on compensation committees to be sure there is nothing in the issuer’s executive compensation program likely to trigger a proxy contest. Not only activist shareholders but also shareholder advocates such as RiskMetrics likely will exploit this combination of new rules. 65433 5
Section 954 of Dodd-Frank requires the SEC to “direct” national securities exchanges and national securities associations to prohibit “the listing of any security of an issuer” if that issuer fails
“to develop and implement a policy providing—
‘(1) for disclosure of the policy of the issuer on incentive-based compensation that is based on financial information required to be reported under the securities laws; and
‘(2) that, in the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws, the issuer will recover from any current or former executive officer of the issuer who received incentivebased compensation (including stock options awarded as compensation) during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement.’”
This provision does not call directly for a clawback from the executive officers receiving the incentive compensation payments. Instead, briefly restated, it requires that (i) the SEC direct (ii) national securities exchanges and national securities associations to require that (iii) listed companies adopt “policies” that include recovery of incentive-based compensation that was based on erroneous financial information that results in financial restatements being required under the securities laws. 
Among many questions under §954 needing to be answered are the following:
- If an “accounting restatement” is required under securities laws, what financial “data” must be taken into account in determining the “excess” of the “incentive-based compensation” that the covered executive received over what he or she would have received absent the erroneous data? 
- b. If a board or compensation committee is given discretion regarding the payment of an incentive award, does this put the payment outside the application of §954 even if financial criteria underlie the award?
- Once the new rules take effect under §954, will they affect only payments made after the effective date? What about awards that, as of the effective date, are mid-cycle (say, two years into a three-year performance cycle)?
- What is meant by “recovery” of “incentive-based compensation”? An employer might recover the economic benefit to the executive by offsetting it against compensation that otherwise would be paid to the executive in the future. This might avoid a possible tax issue for the executive. On the other hand, it might not resolve a possible constitutional issue under the Fifth Amendment if, for example, Dodd-Frank were applied so as to require recovery of an award made to an executive (assume the executive to be faultless) prior to the date of enactment. 
Comment. Compensation committees will need to address §954 of Dodd- Frank promptly because the present language and design of plans and the awards under those plans may determine whether clawback rules to be adopted under §954 in the future will apply to such awards. For example, introduction of factors other than financial factors (such as company discretion as already noted) may alter, or even eliminate, the applicability of §954. At the same time, it is likely that, in order to protect themselves, more companies will insert language into plans and/or awards that provides for recovery in some form of an incentive payment that was based on financial error.
New Pay Ratio to Be Disclosed
Section 953(b) of Dodd-Frank provides that the SEC shall require each issuer to include in the proxy statement a ratio based on:
“the annual total compensation of the chief executive officer (or any equivalent position) of the issuer”
“the median of the annual total compensation of all employees of the issuer, except the chief executive officer (or any equivalent position) of the issuer.”
There have been vigorous protests over the required disclosure of this ratio in the proxy statement. A troublesome feature of the ratio for many issuers may be the impact on shareholders of such issuers who will see this ratio as to their company for the first time. This information, together with other Dodd-Frank changes including the introduction of Say on Pay and authorization of Proxy Access, may cause some anxious moments at many companies.
Apart from this concern, there are numerous questions regarding calculation of the ratio that will need to be addressed. These include:
- In the case of companies with employees located in numerous countries, how are adjustments to be made based on so many cost-of-living differences and currency differentials?
- If Company A manufactures its own components but Company B imports these same components, it would appear that Company B avoids, in computing the CEO pay ratio, the “down draft” of the lower compensation levels Company A is paying its own employees in its own manufacture of these components.
- To what extent will companies be given guidance by the SEC as to how to obtain actuarially equivalent calculations for large groups of employees (in both foreign countries and in the United States, assuming foreign-based employees are included in determining the ratio) in respect of pensions and deferred compensation arrangements requiring such calculations? What sort of modifications will be made in the standards of accuracy imposed on these calculations where companies are forced to make approximations?
In view of these and other questions raised by the CEO pay ratio, issuers generally should begin now the process of accumulating data necessary to calculate this ratio. Many of the calculations, however, will depend upon the positions to be taken by the SEC on questions such as those noted above. Dodd-Frank does not specify the date by which the SEC must adopt its rules covering the calculation of the pay ratio. It is not anticipated that rules will be in effect for the 2011 proxy season. The SEC recently indicated that it does not intend to propose rules regarding the CEO pay ratio until some time in the period of April-July 2011 (See http://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml).
 For this purpose, “covered financial institutions” include, generally, banks, brokerdealers, credit unions and investment advisors and also Fannie Mae and Freddie Mac. See Dodd-Frank §956(e)(2) for the more technical and complete definition of “covered financial institution.”
 For prior discussions on Say on Pay developments, see this column, June 28, 2010, and June 19, 2009. The first time a U.S. public company provided its shareholders with a nonbinding vote on its executive compensation programs was in 2008 when Aflac offered such a vote to its shareholders (a majority of those voting approved the programs). Nonbinding Say on Pay votes are required at companies with outstanding TARP obligations pursuant to §111(e) of the Emergency Economic Stabilization Act of 2008 (EESA) as added by the American Recovery and Reinvestment Act of 2009 (ARRA). Say on Pay laws also have been enacted in several European countries and have been under active consideration by governments in other countries as well.
 The Say on Pay requirements of §951 apply to issuers of securities registered under §12 of the Securities Exchange Act of 1934 (“1934 Act”) which are subject to §14 (Proxies) of such act. (An example of an issuer which is not subject to §14 is a “foreign private issuer” as defined in Rule 3b-4 under such act.) The SEC has the authority (under §951 of Dodd-Frank) to exempt certain issuers (or classes of issuers)—small issuers, for example—from the Say on Pay requirements.
 Section 951 of Dodd-Frank requires that in any proxy or solicitation for a meeting at which shareholders are asked to approve “an acquisition, merger, consolidation, or proposed sale or other disposition of all or substantially all the assets of an issuer,” the person making the solicitation must disclose “any agreements or understandings” that such person has with any named executive officers of either the company being acquired or the acquiring company concerning compensation relating to the acquisition, merger, consolidation, sale or other such disposition. The shareholders must be given a nonbinding vote to approve such agreements or understandings and compensation unless such agreements or understandings have been the subject of prior Say on Pay votes pursuant to §14A(a) of the 1934 Act, as added by §951 of Dodd-Frank.
 The new Proxy Access rules contained in Rule 14a-11 cannot be used by a shareholder trying to gain control of the company. For this purpose, “control” is presumably as defined in Rule 12b-2 of Regulation 12B under the 1934 Act: “the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise.”
 Although the shareholder who meets the threshold and holding period requirements with the highest percentage of voting stock is given preference under the new Proxy Access rule, if that shareholder does not propose nominees representing 25 percent of the number of directors, then other shareholders who meet the threshold and holding period requirements (in descending order of stock holdings following the shareholder with the highest percentage of voting stock) may include nominees including those proposed by any such larger shareholder until such number of shareholder nominees equals (but does not exceed) 25 percent of all directors.
 Section 954 of Dodd-Frank contrasts with §304 of Sarbanes-Oxley (15 U.S.C. §7243 (2002)) which claws back directly from any CEO or CFO subject to its provisions the applicable clawback amounts. See, also, clawback provisions under TARP. EESA §111(b)(3)(B), as amended by ARRA §7001.
 Presumably data relating to earnings must be taken into account. What about stock price (for example, in an incentive award tied to Total Shareholder Return)? Are restricted stock and stock unit awards, unless subject to separate performance criteria, covered by §954? The argument against such awards being covered would be (1) they are not “incentive-based compensation” for purposes of §954 (i.e., they are not, as such, performance-based) and (2) a stock or stock unit award based on time vesting only does not itself entail financial criteria to which §954 is directed.
 See in this connection SEC v. Jenkins, 2919 U.S. Dist. LEXIS 57023 (June 9, 2010). In the Jenkins case, the SEC brought an action under Sarbanes-Oxley §304 against an executive not accused of taking part in the misconduct that gave rise to the clawback. The executive moved to dismiss the action. The motion was denied. In his motion, the executive raised an issue as to the constitutionality of Sarbanes-Oxley §304. The possibility remains that constitutional issues will be raised at trial. Any constitutional issue under Dodd-Frank would be distinguishable from the constitutional issue under Sarbanes-Oxley. Dodd-Frank does not apply directly to the executive but rather directs the applicable securities exchanges and associations to adopt listing rules requiring clawback policies and enforcement by exchanges and associations be in the form of delisting the listed company. (To avoid delisting, the company, of course, would have to recover from the executive.) The affected executive presumably would argue that the federal government cannot do by indirection what it cannot do directly (on this particular point, to apply a new rule retroactively to awards previously paid). Whether any constitutional issue might arise on the ground of retroactive application of the statute to existing legal entitlements, including payments of compensation already made, will depend upon the determinations of the SEC in its future rulemaking as to the listing requirements of the exchanges and associations.