Some of the most heavily publicized provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Act), which was signed into law July 21, 2010, are those relating to the disclosure and determination of executive compensation.  The Act’s executive compensation provisions will affect not only financial services entities, but all public companies, and will require many to review and modify their current compensation practices in rather significant respects.

Key provisions pertaining to executive compensation include:

Say on Pay (§951)

Under the Act, compensation of named executive officers of every public company (subject to the SEC’s ability to exempt a class of issuers, such as smaller reporting companies) must be put to the vote of the shareholders.  This must occur no less than once every three years at either the annual meeting or another meeting for which proxy rules require compensation disclosure.  The vote will not be binding on the issuer or its board of directors.  This provision is effective for the first such meeting held on or after January 21, 2011.

In addition, the Act requires that shareholders be given the opportunity to vote separately on the frequency of the Say on Pay compensation vote. This Say on Pay frequency vote must occur no less than once every six years. Under the Act, the vote will determine whether to hold the Say on Pay vote in one-, two-, or three-year intervals.  The first vote on frequency is to be at the same meeting as the first Say on Pay vote. Institutional investment managers are required to report at least annually how they voted on Say on Pay and Say on Pay frequency during the reporting year.

Say on Golden Parachutes (§951)

The Act also requires that any agreements or understandings with respect to compensation payable to any named executive officer of a public company (subject to the SEC’s ability to exempt a class of issuers, such as smaller reporting companies) in connection with an acquisition, merger, consolidation or sale or other disposition of substantially all of the assets of the issuer must be fully disclosed to shareholders, including the amounts potentially payable, as a part of the proxy or consent solicitation materials requesting approval of the transaction.  Unless previously voted upon in a Say on Pay vote, the agreements must be put to a vote of the shareholders after such full disclosure. 

As with the Say on Pay vote, the Say on Golden Parachutes vote of the shareholders will not be binding on the issuer or its board of directors.  This provision is effective for any meeting held on or after January 21, 2011, where the shareholders are asked to approve an acquisition, merger, consolidation or sale or other disposition of substantially all of the assets of the issuer.  Institutional investment managers are required to report at least annually how they voted on Say on Golden Parachute votes during the reporting year.

Compensation Related Disclosures (§953)

Under the Act, public companies must provide (in proxy or consent solicitation materials for the annual meeting of shareholders) a clear description of all compensation (as defined in existing regulations) paid to the named executive officers but with certain additional disclosures. While the full nature and extent of these additional disclosures will not be known until the relevant regulations have been promulgated, the Act does specify that the following information will be required to be disclosed:

• Pay vs. Performance – information that shows the relationship between executive compensation actually paid and the financial performance of the issuer, taking into account the value of its shares and any dividends or distributions paid.
• CEO vs. Other Employees – information that shows the median of the annual total compensation of all employees of the issuer (other than the chief executive officer), the annual total compensation of the CEO, and the ratio of the median compensation  to the CEO’s compensation.

Expanded Independence Requirements (§952)

Under the Act, the SEC is directed to enact regulations requiring national securities exchanges and associations to adopt rules which a public company (with limited exceptions) must satisfy with respect to its compensation committee as a condition to having the company’s equity securities listed.  These new rules must require that compensation committee members of a listed public company be both members of its board of directors and independent.  The definition of “independence,” as well as any exemption, is ultimately left to the regulated national exchanges and associations as directed by the SEC. 

However, the Act directs that the definition of independence must take into account the source of compensation of any member, as well as whether the member is “affiliated” with the issuer or a related entity in any way other than as a director of the issuer.  SEC regulations are to grant the exchanges and associations rulemaking power to create limited exemptions (such as the exemption of certain relationships in the case of small issuers) beyond those provided by statute.

Similarly, the Act requires that all compensation consultants, legal counsel and other advisers to the compensation committee be selected only “after taking into consideration” factors the SEC concludes will affect adversely the independence of the advisers.  Such factors are to be specified by regulation. Again, the details will not be known until the relevant regulations are released.  However, among the factors to be considered in making the independence determination will be whether the adviser provides other services to the issuer, the amount of fees received for the services as a percentage of the adviser’s employer’s revenue, the adviser’s employer’s conflict of interest policies and procedures, any relationship between the adviser and members of the compensation committee, and whether the adviser owns any of the issuer’s stock. 

Under the Act, compensation committees are granted the power to select a compensation consultant, legal counsel and other advisers. If the committee chooses to exercise this power, then it is obligated to appoint, provide compensation for and exercise oversight over any such adviser.  Proxy or similar solicitations for shareholder meetings held on or after July 21, 2011, must disclose whether the compensation committee retained any compensation consultant, whether any conflict of interest arose with respect to such consultant, and how any such conflict is being addressed.  Such disclosures are not required by Section 952 with respect to legal counsel or advisers other than the compensation consultant.

Public companies are required to “provide for appropriate funding” as determined by the compensation committee, for payment of reasonable compensation for these advisers.  On or before July 16, 2011, the SEC is directed to issue regulations that require national securities exchanges and associations to prohibit the listing of any security of any issuer that violates Section 952.  The exchanges and associations are to have limited exempting authority, such as with respect to smaller reporting issuers.  Finally, issuers are to be given a reasonable opportunity to cure defects.

Special Provisions for Financial Institutions (§956)

The Act requires that new regulations concerning financial institution compensation be issued jointly by several federal financial regulators.  Under these regulations, any covered financial institution with assets in excess of $1 billion will be required to disclose its incentive-based compensation structure (if any) to federal regulators. Sufficient detail will be required in the disclosure to enable the regulators to determine whether the structure provides excessive compensation, or could lead to material financial loss for the covered financial institution.  This disclosure is designed to focus on the structure of compensation arrangements and not the actual compensation of any identified individual. 

At the same time, new regulations are to prohibit incentive-based payment arrangements encouraging inappropriate risks by paying excessive compensation, or that could result in material financial loss for the covered financial institution.  Covered financial institutions under this section of the Act include the following:

• Depository institutions (or holding companies) under the Federal Deposit Insurance Act;
• Broker-dealers registered under the Securities Exchange Act of 1934;
• Credit unions under the Federal Reserve Act;
• Investment advisors under the Investment Advisors Act of 1940; and
• Any “other financial institution that the appropriate Federal regulators, jointly, by rule, determine should be treated as a covered financial institution.”

Note that this section of the Act’s executive compensation provisions applies to private as well as public companies.  The regulations required by this section of the Act are to be promulgated by April 21, 2011.  The statute directs the drafters to certain FDIC regulations for guidance.

Conclusion

The Act does not impose specific limits or rigid structures on executive compensation.  Instead, the Act chooses to regulate executive compensation through increased disclosure to shareholders, expanded independence and the grant of clear authority and funding to compensation committees, and the encouragement of shareholder activism.  Many of the details of these provisions will not be known until the implementing rules and regulations are promulgated.  Affected companies are advised to remain alert to the developments expected over the next year.