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The Harvard Law School Forum on Corporate Governance and Financial Regulation, September 12, 2009 posting



Proposed Pay Reform Rules Raise Questions

Posted by Joseph E. Bachelder III, Law Offices of Joseph E. Bachelder, on Saturday September 12, 2009 at 5:29 pm

(Editor’s Note: This article previously appeared in the New York Law Journal.)

On July 17, the Securities and Exchange Commission (SEC) published in the Federal Register proposed changes in proxy statement disclosure rules affecting executive compensation as well as other matters. On July 31 the House of Representatives passed the Corporate and Financial Institution Compensation Fairness Act of 2009 (H.R. 3269) (the Compensation Fairness Act or the act). The bill, received in the Senate Aug. 3, has been referred to the Senate Committee on Banking, Housing, and Urban Affairs. It is not known when, after the recess, the committee plans to take up consideration of the bill. This column will examine both of these developments (discussion of the SEC proposals is limited to those involving executive compensation).

Proposed Disclosure Rules
The proposed new rules affecting disclosure of executive compensation by companies subject to the disclosure rules of the Securities Exchange Act of 1934 (the 1934 Act) concern (a) disclosure of the impact of compensation policies and practices generally on risks of the employer, (b) the reporting of stock option and other equity awards in the Summary Compensation Table and (c) the reporting on compensation consultants.

Reporting on Risk-Related Aspects of Compensation. The proposed rules require companies to evaluate in the Compensation Discussion and Analysis (CD&A) those risks arising from general compensation policies and overall practices at the company that may have a material effect on the company. 17 CFR 229.402(b)(2). Disclosure is not limited to compensation arrangements with named executive officers. The proposed rules describe situations that may require particular attention in the CD&A such as compensation policies at business units that carry a significant share of the overall enterprise’s risk or units that vary significantly from the risk/reward structure of the company.

The proposed rules also suggest examples of issues that should be addressed such as compensation policies that may have special impact on risk (e.g., short-term versus long-term awards and how they relate to business results, short-term versus long-term), policies involving adjustments for changes in risk evaluation and how the company monitors its own responsiveness to changes in its risk environment. The proposed rules emphasize that the situations and the examples of issues described are illustrations only and not exclusive statements as to what should be disclosed.

Comment. The inherent subjectivity of a discussion of compensation arrangements and their impact on a company’s risks raises questions as to how helpful this discussion will be to shareholders. Companies are not likely to make observations on their risk policies and practices that might put the company, its management or the members of the board, including the compensation committee, in jeopardy. It is questionable whether very meaningful analysis of compensation as a risk factor will be obtained in such circumstances.

New Accounting for Stock and Stock Option Awards
. The proposed new rule would change the current method for reporting grants of stock and stock options. Under it, awards would be reported in the Summary Compensation Table on the basis of the grant date fair market value of awards made during the fiscal year being reported. 17 CFR 229.402(c)(2)(v)-(vi). This contrasts with the current method, adopted in 2006, which requires reporting in the Summary Compensation Table for a fiscal year of the value of stock and stock options recognized in that year for accounting purposes under FAS 123R.

There have been complaints that the charge against earnings for a fiscal year failed to give shareholders the real “cost” for that year: the value of the stock awards and stock options granted in that year. In fact, the current proposal was proposed in connection with the 2006 rule-making but was dropped in the final rule in favor of the current expense-based reporting under FAS 123R.

The proposed rule also would change the reporting of salary and bonus if deferred at the election of the executive. In such event, the deferred amount would be reported as an award in the column designed for the form of award in which the salary or bonus was deferred: Stock Awards, Option Awards or All Other Compensation; or, if pursuant to a non-equity incentive plan, it would be reported in a footnote to the Salary or Bonus column to which it relates and cross-referenced to the Grants of Plan-Based Awards Table.

In connection with the proposed rule, the SEC has requested comments on the possibility that it might require that stock and stock option awards made for services rendered in the fiscal year being reported be included in the Summary Compensation Table even though granted after the end of the fiscal year in question.

New Rules Regarding Compensation Consultant Disclosure. The disclosure rules as adopted in 2006 require that a company (i) disclose its use of compensation consultants in connection with officer and director compensation, (ii) identify those consultants and (iii) provide certain other information regarding consultant services. The SEC has been concerned that some companies may retain a compensation consultant on executive and director compensation and, at the same time, retain such consultant on other compensation and benefit matters as well. In the introduction to the proposed rules, the SEC questions whether such a consultant can be truly independent in advising the committee on executive and director compensation matters.

The proposed rule provides that in such a case the compensation committee must disclose the compensation paid to the consultant for its services in connection with executive and director compensation matters for the committee and also the compensation paid such consultant for advice on other compensation matters. 17 CFR 229.407(e)(3)(iii).

Advice on plans of general applicability in which executives participate on the same basis as other employees (such as a qualified retirement plan) do not, by themselves, require separate reporting (and, if that were the only work performed, there would be no requirement under the proposed rule to report as to such a consultant or as to the fees paid to the consultant in that matter.)

Compensation Fairness Act
The Compensation Fairness Act would adopt new rules for public companies requiring “Say on Pay” advisory votes by shareholders and new rules relating to compensation committee independence (including retention of independent advisers).
[4] The proposed act also would prohibit compensation that encourages excessive risk-taking (captioned in the bill as “perverse incentives”). These prohibitions would apply to “covered financial institutions” (not to issuers generally like the first two proposals noted).

Say on Pay. Section 2 of the Compensation Fairness Act would amend Section 14 of the 1934 Act by adding a new subsection (i), requiring issuers to provide for a non-binding shareholder vote on executive compensation for named executive officers as required to be disclosed in the proxy statement.

Section 14(i)(2), titled “Shareholder Approval of Golden Parachute Compensation,” also would require that a person making a proxy solicitation for a meeting at which shareholders are asked to approve an acquisition, merger, consolidation, proposed sale or other disposition of all or substantially all of the assets of an issuer must disclose in its proxy solicitation materials any agreements and other understandings with named executive officers of the issuer (or, in certain cases, named officers of the acquiring issuer) concerning compensation that is related to the acquisition, merger or sale or other disposition. In the event disclosure is required as provided in the preceding sentence, Section 14(i)(2)(B) provides that shareholders of the issuer must be given an advisory vote on such agreements and other understandings.

Comment. There has been limited experience with the effectiveness of the “Say on Pay” concept as a tool of corporate governance. Advisory-only votes on pay arrangements with senior executives have not been part of corporate practices long enough to make conclusions as to their effectiveness. In addition to TARP-related requirements as to Say on Pay,
[6] there have been other legislative as well as shareholder-activist developments affecting Say on Pay.[7] Advisory votes on pay have a legitimate role in providing shareholders an opportunity to express their points of views without binding management. In fact, binding shareholder votes frequently are required on such matters as authorization of issuance of common stock in connection with compensation plans as well as pursuant to federal tax, securities and other regulatory requirements; and self-regulatory agencies such as the New York Stock Exchange have their own rules requiring in some cases shareholder approval of executive compensation plans. But there would be widespread resistance to subjecting executive pay arrangements across-the-board to mandatory shareholder approval.

The argument against such across-the-board mandatory shareholder approval is that determination of the level, structure and design of executive pay should be made by management under the supervision of the board of directors; shareholders, without direct involvement with the business, are not in a position to make the many, and often complex, choices involved in determining the level, structure and design of executive pay.

Compensation Committee Independence. Section 3 of the Compensation Fairness Act would amend the 1934 Act by adding Section 10B, establishing standards for determining independence of compensation committees.
[8] Section 3 would require that each member of a compensation committee be “independent” under rules to be adopted by the SEC. Under the act, in order to be considered independent, a member of the compensation committee may not “accept any consulting, advisory, or other compensatory fee from the issuer” other than in his or her capacity as board or board committee member.

The Compensation Fairness Act also sets up rules for the compensation committee’s retaining compensation consultants in order to assure the latter’s independence from management’s influence. In this regard, Section 3 of the act provides for standards of independence for compensation consultants and other “similar” advisers to be established by the SEC.

Section 10B(d)(1), as amended by Section 3 of the act, provides that the compensation committee shall have the authority and responsibility to appoint and supervise such consultants. Section 10B(d)(2) requires that the compensation committee disclose in the proxy statement “whether the compensation committee of the issuer retained and obtained the advice of a compensation consultant meeting the standards for independence promulgated pursuant to subsection (c).”
[9] Section 10B(f) requires that the issuer provide appropriate funding to the compensation committee to pay for such compensation consultants, independent counsel and other advisers.

Incentives That Encourage Undue Risks. The third subject of the Compensation Fairness Act is contained in Section 4 and captioned “perverse incentives.” Unlike Sections 2 and 3, it applies only to “covered financial institutions” as defined in Section 4(d)(2) of the proposed act. It would require “covered financial institutions” to provide reports to the appropriate federal regulator(s) (this term is defined in Section 4(d)(1)) that would enable the regulator(s) to determine whether the compensation structure:

(A) is aligned with sound risk management;
(B) is structured to account for the time horizon of risks; and
(C) meets such other criteria as the appropriate Federal regulators jointly may determine to be appropriate to reduce unreasonable incentives offered by such institutions for employees to take undue risks that—
(i) could threaten the safety and soundness of covered financial institutions; or
(ii) could have serious adverse effects on economic conditions or financial stability.

Section 4(b) of the bill directs “the appropriate Federal regulators” to jointly prescribe regulations that prohibit “any incentive-based payment arrangement, or any feature of any such arrangement, that the regulators determine encourages inappropriate risks” regarding the financial safety, soundness and stability of the covered financial institution.
[10] Enforcement is provided for under Section 505 of the Gramm-Leach-Bliley Act (Section 4(c)) 15 U.S.C. §6805 (1999).

Comment. In contrast to the more broadly applicable rules proposed by the SEC discussed above, the Compensation Fairness Act provides for specific rules to be adopted and implemented by federal regulators prohibiting certain pay structures and incentive-based plans of “covered financial institutions.” It is at least subject to question whether federal regulators can adopt specific rules “prohibiting” certain types of compensation structure and incentive-based pay arrangements without unduly interfering with the business decisions necessary to run (and to compensate the people who run) banks and other financial institutions covered by the act.

In addition, the federal regulators must coordinate in adopting and implementing regulations to assure uniformity of treatment of the compensation arrangements of the different institutions. Disparity of treatment could jeopardize some institutions, and unduly favor others, depending on how different regulators interpret what constitutes “alignment” of specific pay structures and pay arrangements with “sound risk management.


[1] The proposed new rule also would eliminate the reporting of the grant date value in the grants of plan-based awards table and eliminate the footnote treatment to similar effect for directors in a footnote to the directors compensation table.

[2] On a separate point, the SEC has requested comments on whether it should require restatement for named executive officers for the two preceding fiscal years being reported to the extent proposed changes in reporting of equity awards would change what had been previously reported for them for those years (including cases in which the executive had not been a named executive officer in the prior year). However, the proposal under consideration (as to which comments have been requested, as noted) would not require redetermination of who were the named executive officers for the prior years.

[3] The proposed rule is not clear as to whether there should be a separate reporting of (i) compensation paid to a consultant for advice to the compensation committee on executive and/or director pay matters and (ii) compensation paid to the same consultant for separate advice to management in respect of the same matters. As written, the proposed rule appears not to require a separate reporting in the circumstance described in the preceding sentence.

[4] Certain companies may be exempted from these provisions if the SEC determines that such an exemption would be appropriate, such as in the case of smaller reporting issuers.

[5] In its “Say on Pay” proposal, the Compensation Fairness Act very much resembles compensation-related provisions of the Shareholder Bill of Rights Act of 2009 (S. 1074) introduced in the Senate in May by Senator Charles Schumer of New York.

[6] See American Recovery and Reinvestment Act, Pub. L. No. 111-5, §7001 (2009), amending the Emergency Economic Stabilization Act, Pub. L. No. 110-343, §111 (the say-on-pay provision can be found in Section 111(e)); see also Treasury Interim Final Rule, TARP Standards for Compensation and Corporate Governance, 74 Fed. Reg. 28,394 (June 15, 2009) (to be codified at 31 CFR pt. 30) and SEC Proposed Rule, Shareholder Approval of Executive Compensation of TARP Recipients, 74 Fed. Reg. 32,474 (July 8, 2009) (to be codified at 17 CFR pt. 240).

[7] For a brief discussion, see this column, June 19, 2009.

[8] The statute defines “compensation committee” as a “committee (or equivalent body) established by and amongst the board of directors of an issuer for the purpose of determining and approving the compensation arrangements for the executive officers of the issuer.” If an issuer has no such committee, the board’s independent members will be considered the compensation committee.

[9] This disclosure requirement would apply to any proxy statement issued for an annual meeting (or special meeting in lieu of the annual meeting) on or after the one-year anniversary of the enactment of the act.

[10] Section 4(a) of the proposed act requires that such regulations be prescribed no later than nine months after the act is enacted.



© 2009 The President and Fellows of Harvard College




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