The Obama Administration and the G-20 have determined that corporate governance failures, including compensation that encouraged short-term risk taking, were significant causes of the financial crisis. Bonuses that rewarded short term profits over the long term health and security of the firm, and other incentive-based compensation for executives to take big risks with excess leverage, threatened the stability of their companies and the economy as a whole. Thus, the draft legislation gives shareholders a say on pay and proxy access, ensures the independence of compensation committees, and requires companies to set clawback policies to take back executive compensation based on inaccurate financial statements as important steps in reining in excessive executive pay and helping shift management’s focus from short-term profits to long-term growth and stability.
The Senate Banking Committee draft legislation provides that proxy materials must include provisions for a separate shareholder advisory vote to approve the compensation of company executives. Similarly, a separate shareholder advisory vote is required for golden parachute agreements in connection with a takeover. These non-binding shareholder votes cannot be construed to overrule a decision by the board, to create or imply any change to the directors’ fiduciary duties or create any new duties, or to restrict or limit the ability of shareholders to make proposals for inclusion in proxy materials related to executive compensation.
The Restoring American Financial Stability Act provides shareholders with this powerful opportunity to hold accountable executives of the companies they own, and a chance to disapprove where they see the kind of misguided incentive schemes that threatened individual companies and in turn the broader economy.
The draft also directs the SEC to clarify disclosures relating to executive compensation, and require the disclosure of information showing the relationship between executive compensation and the financial performance of the company. There must be disclosure of charts comparing executive compensation with stock performance over a five-year period or another period as the SEC determines.
The draft amends Section 16 of the Exchange Act to require companies to develop and implement clawback policies. Thus, companies must adopt polices to take back executive compensation if it was based on inaccurate financial statements that did not comply with accounting standards and that required an accounting restatement due to the material noncompliance with any financial reporting requirement under the securities
laws. The company must recover from any current or former executive officer who received incentive-based compensation, including stock options, awarded during the three-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.
The draft also directs the SEC to require companies to disclose in their annual proxy statement whether their employees are permitted to engage in hedging by purchasing financial instruments, such as equity swaps, that are designed to hedge or offset any decrease in the market value of equity securities granted to employees by the company as part of employee compensation.
The draft gives shareholders access to management’s proxy card to nominate directors. Providing shareholders a greater role in choosing directors can help shift management’s focus from short-term profits to long-term growth and stability. Specifically, within, 180 days of enactment, the SEC must issue rules permitting the use by shareholders of management proxy solicitation materials for the purpose of nominating individuals to the board of directors, under such terms and conditions as the Commission determines are in the interest of shareholders and the protection of investors.
Corporate governance best practices often specify that the same individual should not serve as board chairman and CEO. In the spirit of the comply or explain concept enshrined in European corporate governance codes, the draft directs the SEC to adopt rules requiring a company to explain in its annual proxy sent to investors the reasons why it has chosen the same person to serve as board chair and chief executive officer or why it has chosen different individuals to serve as board chair and CEO.
Within one year, the draft directs the SEC to adopt rules prohibiting companies from having a board of directors with staggered terms of service unless the shareholders have approved such in advance. The percentage of shareholders required to approve a board of directors with staggered terms of service must be the percentage required by the company for an amendment to the certificate of incorporation or the bylaws. The draft defines a board with staggered terms of service as a board that conducts an annual election for membership in which fewer than all board members are elected.
Companies that already have boards with staggered terms of service not approved by shareholder vote would have to seek shareholder approval at the first annual meeting after the SEC rules are adopted.
In a major corporate governance improvement, the draft mandates independent board compensation committees, as well as mandating the independence of any compensation consultants and legal advisers hired by the committee. This will be a condition of listing on an exchange. In determining the independence of compensation committee members, SEC rules must require exchanges to consider the source of compensation and any affiliation with the company or any of its subsidiaries.
SEC rules must also allow an exchange to exempt a particular relationship from the independence requirements, taking into consideration the size of an issuer and any other relevant factors. Separately, the SEC is directed to adopt rules defining independence for compensation consultants and legal counsel hired by the compensation committee. Also, the SEC is directed to conduct a study and file a report on the effects of using compensation consultants on company performance.
The compensation committee has sole discretion to hire and obtain the advice of a compensation consultant and is directly responsible for the compensation and
oversight of the work of the consultant. However, the compensation committee cannot be required to implement or even act consistently with the advice or recommendations of the compensation consultant. At the end of the day, nothing can affect the ability or the obligation of a compensation committee to exercise its own judgment in the fulfillment of its duties.
Further, prosy or consent solicitation materials for an annual or special meeting of shareholders must disclose if the compensation committee retained or obtained the advice of a compensation consultant; and whether the work of the compensation committee has raised any conflict of interest and, if so, the nature of the conflict and how it is being addressed.
The draft also gives the compensation committee sole discretion to hire and obtain the advice of counsel and other advisers; and provides that the committee is directly responsible for the compensation and oversight of the work of the consultant. However, the compensation committee cannot be required to implement or even act consistently with the advice or recommendations of counsel. At the end of the day, nothing can affect the ability or the obligation of a compensation committee to exercise its own judgment in the fulfillment of its duties.
The legislation directs companies to provide appropriate funding, as determined by the compensation committee, for the payment of reasonable compensation to a compensation consultant; and to independent legal counsel or any other adviser to the committee.
SEC rules must allow exchanges to consider exempting a category of issuers from the compensation committee requirements. In determining appropriate exemptions, the exchange must take into account the potential impact of the requirements on smaller reporting companies.
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