How the Dodd-Frank Act Is Changing Corporate Governance

Just how much have the governance provisions of the Dodd-Frank Act actually enhanced corporate governance? It depends on who you ask.

While some bemoan the law's scattershot approach to governance, most say that its biggest effect is that it has caused investors and boards to communicate more with each other. And nearly everyone agrees that's a good thing.

The biggest change to governance has come from a provision of Dodd-Frank that provides investors with an advisory vote on executive compensation plans, known as “say on pay.” While most companies have received majority votes on their plans, the fear of a low tally has forced many companies to make changes to executive compensation.

Say-on-pay has also pushed boards to reach out to investor groups to assess their views on pay plans, and that has opened the door to a wider discussion on other governance topics. “This one small provision in the Dodd-Frank Act has been a catalyst for engagement between companies and their shareholders,” says Amy Borrus, deputy director with the Council of Institutional Investors. 

The new channels of communication could have a big effect on how investors register their displeasure with the board, say governance experts. In the past, shareholders who were unhappy with a company's executive compensation program had one option: to vote the directors out, notes Robert McCormick, chief policy officer with proxy advisory firm Glass Lewis & Co. That's not always the action shareholders might feel is in the best interests of the organization. “Now, they can send a more direct message,” McCormick says.

Indeed, most corporate boards are well aware of the power of these votes, even though they're non-binding and about 98 percent passed in 2013, according to Equilar. Given that so many votes are supported by wide margins, directors don't want their firms to be in the minority that either fail or just barely pass, Borrus says. “They want a strong margin of support.”

To achieve that, board members are more actively reaching out to investors. A study, “The First Year of Say-on-Pay Under Dodd-Frank: An Empirical Analysis and Look Forward,” by researchers at Wake Forest and Vanderbilt, concluded, in part: “Mandatory say-on-pay seems to have encouraged management to be more responsive to shareholder concerns about executive pay and corporate governance.”

While governance advisers generally agree the increase in dialogue between investors and shareholders is a positive development, some say say-on-pay hasn't changed the overall compensation picture that much. Expectations that the provision would reduce CEO compensation levels, for example, haven't been met, notes Patrick McGurn, executive director at proxy advisory firm ISS.  He says some politicians probably looked at say-on-pay as a way of dealing with broader issues of income disparity and runaway executive pay. “But say-on-pay hasn't done that anywhere.”

Others say it doesn't get at underlying problems with executive compensation plans. Allowing just a straight up or down vote on executive compensation “is kind of a blunt instrument,” says William Kelly, a partner with the law firm Davis Polk. “You don't get nuanced lessons.”

According to Kelly, some of the difficulties with the governance provisions of Dodd-Frank are that they are too varied and inconsistent in approach. “Certainly, there's no coherent theory of corporate governance that you can get from Dodd-Frank,” says Kelly.

David Lynn, a partner and co-chair of the corporate finance practice at law firm Morrison & Foerster, says Dodd-Frank falls short on governance reforms, at least compared to the Sarbanes-Oxley Act. SOX, he says, was an attempt to learn from the wrongdoing that occurred at companies like WorldCom and Enron, and thus focused on the internal control function and auditor independence. In contrast, Dodd-Frank takes a “scattershot” approach and includes a grab-bag of items that were making headlines at the time, Lynn says. “You can't say that if we'd had say-on-pay the financial crisis wouldn't have happened.”

Disclosure Provisions

Several Dodd-Frank governance provisions require companies to disclose information on everything from the independence of their compensation committee members to the ratio of CEO compensation to that of rank-and-file employees. Again, the potential effect–not all the regulations have been issued–likely will be mixed, say governance advisers.

One is Section 952, which deals with the independence of compensation committee members as well as any compensation consultants a company might engage. The rules the SEC adopted in January 2013 determine independence based on several factors, including any other services provided by the consultant as well as the business or personal relationship between the consultant and members of the compensation committee.

“Certainly, there's no coherent theory of corporate governance that you can get from Dodd-Frank.”

—William Kelly,

Partner,

Davis Polk

So far, the regulations don't appear to have had much of an effect. “I think this was a solution in search of a problem,” McGurn says, as the NYSE and Nasdaq already had requirements regarding compensation committee and consultant independence. “It's probably good to have the statutes modernized, but the practice had outpaced the rate of change” in the legislation, he adds.

Section 953 of Dodd-Frank requires companies to compare and disclose the ratio of total CEO compensation to the median total compensation of all other employees. The SEC proposed rules on the pay ratio disclosure in September 2013, with a sixty-day comment period, but it has yet to issue final rules. Many companies say they are concerned the disclosure will be misleading and difficult to compile.

                   ABOUT THIS SERIES

Compliance Week's exclusive four-part series on the Dodd-Frank Act will take a look at the state of rulemaking to carry out the 2010 landmark reform law. We'll explore how well some of the law's components are working and if it has had the intended effect of improving corporate governance and creating stability in the banking sector, along with what it is costing companies to comply and what's still to be done to finish rulemaking on the law.

Part 1: The Dodd-Frank Act: Where Are We Now, Feb. 4Part 2: How the Dodd-Frank Act Is Changing Corporate Governance, Feb. 11Part 3: The Costs of the Dodd-Frank Act, Feb. 19Part 4: Dodd-Frank Act Still a Work in Progress, Feb. 25

Charles Elson, law professor and chair with the John L. Weinberg Center for Corporate Governance at the University of Delaware, says he is also opposed to the required disclosure. “It's more a political thing; to shock,” he says. Still, Elson sees one potential benefit to the rule. “It will force boards to look at pay in the totality of the organization,” Elson says.

Section 953 also requires companies to disclose information on pay-for-performance executive compensation practices. Although the SEC has yet to propose and adopt rules on this provision, a number of companies already provide such information, reasoning that it's an effective means of selling the rationale behind their compensation programs, McGurn says.

The next section, 954, requires the SEC to direct the stock exchanges to prohibit companies from listing securities if they haven't developed and implemented compensation clawback policies. These rules also are also still in the works.

“This is one of the most heavily anticipated from investors' point of view,” McGurn says. While Sarbanes-Oxley also included a claw-back provision, it applied just to the CEO and CFO. “Clawbacks under Dodd-Frank are closer to the adage, ‘If you didn't earn it, you must return it,'” he says. And the policies would apply to “any current or former executive officer of the issuer who received incentive-based compensation.”

However, many companies already disclose their clawback policies, McCormick points out. Indeed, according to a 2012 Ernst & Young report, 86 percent of the Fortune 100 companies do so, up from 18 percent in 2006. “Shareholder pressure was sufficient; it really pushed companies to do more.”

Similarly, many companies already disclose whether their directors and employees can hedge any decreases in the market value of their stock—another requirement contained within Section 955 of Dodd Frank. “You can see these in most Fortune 500 companies' proxy statements,” Lynn says. The SEC has yet to propose and adopt these rules. 

If No Dodd Frank?

PROXY ACCESS

Below is an explanation of private ordering, which is used to gain proxy access on a company-by-company basis.

In 2011, the U.S. Court of Appeals for the District of Columbia vacated the Security and Exchange Commission's Rule 14a-11, which would have allowed shareholders with at least three percent of the shares outstanding to nominate up to 20 percent of a company's board.

However, shareholders still can use what's known as private ordering to gain proxy access on a company-by-company basis. This year, 12 shareholder proposals appeared on ballots, according to ISS Governance. That was up from nine in 2012. While average support dropped from 35.6 to 30.8 percent, three proposals received majority support, up from two in 2012. Additionally, investors' votes indicated “a strong preference for proposals with minimum ownership thresholds of three percent of shares outstanding for three years,” ISS said in its 2013 Proxy Season Review.

Even before 2011, proxy access proposals already were moving along at the state level, says Charles Elson, law professor and chair with the John L. Weinberg Center for Corporate Governance at the University of Delaware. He points out that Delaware enacted proxy access rules in 2009.

However, that doesn't mean that the SEC's rule was superfluous. In a 2009 paper, “Delaware's New Proxy Access: Much Ado About Nothing?” Lisa Fairfax, professor of law at the George Washington University Law School, argues that potential action by the SEC actually prompted Delaware's actions. “While not necessarily a persistent check, Delaware nevertheless shapes it laws with the background understanding that its failure to sufficiently protect the interests of shareholders and the corporation could trigger federal intervention.”

—Karen Kroll

The fact that many companies have begun implementing some of the provisions contained within Dodd-Frank even before the SEC has issued final rules prompts the question: Would investor activism have led to these changes, even without the legislation?

Again, opinions differ. “If there were no governance provisions within Dodd-Frank, probably from a governance standpoint, we'd be in the same place,” Elson says. State law—primarily in Delaware, which says it is home to more than 50 percent of public companies—had already been pushing this, he adds. And, Delaware's regulations tend to “create parameters around which boards can function,” Elson says. Federal involvement, in contrast, “creates fear and a bureaucratic way of looking at things.” 

But, trying to accomplish change one company at a time—often the option left absent regulation—can be arduous.

Borrus of the CII points to the issue of mandatory majority voting for directors in uncontested elections, which wasn't addressed in Dodd-Frank. While more than three-quarters of companies in the S&P 500 use majority voting, the percentage is far lower among smaller companies. Most use plurality voting. As a result, even directors who fail to gain a majority of the votes cast can keep their board seats. The CII has tried, as yet without success, to convince the Delaware bar to make majority voting the default standard under Delaware corporation law. It now is pressing NASDAQ and NYSE to require listed companies to use majority voting.

“Pushing for change on a company-by-company basis takes long, hard work,” Borrus says, adding that a majority-voting requirement is in place in most developed markets around the world. “You don't want lawmakers or regulators to legislate every twist and turn of corporate governance. But critical, basic shareholder rights should be universal for all public companies,” she adds.