More Dodd-Frank Compensation Rules Coming in 2012

The Securities and Exchange Commission has been happy to put off rulemaking on new compensation disclosures required by the Dodd-Frank Act, partly because Congress didn't include deadlines in the law. But according to the SEC, new rules aren't far off.

Despite wiggle room in the Dodd-Frank Act that allows the agency more time to adopt the rules, the SEC said in a recent report that it will soon issue proposals on the requirements. “While the Dodd-Frank Act did not mandate a deadline for their adoption, the Commission will also consider additional executive compensation requirements.” The statement was made in its Performance and Accountability Report for Fiscal Year 2011 released last month. The Commission's fiscal year ended on Sept. 30.

The full spectrum of the executive compensation disclosure requirements under the Dodd-Frank Act will include rules mandating new listing standards relating to specified clawback policies,  new disclosure requirements for executive pay ratios, rules on employee and director hedging, and the relationship between executive compensation and company performance. “I think everybody does expect the SEC to promulgate the rules. The questions we have are when and how these rules will come out,” says Jeffrey London, a partner at law firm Kaye Scholer.

The SEC has listed on its Dodd-Frank rulemaking schedule to propose all these rules by the second half of this year and has also scheduled the final adoption of these rules in the first half of 2012. As we move into the last calendar month of the year, the SEC has yet to issue any proposed rules related to the four areas. “The timing is important as companies have to make changes administratively when implementing the rules,” says London.

Some compensation attorneys are doubtful of the SEC's self-imposed timeline. “I will be shocked and surprised if they can meet all the deadlines. Most likely, we will not see the final rule on pay ratios,” says Michael Melbinger, chair of the employee benefits and executive compensation practice at law firm Winston & Strawn.

Many companies are waiting around to see what happens. For example, David Frishkorn chief compliance officer at Comverse Technology, says his company has already begun to address some of these requirements. “We have contracted outside consultants to advise us on company pay packages, and they have done a risk assessment on the compensation issue,” he says. He adds that the company had also recently conducted meetings with shareholders on their executive compensation practices on an advisory basis.

Pay Ratios and Clawbacks

Additional hold-ups are possible, since some of the rules are fairly complex and likely controversial, meaning the SEC will get plenty of comment letters to wade through. For example, many companies, compensation consultants, and others say the requirement to disclose CEO pay as a ratio of total employee pay leaves much still to be settled. In order to meet the requirement, companies will need to gather wage information from all employees. The task can be overwhelming for some companies with a global presence. “It is a fantastic amount of work to gather the information from employees worldwide,” says Steve Seelig, executive compensation counsel at global consulting firm Towers Watson.

“I think everybody does expect the SEC to promulgate the rules. The questions we have are when and how these rules will come out.”

—Jeffrey London,

Partner,

Kaye Scholer

The good news is that the SEC is still considering how to implement the rules, and they are exploring possible methods to simplify the calculation, he says. Some commentators have suggested to the Commission to come up with a simplified approach for companies to meet the requirement, the approximation method being one of them. “What we have been hearing from the SEC is that they have said to Congress there is no regulatory mandate to allow companies to use the approximation approach,” he adds.

Others argue that the calculations will be so skewed by the location of any given company's workforce that they will be difficult to compare and misleading. According to Seelig, executive pay among multinational companies that employ workers in lower-cost jurisdictions will look worse than companies that only employ in the United States. London points out that another issue with the pay ratios is whether investors will find the data meaningful at all. He says that he has been recommending that his clients adopt the wait-and-see approach when it comes to the pay-ratio disclosure. “This is the one rule that I tell my clients where those that procrastinate are rewarded,” he says.

DODD-FRANK AND BEYOND

The following excerpt from the SEC's FY 2011 Performance and Accountability Report discusses the Commission's progress in regard to rulemaking required under the Dodd-Frank Act.

In 2012, the SEC plans to conclude the vast majority of the rulemaking required by the Dodd-Frank Act and subject to deadlines set by Congress.

While the Dodd-Frank Act did not mandate a deadline for their adoption, the Commission will also consider additional executive compensation requirements. These will include rules mandating new listing standards relating to specified “clawback” policies, and new disclosure requirements for executive pay ratios, employee and director hedging, and the relationship between executive compensation and company performance.

The Commission has already proposed a number of regulations required by Title VII of the Dodd-Frank Act related to the regulation of over-the-counter derivatives. While proposing and finalizing the remaining rules, the SEC will also continue working with other regulators and market participants to construct the new regulatory framework in a way that takes into account the steps market participants will need to take to comply with the new regulations, and the order in which those steps might best be taken.To that end, the SEC will seek public comment on a detailed implementation plan that will permit a roll-out of the new requirements in a logical, progressive, and efficient manner, while minimizing unnecessary disruption and costs.

The SEC will continue to advance a number of studies required by the Dodd-Frank Act. Among these is a study of the credit rating process for structured finance products and the conflicts associated with the “issuer-pay” and the “subscriber-pay” models. A key part of this effort will be examining comments, proposals and data already received regarding the feasibility of establishing a system in which a public or private utility or a self-regulatory organization would assign agencies to individual rating projects, rather than continuing to rely on the current issuer-driven business model.

The SEC will consider the recommendations of a staff study on the obligations of investment advisers and broker-dealers that there be a universal fiduciary standard of conduct which applies to both types of registants when they are providing personalized investment advice to retail investors, and that regulations regarding the two professions be better harmonized.

Other agency priorities arising from the Dodd-Frank Act will include rules intended to better protect investors in the asset-backed securities (ABS) market by improving the disclosure and offering process for ABS and prohibiting many material conflicts of interest by entities packaging and selling them; rules regarding the registration of municipal advisers; and rules requiring that reporting companies provide information about their use of certain “conflict minerals” in their products.

One key rulemaking not related to the Dodd-Frank Act that the SEC expects to advance is the proposal to create a consolidated audit trail, which would allow regulators to track information related to trading orders received, routed and executed across multiple securities markets. The consolidated audit trail should allow the agency to rapidly reconstruct trading activity and quickly analyze both suspicious trading behavior and unusual market events.

The SEC, working with a team from the Financial Stability Oversight Council, is considering further structural changes to money market funds, building on reforms adopted shortly after the financial crisis, during which the Reserve Primary Fund “broke the buck.” These reforms would seek to address funds' susceptibility to runs and provide for a greater cushion in the case of an emergency.

The SEC is also reviewing ways to reduce the regulatory burdens on smaller companies, particularly burdens associated with capital formation, in a manner consistent with the Commission's investor protection mandate. This review will consider, among other things, the rules related to the triggers for public reporting, communications in public and private offerings, and new capital raising strategies.

Source: SEC's FY 2011 Performance and Accountability Report.

Another issue on most companies' and investors' radar is the provision on clawback policies. The Dodd-Frank provision will broaden the scope of pay recoupment among companies. Under Sarbanes-Oxley, only those responsible for wrongdoing that causes the financial restatement of a company are subject to clawbacks of up to one year of compensation. Dodd-Frank expands clawbacks to include all executives that are involved and lengthens the pay recoupment period to three years prior to the financial restatement of a company.

Many of the definitions of the terms used in calculation of incentive-based pay have yet to be determined. And there are still issues around individual pay indemnification. “The latest question is can [executives] buy insurance to protect their pay,” says Seelig.

London says another issue companies are contemplating is the existing compensation contracts that do not have the new clawback provisions built into the terms. “Some of our clients are already incorporating the broad-based clause in their clawback policies. If you have not done so, you can ask existing executives to sign off on the amendment to include the provision,” he says.

Pay-for-Performance and Hedging Activities

Although many companies are already familiar with the concept of pay-for-performance given the experiences they have gathered in the past proxy season, there will be no way to tell if what companies have been doing are in line with the final rule.

“This is a tricky one. The requirement for the rule in Dodd-Frank is so vague and general. You really cannot comply without the rule,” says Melbinger. There is no shortage of questions from companies. Many wish for more information on the timeframe, the choice of performance metric, and whether performance should be viewed in absolute or relative terms.

Opinions vary on the number and type of metrics that will be used in the final rule. London expects the performance metrics to include a group of performance indicators to determine executive compensation, while Melbinger says the SEC is more likely to pick one indicator only, most likely the total shareholder return.

 “The SEC will want an apples-to-apples comparison. They will want graphs to be exactly the same for all companies,” says Melbinger.

Another issue to consider is the definition of pay, says Seelig. “The statute says it must be based on the amount actually paid, but the question both the SEC and companies have to determine is how to define pay when equity is involved in the structure,” he says.

The SEC is also expected to adopt rules that would prohibit some forms of hedging against holding of company stock by executives and directors. Most compensation experts don't expect this to be a difficult area, since companies already have policies in place when it comes to hedging. “The SEC is only trying to address if they are sufficient,” says Seelig.

London says among his clients, he found that larger companies are more prepared for the upcoming regulations compared to smaller firms. Many large companies have begun seeking experts' guidance on these upcoming requirements. “Unfortunately, smaller companies do not have the manpower,” he says.