The Future of Comp Committees Under Dodd-Frank

Eight years ago, the Sarbanes-Oxley Act piled huge new duties onto corporate audit committees. Now their colleagues on compensation committees are bracing to see whether they’ll suffer the same fate under the Dodd-Frank Act.

So far the answer isn’t clear. The Dodd-Frank Act itself does not spell out new expectations for compensation committees anywhere near as extensively as SOX did for audit committees. Instead, all eyes will be on the Securities and Exchange Commission this fall as it churns out reams of required new regulations under Dodd-Frank. Those rules will address new independence standards, conflicts of interest, shareholder say-on-pay votes, compensation clawbacks, and more.

Kalfen

“This is just setting the stage for significant rulemaking,” says Donald Kalfen, a partner and senior consultant with Meridian Compensation Partners.

What’s more, at least some of the forthcoming rules are already common practice. For example, one provision requires that compensation committees be composed entirely of independent directors, and allows the committee (rather than management) to use compensation consultants. That’s already the rule for companies listed on the New York Stock Exchange.

In addition, while Nasdaq doesn’t require listed companies to maintain a compensation committee per se, all decisions about executive pay must be made by a company’s independent directors or a compensation committee comprised of independent directors.

One question, Kalfen says, is whether the SEC will define “independence” more restrictively than the NYSE and Nasdaq currently do. For a director, that could call into question the nature and source of his compensation, rather than just the amount; companies would need to study any consulting or advisory fees the director receives, for example, as well as any affiliations between the director and the company or its subsidiaries.

The SEC will also be pumping out rules about the independence of compensation advisers. For an adviser to be truly independent of the company, compensation committees will need to consider items such as:

The fees the company pays to the adviser, in total numbers and compared to the company’s total revenue;

The adviser’s own policies and procedures designed to prevent conflicts of interest;

Any business or personal relationship the adviser may have with members of the compensation committee; and

Whether the adviser owns any stock in the company.

One perceived conflict, for example, is one consultant provides compensation advice to both in-house management and the board at the same time. The obvious suspicion is that the consultant will come up with pay schemes favoring management, “so that could potentially taint the advice of the comp committee on pay levels,” Kalfen says. He expects the SEC’s forthcoming rules to clarify when such arrangements will be forbidden.

Wild Cards

Reda

Other provisions of the Dodd-Frank Act could lead to significant new burdens on compensation committees. One controversial provision is the requirement that companies report “internal pay equity”—that is, the ratio of the CEO’s compensation compared to the median compensation for all other employees. “For a large company, that is a monumental task that is not really worth the amount of money you have to pay to accomplish that,” says James Reda, managing director of compensation consulting firm James F. Reda & Associates.

“[P]ublic companies aren’t concerned that they have to make the disclosure; they’re just concerned about the practical aspects of being able to make the disclosure.”

—Donald Kalfen,

Partner,

Meridian Compensation Partners

Calculating median worker pay might not be easy. For example, how should a company translate its overseas employees’ pay into U.S. dollars? Are part-time or seasonal employees included? Are union employees included?

Friske

Doug Friske, a compensation consultant at Towers Watson, also contends that investor groups aren’t interested in CEO pay relative to the average worker, but rather in CEO pay relative to that of other executives at the company. “So it will be interesting to see how it plays out, when there are a lot of people who question its value,” he says.

Investor activists might challenge that statement, but without question, CEO pay relative to average worker pay has soared; the Institute for Policy Studies says the multiple went from 42 to 1 in 1960 to about 350 to 1 today. Still, “public companies aren’t concerned that they have to make the disclosure; they’re just concerned about the practical aspects of being able to make the disclosure,” Kalfen says. The only step they can take today, he says, is “to start thinking about how they’re going to collect that data.”

The SEC might develop a safe harbor clause, where companies can rely on reasonable estimation techniques, “but it’s a pretty big undertaking,” Reda says.

Another looming question will be expansion of clawback provisions, which allow a company to recoup executive pay that was awarded based on financial results later proven to be bogus. SOX already includes a clawback provision, but it is limited to the CEO and the CFO and only for the previous 12 months of financial results.

Under the Dodd-Frank Act, the SEC must publish rules directing U.S. stock exchanges to require clawback provisions for all listed companies. Those provisions must apply to all incentive-based compensation (including stock options), for current and former executive officers, for the previous three years’ of results rather than one.

Clawback clauses themselves, while relatively new to the corporate governance world, are actually quite popular with directors and shareholders alike. The challenge under Dodd-Frank will be how to implement them since they will be mandatory: compensation committees will have no discretion whether to trigger the clawback, nor any discretion in how much to clawback.

Such discretion is important, however, since directors often want some degree of judgment about how much pay to claw back under various circumstances. “There will need to be significant clarification from the SEC,” Kalfen says. “Presumably, the SEC will come out with some formula on how you determine the amount to claw back.”

For now, companies wondering whether they should revise any existing clawback provisions they already have should simply wait. “There’s no way at this point to make changes compliant with the new law, because no one knows exactly what it all means,” Kalfen says.

Dolmat-Connell

“The real issue … is that there’s been no case law in all of this,” says Jack Dolmat-Connell, president of compensation consulting firm DolmatConnell & Partners. Until there is, he says, companies will struggle with how to calculate the sums they want to claw back, and how well such clauses can be enforced.

And then there are the say-on-pay votes. The Dodd-Frank Act gives shareholders the right to a non-binding vote on executive pay packages at least once every three years. In addition, at least once every six years, companies must give shareholders a separate non-binding vote on whether say-on-pay votes should occur every one, two, or three years. (In certain circumstances, shareholders will also get non-binding votes on executives’ severance packages as well.)

Experts tell Compliance Week that, given the results of past voting patterns, shareholders will probably approve the executive pay packages at most large public companies. Those at risk of receiving a majority of “against” votes on their executive pay arrangements will be companies that have poor financial results, low shareholder returns or outlier pay practices.

For now, compensation committees can lean on several sources for help, such as the National Associate of Corporate Directors and the Center on Executive Compensation, Friske says. But at this point, even the experts are unclear about what the answers will ultimately be. “I believe we’re talking years before we understand what’s resulted from all of this,” Friske says.

Kalfen agrees. “This is just the tip of the iceberg.”