Kevin D. Cramer, Sandra Cohen, James Lurie
July 21, 2010
Earlier today President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act), which in various iterations has been the subject of intense debate on Capitol Hill for much of the past year. The Act will bring about a major revamping of the U.S. financial regulatory landscape, including the creation of a new consumer protection bureau within the U.S. Board of Governors of the Federal Reserve System (the Federal Reserve), restrictions on the ability of banks to invest and trade in securities for their own account and new regulations governing derivatives.
While the Act represents sweeping financial reform, it also contains many provisions that are applicable to non-financial industry companies.
We have set out below a discussion of certain provisions of the Act that we believe may be of particular interest to our clients relating to:
When reviewing this update, please note that critical details remain to be addressed through the rule making process at various federal regulatory agencies. Thus, the full scope of the reforms contained in the Act will not be known for some time.
The Act provides the Commission with explicit authority to (but does not mandate that it) adopt rules that would require a U.S. publicly traded company to include in its proxy solicitation materials a nominee submitted by a shareholder to serve on the company’s board of directors and that would require the Company follow a certain procedure in relation to such a solicitation. It further provides that the Commission may issue rules permitting the use by a shareholder of proxy solicitation materials supplied by an issuer for purposes of nominating individuals to serve on the board of directors. The Act does not prescribe any specific parameters for any proxy access rules that are adopted, leaving that up to the Commission. Furthermore, there is no requirement in the Act that the shareholder seeking proxy access must hold a specified percentage of the issuer’s securities or have been a holder of such securities for a stated period of time. In contrast, many Canadian public companies are subject to Canadian corporate law requirements that permit shareholders holding at least 5% of the outstanding shares of the company to require the company to include in its proxy solicitation materials nominations for the election of directors. The Act specifically requires that the Commission consider whether small issuers should be exempt from such new rules due to any disproportionate burdens such a policy would impose on them. As implementation of any new rules governing proxy access relates to proxy solicitations under Section 14(a) of the U.S. Securities Exchange Act of 1934 (the Exchange Act), Canadian foreign private issuers would not be affected as all foreign private issuers are exempt from having to comply with U.S. proxy requirements.
On July 14, 2010, the Commission issued a Concept Release on the U.S. proxy system, seeking public comment on the accuracy, transparency, and efficiency of the voting process; communications and shareholder participation; and the relationship between voting power and economic interest. While the Chair of the Commission has publicly stated her commitment to putting a proposal on proxy access before the Commission within a timeframe that would permit rules to be in effect for the 2011 proxy season, proxy access has been a particularly contentious issue for the Commission and it remains to be seen whether this goal can be met.
Risk Committees for Nonbank Financial Companies and Bank Holding Companies
The Federal Reserve is directed by the Act to require each nonbank financial company that it supervises and is a publicly traded company, to establish a risk committee that will be responsible for oversight of the enterprise-wide risk management practices of the entity. The risk committee must be in place no later than one year after it receives notice that it is an institution subject to supervision by the Federal Reserve and subject to certain prudential standards. The Federal Reserve is also required to issue regulations requiring each bank holding company that is a publicly traded company and has total consolidated assets of not less than US$10 billion, to establish a risk committee. The Federal Reserve may also require bank holding companies with fewer than US$10 billion in consolidated assets to establish a risk committee. The Act provides that a risk committee must have such number of independent directors as the Federal Reserve may determine appropriate, based on the number of the institution’s operations, size of assets and other appropriate criteria. It further specifies that such committee must include at least one risk management expert experienced in identifying, assessing and managing risk exposures of large, complex firms.
Discretionary Voting by Brokers
The Act requires that national securities exchanges such as the NYSE or the NASDAQ prohibit broker discretionary voting in connection with a shareholder vote regarding: (a) the election of directors (other than in an uncontested election of the board of any investment company registered under the U.S. Investment Company Act of 1940); (b) executive compensation; or (c) any other significant matter as determined by the Commission. Previously, an amendment to NYSE Rule 452 eliminated broker discretionary voting in the election of directors but still permitted brokers to vote uninstructed shares on management proposals relating to executive compensation, such as the non-binding “say on pay” votes described below, which were considered routine matters. The Act therefore eliminates this ability.
Elimination of Sarbanes-Oxley Act Auditor’s Attestation Report on Internal Control Over Financial Reporting for Smaller Public Companies
Section 404(b) of the Sarbanes-Oxley Act requires public companies, including foreign private issuers, to include in their annual report, an auditor’s attestation report on internal control over financial reporting. In response to complaints from companies with small market capitalizations regarding the cost of complying with this requirement, the Act exempts from such attestation requirement any issuer that is neither a “large accelerated filer” nor an “accelerated filer” as defined by Commission rules. As a general rule, any public company with an aggregate worldwide market value of voting and non-voting common equity held by non-affiliates of less than US$75 million as of the last business day of the company’s most recently completed second fiscal quarter will now be exempted from the auditor attestation requirement. In Canada there is no requirement for publicly traded companies to provide an auditor attestation report on internal control over financial reporting, therefore small cap Canadian issuers whose securities trade in the United States will benefit from this reform. The Act also directs the Commission to conduct a study to determine how it can reduce the burden of complying with the attestation report requirement for companies with a market capitalization of between US$75 million and US$250 million, while maintaining investor protection.
Chairman and CEO Disclosures
The Act directs the Commission, not later than 180 days after enactment of the legislation, to issue rules that will require U.S. public companies to disclose in their annual proxy statements the reasons why they have separated or combined the positions of chairman of the board of directors and chief executive officer. As foreign private issuers are not subject to the U.S. proxy rules, this provision will not apply to Canadian dual-listed companies, but may become viewed as a disclosure “best practice.” In Canada, we note that the typical practice for issuers listed on the TSX is to split these roles between two individuals, and, if one person is serving as both chairman and CEO, to appoint a lead director.
The Commission’s 2009 amendments to its proxy rules already require substantially similar disclosure to that required by the Act and, in cases where these positions are combined, include a requirement to disclose whether the company has, and the role of, a lead independent director. Accordingly, it is unclear whether the provision of the Act will result in any significant new disclosure requirements.
Say on Pay – Two New Requirements
A new Section 14A has been added to the Exchange Act which deals with shareholder voting on executive compensation. The new voting requirements relate to proxy solicitation materials that include disclosure on executive compensation and “golden parachute” arrangements and are applicable to all domestic U.S. reporting companies. We expect that Commission rulemaking will confirm that these new requirements are not applicable to foreign private issuers, because foreign private issuers are currently exempt from the proxy statement requirements of Section 14(a) of the Exchange Act.
Say on Pay General Vote: Starting with the 2011 proxy season, all issuers subject to the Commission’s proxy rules will be required to solicit, at least once every three years, a non-binding shareholder vote to approve the executive compensation disclosed in the issuer’s proxy statement. At the 2011 annual meeting, U.S. domestic issuers must also let shareholders determine the frequency with which such votes must occur – annually, biennially, or triennially – and thereafter are required to re-solicit shareholder input on the timing of such vote at least once every six years. This U.S. legislative change is likely to accelerate the voluntary adoption of say on pay voting in Canada.
Say on Pay – Golden Parachute Vote: At any meeting of shareholders occurring more than six months after the Act’s enactment at which an issuer or other soliciting person seeks shareholder approval of an acquisition or merger, or sale of all or substantially all of the issuer’s assets, the issuer or other soliciting person must disclose in its proxy statement “in a clear and simple form in accordance with regulations promulgated by the Commission,” all compensation arrangements, whether present, deferred or contingent, with named executive officers that relate to the transaction, the conditions for payment and the amount of compensation that may be paid to them. The shareholders are then entitled to exercise a separate, non-binding vote to approve the disclosed compensation arrangements, unless such arrangements previously were subject to a say on pay vote. While the exact form and scope of those disclosure requirements is subject to Commission rulemaking, we note that current Commission rules already require disclosure about compensation and other interests that executive officers may have in a transaction, so it is unclear how much additional disclosure will be required by the Commission as a result of the Act or whether the additional non-binding vote will have any chilling effect on these types of “golden parachute” compensation arrangements
With respect to each of the above new disclosure and vote requirements, the Act specifies that the shareholder vote is not binding on the board of directors and cannot be construed as either overruling any company or board direction, or create or imply any change to, or create any additional, fiduciaries duties of the company or the board. The Commission may exempt issuers from both of the foregoing requirements.
Institutional Investment Managers Disclosure of Say on Pay Voting Record
Under the Act, institutional investment managers subject to Section 13(f) of the Exchange Act, will be required to disclose their say on pay and say on golden parachute voting records at least annually unless otherwise required by the Commission.
Independent Compensation Committees
The Act requires the Commission to adopt rules within twelve months after enactment that direct the national securities exchanges to prohibit the listing of any issuer that does not have a compensation committee composed entirely of independent directors (considering, among other things, the director’s source of compensation, including any consulting, advisory or other compensatory fee paid by the issuer, affiliate status and any other factors established by the Commission). This new requirement is similar to, although not identical to, the independence requirements imposed on audit committee members by the Sarbanes-Oxley Act. While the NYSE and Nasdaq listing requirements already include independence requirements for listed company’s compensation committees, the standards to be established by the Commission could be more stringent than those currently imposed by the stock exchanges. The Commission rule must also provide a reasonable opportunity for a company to cure any non-compliance with the new requirements. Foreign private issuers are expressly exempt from this new requirement if they provide annual public disclosure indicating the reasons the issuer does not have an independent compensation committee. However, U.S. listed foreign private issuers may prefer to comply with the independent compensation committee requirements rather than make the required disclosure of non-compliance and the reasons they do not comply. In addition, controlled companies (those in which more than 50% of the voting power is held by an individual, group or other issuer) are exempt from these new requirements.
Independent Consultants and Counsel to Compensation Committees
Although compensation committees are not required to engage compensation advisers, many do so as a matter of good governance. Issuers will soon be required to consider the independence of those advisers from the influence of management prior to hiring such advisers. The Act requires the Commission to adopt rules, within twelve months after enactment, that would permit an issuer’s compensation committee to engage compensation consultants, legal counsel and other advisers only after considering their independence. The Act directs the Commission to identify factors to be considered in assessing the independence of these advisers, including:
- other services performed for the company;
- the fees paid to the adviser as a percentage of total revenue of the adviser;
- processes in place by the adviser that are designed to prevent conflicts of interest;
- procedures for selection;
- business or personal relationships with members of the compensation committee; and
- any stock of the issuer owned by the adviser.
These factors must be “competitively neutral” among categories of consultants, counsel and other advisers. Furthermore, similar to current NYSE corporate governance listing requirements, the Act requires that the issuer’s compensation committee must have the authority to retain, determine compensation and oversee the work of any independent compensation consultant or legal counsel, and the company must fund the engagement. Foreign private issuers are not expressly exempt from this requirement, so any relief for them will need to be included in forthcoming Commission rules or revised requirements of the stock exchanges.
Commencing one year after enactment of the Act, proxy statements for U.S. domestic listed issuers will be required to disclose, in accordance with regulations of the Commission, if the compensation committee retained or obtained the advice of a compensation consultant, whether the work of the compensation consultant raised any conflict of interest, and if so, the nature of the conflict and how it was addressed. While foreign private issuers are not subject to these proxy requirements, such disclosure may represent a developing “best practice”.
Clawback clauses, which require executives to disgorge ill-gotten gains or bonuses, have become increasingly popular compensation tools to manage business risk, but are not required by law to be included in company contracts. The Act now requires issuers, as a condition of listing on a national securities exchange, to develop policies that re-coup incentive payment amounts paid to current or former executive officers during the three-year-period prior to any accounting restatement due to the issuer’s material non-compliance with financial reporting requirements under the U.S. securities laws. Misconduct is not required as a condition to the clawback. Amounts that exceed what would have been paid to the executive after giving effect to the restatement are subject to recovery under the new law. The scope of the clawback is unclear under the Act, although it expressly includes stock options which were awarded as compensation. The clawback provisions of the Act are broader than those contained in the Sarbanes-Oxley Act, which only apply to the CEO and CFO, require a material restatement of an issuer’s financial statements caused by “misconduct” as a condition for clawback and cover only a one-year look-back period. The Act also requires issuers to provide disclosure of the policy of the issuer on incentive-based compensation that is based on financial information required to be reported under the securities laws. Whether foreign private issuers will be subject to the foregoing provisions will be dependent on Commission rules that are adopted to implement the foregoing requirements and related new stock exchange listing standards.
Employee and Director Hedging
The Act mandates that the Commission develop rules (although no time table for adoption is set forth in this Act), requiring a U.S. public company to disclose in its proxy materials prepared for an annual shareholders meeting, whether any employee or director (or such person’s designee) is permitted to purchase financial instruments that are designed to hedge or offset any decrease in market value of equity securities of the issuer granted as compensation or otherwise beneficially owned by such person. While foreign private issuers will not be subject to these new proxy statement requirements, such disclosure should be considered by Canadian dual-listed issuers as a developing “best practice.”
New Executive Compensation Disclosure
New rules to be adopted by the Commission will require proxy statements for an annual meeting of shareholders to include a discussion of the relationship between executive compensation actually paid and the issuer’s financial performance, taking into account changes in value of the issuer’s stock and dividends. The disclosure may include a graphic or pictorial representation of such information. It is unclear what additional disclosure will be required as a result of these new requirements as similar disclosure is already required under existing Commission rules.
The Act also requires the Commission to amend its executive compensation disclosure requirements to require disclosure in any filing with the Commission of:
- the median of the total compensation of all employees of the issuer, other than the CEO;
- the annual total compensation of the issuer’s CEO; and
- the ratio comparing those two amounts.
As this new requirement applies to any filing with the Commission which includes executive compensation disclosure complying with the U.S. requirements for executive compensation disclosure, foreign private issuers who comply with those disclosure requirements will be subject to the new rules absent exemption by the SEC. This requirement is expected to impose a tremendous burden on corporations, in part because it requires the use of compensation data that is not typically readily available. For example, rather than requiring a simple averaging of all cash compensation costs for the year, it requires the calculation of “total compensation” for each employee in order to find the precise median employee. “Total compensation” refers to the same compensation definition as for disclosure of CEO pay, including the special rules for non-cash items. We expect that foreign private issuers will be exempt from this requirement via rules from the Commission.
Financial Institutions: Enhanced Disclosure and Reporting of Executive Compensation
Not later than nine months after enactment, the appropriate Federal regulators, which includes: the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency (OCC), the Board of Directors of the Federal Deposit Insurance Corporation (FDIC), the Director of the Office of Thrift Supervision (OTS), and the Securities and Exchange Commission, must jointly prescribe regulations or guidelines that:
- requires each covered financial institution to disclose to the appropriate Federal regulator the structures of all incentive-based compensation arrangements offered by the covered financial institution sufficient to determine whether the compensation structure provides an executive officer, employee, director, or principal shareholder of the covered financial institution with excessive compensation, fees, or benefits, or could lead to material financial loss to the covered financial institution; and
- prohibits any types of incentive-based payment arrangement, or any feature of any such arrangement, that the regulators determine encourages inappropriate risks by covered financial institutions by providing an executive officer, employee, director, or principal shareholder of the covered financial institution with excessive compensation, fees, or benefits, or that could lead to material financial loss to the covered financial institution.
Standards established must be comparable to existing safety and soundness standards for excessive compensation established under Federal Deposit Insurance Act for insured depository institutions. For purposes of the foregoing, a covered financial institution is broadly defined to include; (i) a depository institution or depository institution holding company, (ii) a registered broker dealer, (iii) a registered investment advisor and (iv) any other financial institution that the appropriate Federal regulators, jointly, by rule, determine should be treated as a covered financial institution for purposes of these requirements that in any such case has assets of at least $1 billion. The required regulations appear to apply to all covered financial institutions, including those incorporated outside the United States. In late June 2010, the Federal Reserve, the OCC, the FDIC, and the OTS issued new guidance on executive compensation. That guidance applied to the U.S. operations of foreign banks with a branch, agency or commercial lending company in the United States. While the guidance indicated some deference to home country supervision with respect to the U.S operations of foreign banks, it is unclear whether similar deference will be accorded as a result of the adoption of the Act’s new requirements that apply at the holding company level.
Special Note for Canadian “SEC Issuers”
Unlike other foreign private issuers, Canadian issuers that voluntarily comply with the Commission’s executive compensation disclosure requirements in their proxy statements in order to avail themselves of the exemption from Canadian compensation disclosure requirements will be subject to the Act’s new proxy disclosure requirements and the Commission’s implementing rules.
U.S. Federal Securities Laws
Extraterritorial Jurisdiction of Antifraud Provisions
The Act confers jurisdiction on the district courts of the United States and the United States courts of any Territory for actions or proceedings brought by the Commission or the United States alleging certain violations of the Securities Act of 1933, (the Securities Act) as amended, dealing with various fraudulent activities. The activities must be in connection with the offer or sale of any securities or any security-based swap agreement involving; (a) conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors; or (b) conduct occurring outside the United States that has a foreseeable substantial effect within the United States. Similar grants of jurisdiction are made in connection with violations of the Exchange Actand the Investment Advisers Act of 1940. These changes will have the effect of limiting the application of the recent U.S. Supreme Court decision, Morrison v. National Australia Bank, where the Court ruled that the antifraud provisions of the Exchange Act did not apply extraterritorially and, therefore, there is no basis for a cause of action based on alleged misstatements or omissions under Section 10(b) of the Exchange Act and Rule 10b-5 involving securities purchased on a foreign stock exchange. As the Act’s new jurisdictional provisions apply only to actions by the Commission or the United States, they will have no effect with regard to Supreme Court’s holding in Morrison barring suits by private litigants. However, under the Act, the Commission is required to solicit public comment and conclude a study within 18 months of enactment to determine the extent to which the jurisdiction of U.S. courts to consider private rights of action under the antifraud provisions should be extended in the same manner.
Beneficial Ownership and Short-Swing Profit Reporting
The Act amends the reporting obligations under both Section 13(d) and Section 16(a) of the Exchange Act to provide that the Commission may establish a shorter time period within which reports must be filed with the Commission. Currently, under Section 13(d) a person who acquires more than 5% beneficial ownership interest in the equity securities of any public company, including foreign private issuers, must file a report within ten days after such acquisition. Similarly, Section 16(a) requires any shareholder who becomes a beneficial owner of more than 10% of any class of equity security of a publicly traded issuer or any person who becomes a director or officer of such an issuer, to file a report within 10 days after becoming a beneficial owner, director or officer and thereafter to file reports of ownership changes within two days of the change. Shareholders, directors and officers of foreign private issuers, however, are not subject to the requirements of Section 16, so the Section 16(a) reform will not have any impact on them.
The scope of securities subject to such reporting requirements has also been expanded as the Act amends the definition of “security” in both the Exchange Act and the Securities Act to include “security-based swaps.” Generally, a security-based swap is defined as any agreement, contract or transaction that is a swap and is based on a narrow-based security index (nine or fewer securities); a single security or loan; or the occurrence (or non-occurrence) of an event concerning a single issuer of a security or the issuers of securities in a narrow-based security index. The Act provides that, for purposes of Section 13 and Section 16 of the Exchange Act, a person shall be deemed to acquire beneficial ownership of an equity security based on the purchase or sale of a security-based swap, only to the extent that the Commission determines, after consultation with the prudential regulators and the U.S. Secretary of Treasury, that the purchase or sale of the security-based swap, or class of security-based swap, provides incidents of ownership comparable to direct ownership of the equity security. Furthermore, it must be necessary to achieve the purposes of Section 13 that such transaction be deemed the acquisition of beneficial ownership of the equity security.
Repeal of Securities Act Rule 436(g)
Among numerous other rating agency reforms, the Act specifically repeals Rule 436(g) under the Securities Act which provides that rating agencies would not be considered “experts” for registration statement purposes. The effect is to require Nationally Recognized Statistical Rating Organizations (NRSROs) to file consents to be named as experts each time their ratings are used in a prospectus, and take on liability under the Securities Act in the event that their opinion, as disclosed in the prospectus, contains a material misstatement or omission. It is unclear at this time what impact this repeal will have on market practice for investment and non-investment grade offerings, both by U.S. domestic and foreign private issuers, or the willingness or ability of rating agencies to provide consent for their ratings to be referred to in prospectuses for offerings registered under the Securities Act because expertizing their ratings disclosure will increase the NRSRO’s liability for that information. In this connection, we note that the Commission has an outstanding proposal that would require any rating used to sell securities be included in the related Securities Act prospectus. The Act removes various statutory references to credit ratings in the Exchange Act effective two years from enactment and requires within one year of enactment that the Commission (as well as other federal regulators) remove from its regulations any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of creditworthiness as the regulator shall determine appropriate. The Commission has already proposed amendments to its rules to implement these types of changes.
Regulation D Amendments
The Act requires that within one year after enactment the Commission promulgate rules that will disqualify certain “bad actors” from relying on the Securities Act Rule 506 exemption from the registration requirements for certain private offerings and sales of securities. These “bad actors” would include; (i) persons convicted of any felony or misdemeanour in connection with the purchase or sale of a security or a false filing with the Commission, (ii) persons barred from association with regulated entities or engaging in the securities, insurance, banking, savings association or credit union business for fraud, manipulation or deception or (iii) persons subject to final order based on a violation of any law prohibiting fraud, manipulation or deceptive conduct.
Revised Accredited Investor Qualifications
The Act changes an important exemption for private securities offerings to U.S. investors. Previously, “accredited investors” included natural persons with a net worth of US$1 million, either individually or jointly with a spouse. The Act obligates the Commission to amend the net worth calculation to exclude the value of a person’s primary residence. We understand that the SEC staff may be taking the position that this change is effective immediately, without need for any Commission rulemaking. Subscription agreements for private placement offerings and “accredited investor” questionnaires would therefore need to be revised immediately. The Act also authorized the Commission to review and revise other aspects of the definition of accredited investor as it applies to natural persons, which may result in modifications to the current alternative “accredited investor” eligibility requirements that are based on income rather than net worth. Finally, the Act directs the U.S. Comptroller General to undertake a study within three years regarding the appropriate criteria for accredited investor status and eligibility to invest in private funds.
The Act establishes monetary awards for whistleblowers in any Commission enforcement actions resulting in sanctions of over $1,000,000, with award amounts determined as a percentage of the recovery. The bounty must also be paid by the Commission where the information provided by the whistleblower leads to enforcement action by the Justice Department, another federal agency, a self-regulatory organization or a state attorney general. It is expected that the Commission will actively promote this new whistleblowing incentive. The Act also creates a private right of action for whistleblowers against employers who retaliate.
Aiding and Abetting Liability
The Act clarifies and extends the scope of aiding and abetting liability for securities law violations by allowing government enforcement actions against persons who “knowingly or recklessly” provide substantial assistance for such violations.
We will continue to monitor developments on these matters and update our clients as Commission and stock exchange implementing rules are adopted. For more information about these developments, please contact the authors of this update.
This publication is provided for general information purposes only and does not constitute legal or other professional advice or an opinion of any kind. Recipients of this publication are advised to seek specific legal advice by contacting members of Osler regarding any specific legal issues. The information in this publication is current as of its original date of publication, but should not be relied upon as accurate, timely or fit for any particular purpose. Receipt of or use of this publication does not create a lawyer-client relationship.