With the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Act), the U.S. financial regulatory system has been fundamentally reshaped. The Act is intended to prevent the type of financial crisis which began in the sub-prime mortgage industry in the United States and spread throughout the international financial system, culminating in the collapse of Lehman Brothers. The shockwaves from that collapse are still being felt as we continue to see more bank failures than any other time since the Great Depression.
The Act will have implications well beyond debating whether financial institutions should be "too big to fail." This alert focuses on certain aspects of the Act that impact the federal securities laws and so will have consequences beyond the banking industry.
The Act authorizes (but does not require) the Securities and Exchange Commission (SEC) to establish rules either allowing or requiring a shareholder to use a public company's proxy solicitation materials to nominate director candidates, subject to, and in accordance with, the terms, conditions and procedures determined by the SEC. This Congressional authorization should preempt challenges to the SEC's ability to regulate matters which have historically been left to state law. The SEC has indicated it will be issuing a final rule on this subject before the 2011 proxy season. The Act also authorizes the SEC to exempt issuers or classes of issuers from the proxy access requirements.
The Act requires that each publicly traded bank holding company with total consolidated assets of $10 billion or more and certain publicly traded nonbank financial companies establish a risk committee. In addition, the Federal Reserve may require other publicly traded bank holding companies with total consolidated assets of less than $10 billion to do the same. The risk committee is to be responsible for the oversight of enterprise-wide risk management practices and must include at least one risk management expert. The risk committee must also include the number of independent directors as the Federal Reserve determines to be appropriate, based on the company's nature of operations, the size of its assets and other criteria. The Act requires the Federal Reserve to issue final rules on this subject by 2011.
The requirement to establish a risk committee is in addition to the analysis that public companies are currently required to conduct under Item 402(s) of Regulation S-K with respect to risks arising from a company's compensation policies and practices.
CEO and Chairman
The Act requires the SEC to issue rules mandating each public company to disclose in its annual proxy statement why the company has chosen the same person to serve as CEO and Chairman of the Board or, alternatively, why the company has chosen to have different individuals serve in those positions. Effective in February 2010, Item 407 of Regulation S-K was amended to require each public company to describe its board leadership structure, including whether the same person serves as both principal executive officer and Chairman of the Board and why the chosen structure is appropriate. As a result, the Act's provisions are unlikely to significantly impact disclosures being made with respect to a company's leadership structure.
Say on Pay
"Say on Pay" proposals have become increasingly common in the past few years and are required for financial institutions participating in the Troubled Asset Relief Program/Capital Purchase Program. Under the Act, each public company must propose, for shareholder vote, a non-binding resolution (Say on Pay Resolution) to approve the compensation of the company's executive officers at least once every three years. In addition, at least once every six years, each public company must propose, for shareholder vote, a resolution to determine whether the Say on Pay Resolution should be presented for shareholder vote every one, two or three years. The proxy statement for the first annual or other meeting of shareholders occurring in or after January 2011 must include both of these resolutions to be voted on by the shareholders. The most recent proxy season witnessed several examples in which companies lost on this proposal.
Say On Golden Parachute
A proxy statement for an annual or special meeting that involves an acquisition, merger, consolidation or proposed sale or other disposition of all or substantially all of the assets of a public company occurring in or after January 2011 must disclose, in a clear and simple form and in accordance with rules to be issued by the SEC, (1) any agreements or understandings that the company has with any named executive officers concerning any type of compensation based on or related to the transaction, (2) the type of compensation (present, deferred or contingent), and (3) the aggregate total of all such compensation that may be paid or become payable to the named executive officers. The proxy statement must also include a non-binding resolution subject to shareholder vote to approve the compensation arrangements or understandings, unless those arrangements were previously approved by the shareholders under a Say on Pay Resolution, as described above.
The SEC is required to issue rules directing the national securities exchanges and associations to prohibit the listing of any equity security of a company unless the company develops, implements and discloses its policies on recouping incentive-based compensation in the event of an accounting restatement due to the company's material noncompliance with any financial reporting requirements under the securities laws. The Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) imposed a clawback requirement but only on a company's CEO and CFO. The clawbacks under the Act would be triggered by a broader set of circumstances and would apply to all executive officers.
The SEC is required to issue rules directing the national securities exchanges and associations to prohibit the listing of any equity security of a company (other than certain specifically listed types of issuers) unless each member of the company's compensation committee is "independent." These new independence standards may not be the same as the listing standards currently in place, as the securities exchanges and associations are to consider consulting, advisory or other compensatory fees received by the compensation committee member from the company and whether the committee member is affiliated with the company. By virtue of this requirement, the Act brings in the audit committee independence test and applies it to compensation committee members.
The compensation committee must have the authority, in its sole discretion, to retain and obtain the advice of a compensation consultant, legal counsel or other adviser and must be directly responsible for the oversight of the work and appointment and compensation of the consultant, legal counsel or adviser. The Act requires the SEC to issue rules mandating that the compensation committee may only select a compensation consultant, legal counsel or other adviser to the committee after taking into account certain factors identified in the SEC's rules, including other work the consultant, legal counsel or adviser does for the company. For any annual meeting held in or after July 2011, the company must disclose in its proxy statement the name of its compensation consultant, if any, and must describe any work done by the consultant that may be a conflict of interest and how any conflict of interest is being addressed.
The Act requires the SEC to issue the rules described above by July 2011. Public companies must, however, be provided with a reasonable opportunity to cure any noncompliance under these new rules.
Enhanced Executive Compensation Disclosures
The Act requires the SEC to issue new rules mandating a public company to include certain enhanced executive compensation disclosures in its annual meeting proxy statement, including:
- the relationship between executive compensation actually paid and the financial performance of the company;
- the median of the annual total compensation of all employees except the CEO, the annual total compensation of the CEO, and the ratio comparing the two annual total compensation amounts; and
- whether any employee or director is permitted to engage in hedging of the company's securities.
Brokers are not permitted to vote on certain non-routine matters unless they receive voting instructions from the beneficial owners of the securities. Effective January 1, 2010, the election of directors was added to the list of non-routine matters. The Act further expands the list of non-routine matters to include resolutions with respect to executive compensation, which would include the Say on Pay and Say on Golden Parachute votes mandated by the Act.
The Act will fundamentally change the derivatives market, which has been seen as a major contributor to the financial crisis. The focus of the reform measures is on the over-the-counter (OTC) market, which has been largely unregulated and by the time of the 2008 crisis had grown to more than $100 trillion in size. The Act will impose clearing, exchange trading, registration, margin and capital recordkeeping requirements on a broad range of swaps and other derivatives. Both the SEC and the Commodity Futures Trading Commission (which had previously been prevented by statute from regulating OTC derivatives) will now have broad and overlapping authority to regulate swaps and participants in the markets.
Most of the derivatives reforms will affect the largest financial institutions and hedge funds that have spurred the enormous growth in the use of derivatives. However, many other businesses use hedges and other forms of derivatives in their day-to-day business operations. The Act provides an exemption from the requirement to clear swaps through regulated clearing organizations for non-financial parties who use swaps to hedge or mitigate commercial risk. This type of user will have to notify the regulators how it meets its financial obligations associated with non-cleared swaps. If the commercial end-user is a public company, then a committee of the board of directors must approve any election not to clear a swap.
If a swap is required to be cleared, it must be traded on a designated market or exchange, unless the market or exchange does not make that kind of swap available for trading. It remains to be seen whether this will create a loophole for the creation of a new derivatives market operating outside the reforms of the Act.
More Investment Advisers Will be Subject to Regulation
The Act eliminates the "private adviser" exemption in the Investment Advisers Act of 1940 (Advisers Act). As a result, advisers to hedge funds or private equity (not including venture capital) funds and advisers that have assets under management exceeding a specified threshold will now be required to register with the SEC. They will also have to comply with requirements to have compliance policies and procedures, maintain books and records and make publicly available filings with the SEC. These newly registered advisers will also be subject to periodic SEC examination and other substantive rules including limits on advisory fees, disclosure requirements and custody of assets. The registration requirements will become effective in 2011. The Advisers Act limits the type of clients that an adviser may have a performance-based compensation arrangement with to "qualified clients" who must meet specified financial tests. The Act provides that the dollar tests used for this purpose must be adjusted for inflation beginning in 2011 and every five years thereafter.
One change made by the Act immediately impacts those issuers currently engaged in private offerings by potentially reducing the number of natural persons eligible to invest in a private placement. The definition of "accredited investor" is one that many issuers rely on in determining whether the offering is exempt from registration under the Securities Act of 1933, as amended. If an issuer complies with the requirements of Rule 506 of Regulation D, the issuer may sell securities to up to 35 non-accredited investors and to an unlimited number of accredited investors. Natural persons, corporations and other legal entities may qualify as accredited investors. Prior to the Act, a natural person was an "accredited investor" if (1) at the time of purchase, he or she had individual net worth, or joint net worth with his or her spouse, of more than $1 million, or (2) in each of the two most recent years, he or she had individual income of more than $200,000 or joint income with his or her spouse of more than $300,000, and a reasonable expectation of reaching the same income level in the current year. The Act changed the financial test used to determine "accredited investor" status as it relates to natural persons by excluding the value of a person's primary residence from the $1 million net worth test. This change reflects Congress' belief that many Americans, and particularly those who qualified as accredited investors on the basis of rising home values, did not understand the risks associated with, and the complexity of, their investments. It is expected that the SEC will allow investors to exclude a mortgage or other debt secured by the investor's primary residence that does not exceed the fair market value of the residence for purposes of determining a natural person's net worth. For those companies currently involved in or contemplating fund raising activities, this change likely will impact current investors and require changes to disclosure and subscription documents that have already been drafted.
Reporting Beneficial Ownership in Public Companies
The Act amended the definition of "security" in the federal securities laws to include security-based swaps. The Act also gives the SEC the authority to extend the beneficial ownership reporting requirements (Williams Act) provisions of Sections 13(d) and 13(g) of the Securities Exchange Act of 1934, as amended (Exchange Act), to include the purchase or sale of security-based swaps. The Act also authorizes the SEC to shorten the time period within which an initial Schedule 13D reporting the acquisition of beneficial ownership of more than 5% of a public company must be filed to less than ten days. The Act permits the SEC to shorten the current ten day timeframe within which a reporting person under Section 16 of the Exchange Act (essentially directors, executive officers and more than 10% owners of a company) must file an initial Form 3.
Exemption from Sarbanes-Oxley Section 404(b)
For years, the SEC has been delaying the date by which smaller companies must comply with Section 404(b) of Sarbanes-Oxley. This provision requires companies to have their independent auditors attest to the effectiveness of the company's internal controls over financial accounting. This requirement has been seen as imposing disproportionately large costs for documentation and testing internal controls on companies which are unlikely to have complex systems of internal control. Companies with less than $75 million in market capitalization (non-accelerated filers) are now permanently exempt from such requirement. The SEC has confirmed the exemption will apply to non-accelerated filers whose fiscal year ends July 15, 2010 or thereafter, even though the Act was not signed until July 21, 2010. This exemption does not eliminate the requirement under Section 404(a) of Sarbanes-Oxley, which requires management to perform its assessment of the effectiveness of the company's internal controls.
The Act Remains a Work in Progress
Despite the significant length of the Act itself, many aspects of its reforms remain unfinished. The Act contemplates over 200 rule-making procedures to be conducted by multiple federal agencies to implement separate portions of the law. The Act also calls for 67 studies, or one-time reports, that are to be conducted in the next few years. The ultimate outcome of these rule-making procedures and studies may lead to fundamental departures from the text of the Act as it exists today. As a result, it is likely to be many years before the impact of the Act can be accurately determined.This is not a complete summary of the provisions of the Act affecting the securities laws.