Henry C. Blackiston

If you are a member of the Compensation Committee of a public company, you have your work cut out for you. The passage of Sarbanes-Oxley some years ago, the passage of section 409A of the Internal Revenue Code and adoption of over 300 pages of related regulations, the SEC proposals on Proxy Disclosure in July of 2009, and the proposed legislation of the U.S. Treasury at the same time have all had a profound impact on the way members of Compensation Committees do their jobs, as has been discussed in a previous article on this topic in this publication last fall.1 In addition, in the wake of the recent financial crisis, shareholder activist groups such as CALPERS and Risk Metrics have played larger and larger roles in influencing decisions of Compensation Committees. Although all these factors principally affect public companies, they also have an influence on the best practices of the management of non-public companies which may need a “clean house” in order to secure funding from outside sources, or which may need to prepare to go public in the future.

Given this background, when President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act on July 21, 2010 (“Dodd-Frank”), it added another layer of complexity to the responsibilities of Compensation Committee members. Although many of the themes of previous initiatives are echoed in the final legislation, the new legislation contains some new standards as well. Unfortunately, many of the uncertainties surrounding the new legislation will not be settled until the SEC issues regulations on the various topics. Nevertheless, there is much Compensation Committees can do now to prepare for compliance with the new rules.

The purpose of this article is to summarize the new legislation as it impacts on the duties of Compensation Committees, and to suggest ways in which such Committees can start to prepare now for compliance in the future.

Dodd-Frank basically affects Compensation Committees in three areas: 1) transparency, 2) independence, and 3) risk management.

Requirements Affecting Transparency


1. The New Rules

Dodd-Frank requires that in any public company’s proxy statement for a shareholder meeting in which the SEC has mandated compensation disclosure, there must be a separate non-binding resolution subject to shareholder approval. The resolution must approve the executive compensation as disclosed for the named executive officers. This is consistent with the Treasury department’s legislation proposed in July of 2009. Of particular note is that this applies to the proxy statement for the first annual meeting of shareholders held on or after January 21, 2011.

The resolutions must allow the shareholders to determine whether the say-on-pay vote will be every one, two or three years.

The law requires that the company must obtain shareholder-approval regarding the frequency of the say-on-pay vote, at least once every six years.

Where compensation disclosure is mandated by SEC rules in a change in control context, there must be a) disclosure of the compensation contingent in the change in control and b) a separate say-on-pay vote to approve such compensation. Although the say-on-pay vote is not binding and cannot be construed as overriding a company or board decision, or create additional fiduciary responsibilities for either, a negative vote would certainly have to be taken seriously by the Company and its Board. Acting notwithstanding such a vote would undoubtedly cause the wrath of shareholders, particularly institutional investors and activist groups. Since the new rules require institutional investment managers to report at least annually on how it voted on say-on-pay votes, such managers will be much more conscious of their voting decisions and much less subject to the influence of the company’s management. In addition, the new law also requires national securities exchanges to prohibit institutions which are not beneficial owners of securities (such as broker-dealers) from voting on say-on-pay matters without specific instructions from the beneficial owner.3

2. Effect of Say-on-Pay on Compensation Committees

The say-on-pay rules affect the responsibilities of Compensation Committees in several ways:

  • Because of the say-on-pay process, Committees will need to communicate early and often with institutional shareholders to insure favorable votes. These conversations should be year-round, not just during proxy season.
  • Institutional shareholders will not be as influenced by management as before because of the pass-through voting of those that are broker-dealers, and because of the public disclosure of their votes. Compensation Committees and Management will have to work harder to encourage a favorable vote, and, more importantly, will have to be mindful of the possibility of a negative vote in all compensation design decisions.
  • Committees will need to reevaluate the completeness and soundness of the Compensation Decision & Analysis (“CD&A”) since it will be heavily relied on by shareholders in making say-on-pay decisions.
  • Committees must meet with management early to discuss what action to take in the event of a negative say-on-pay vote. Should the Board meet? Should there be a meeting with the largest shareholders? Under what circumstances should decisions be reversed?
  • Committees must be mindful that a failure to communicate adequately and often with shareholders may result in those shareholders voting for an annual say-on-pay vote in the future.

Disclosure of Pay

Several provisions of Dodd-Frank mandate new disclosures of compensation information in the proxy materials. Such disclosures put Compensation Committee decisions on pay under the microscope more than ever, by revealing discrepancies between pay and corporate performance, and discrepancies between CEO pay and that of other employees.

1. Pay vs. Performance

Dodd-Frank directs the SEC to issue rules (no date is specified) that require public companies to disclose in any proxy statement for an annual meeting a “clear description” of the relationship between executive compensation actually paid and the financial performance of the company.4 This is similar to existing SEC rules, so it is not clear whether regulations under Dodd-Frank will impose any substantially new requirements. Dodd-Frank states that the disclosure must take into account any change in stock value, dividends or distributions, and may include a “graphic representation” of the information required.

2. CEO Pay Ratio

Particularly troubling for companies is the new mandate to disclose the following in proxy statements:

(i) The median of annual total compensation of all employees except the CEO;

(ii) The total compensation of the CEO; and

(iii) The ratio of (i) to (ii)

There are practical difficulties – particularly for companies with employees working overseas – with obtaining summary compensation data for rank and file employees. Can union employees or part-time employees be excluded? How should foreign earnings be calculated in U.S. dollars?

3. Effect on Compensation Committees

By mandating a detailed disclosure of pay vs. performance, Compensation Committees may shift to equity-based compensation vs. long-term cash compensation, since stock value and dividends are stated by Dodd-Frank to be an important component of performance.

Because of the requirement to disclose the ratio of CEO pay to that of the rank and file, Compensation Committees (which are often responsible for collecting such data) will face some practical difficulties. Although Dodd-Frank does not contain an effective date for the requirement, it should be expected that SEC explanatory rules will be issued in the near term, making it important that Committees get started early in figuring out how to collect the data to insure future compliance.

The additional disclosure requirements will make even more transparent the effects of executive compensation decisions and strategies of Compensation Committees. As a result, those decisions will be more subject to public scrutiny than even before, further increasing the diligence required of Committee members.

Requirements Mandating Independence

The theme of independence for Compensation Committees is not new. The New York Stock Exchange and NASDAQ rules already have broad independence requirements. In addition, the Treasury Department’s proposed legislation in July 2009 contemplated new standards of independence for Compensation Committee members which went beyond the NYSE and NASDAQ rules. What Dodd-Frank did was codify many of those standards by amending the Securities Exchange Act of 1934 and by requiring the SEC to direct the national securities exchanges to prohibit the listing of any security of a company (with certain exceptions) that does not comply with the new standards.5 So now Compensation Committees that do not meet the new standards will cause the de-listing of the shares of the Company.

The new rules will, as a practical matter, be effective for proxy materials for an annual meeting occurring on or after July 21, 2001. The SEC must act by then.

The rules have an impact on four areas, each of which are summarized below: 1) the independence of the Committee itself, 2) the responsibility and authority of the Committee regarding its advisers, 3) the funding required to pay advisers and 4) the independence of the Committee’s consultants and advisers.

Independence of the Committee

The mandate for independence will not be fully understood until the SEC issues its rules on the topic. However, Dodd-Frank requires those rules to consider relevant factors which must include:

  •  the source of compensation paid to a member of the Board, including consulting and advisory fees; and
  • whether a member of the Board is affiliated with the issues to one of its affiliates.

Compensation Committees should review their Charter with the help of outside counsel, to consider whether revisions are desirable to incorporate the new independence standards. It probably makes sense to wait for the SEC’s regulations on the topic before finalizing any changes.

Authority of the Committee

Dodd-Frank empowers, but does not require, the Compensation Committee to retain compensation consultants, legal counsel, or other advisers “in its sole discretion.”6

The Committee must be “directly responsible” for the “appointment, compensation and oversight of the work” of the adviser.

Despite such authority, Dodd-Frank makes clear that the Committee need not act consistently with the advisers’ recommendation and must “exercise its own judgment” in discharging its responsibilities.

In any proxy statement for an annual meeting occurring on or after July 21, 2011, two things must be disclosed: (1) whether the Committee retained a consultant or adviser, and (2) whether the work of the consultant or adviser raised any conflicts of interest issues, and, if so, the nature of the conflict and if it was resolved.


The new law mandates that the company provide for “appropriate funding”, “as determined by the Compensation Committee in its capacity as a committee of the board of directors” for paying reasonable compensation to consultants, advisers and legal counsel.7

This new provision suggests that Compensation Committees should begin soon to negotiate with the Board for a reasonable budget for outside counsel and other advisers expected to be retained in the future.

Independence of Consultants and Advisers

Dodd-Frank mandates that before hiring a consultant, adviser or legal counsel, the Committee must identify factors that affect the independence of the adviser. These factors must include:

  •  the provision of other services by the adviser to the company
  • the adviser’s fees received from the company as a percentage of its total revenues
  • the conflict of interest policies of the adviser
  • business or personal relationship of the adviser and member of the Committee
  • stock of the company owned by the adviser Note that the new law does not mandate the independence of the advisers, but simply that the Committee must first consider the degree of such independence before hiring them.

Effect on Committee of New Independence Standards

It is likely that the above new independence rules will have the following impact:

1. First and foremost, Committee members, with the help of counsel, should be sure that every member complies with the new independence standards. This may mean waiting until the SEC’s rules are published, but it can be assumed that these rules will be similar to existing rules.

2. Outside counsel, which is not already acting as counsel to the Company or to the Board, should be engaged, making certain that such counsel is only engaged after taking into consideration the independence factors described above.

3. Engagement letters for all outside advisers should be reviewed to be sure that Dodd-Frank’s independence and conflicts policy requirements are met. Committees must insist on conflicts policies in writing from all advisers.

4. Committees should negotiate with the full Board to develop a budget for the use of outside advisers and counsel.

5. It is likely that Committees will use a number of outside advisers in dealing with the new environment to fully tap expertise in a complex environment, and will rely less on in-house expertise.

Requirements Relating to Risk Management

One of the most important themes affecting the best practices of Compensation Committees is risk management. In other words, in discharging their responsibilities of designing compensation programs they must be focused on unnecessary risk-taking. This theme appeared in the SEC’s proposed new proxy rules in July 2009 and in the Obama administration’s TARP Rules. For a further discussion, reference should be made to the earlier article on this topic appearing in this publication.8

The Dodd-Frank legislation contains two provisions which affect the responsibilities of Compensation Committees regarding minimizing risk: the disclosure of hedging activities and a mandate to provide clawbacks for certain incentive-based compensation.

Disclosure of Hedging

Dodd-Frank includes a provision requiring the SEC to adopt rules which require each public company to disclose in any proxy statement whether any employee or member of the Board is permitted to purchase financial instruments (such as forward contracts, equity swaps, collars, etc) that are designed to hedge any decrease in the market value of the company’s equity.9 The disclosure is required whether the instrument is granted to the individual as part of a compensation package, or is already held by the individual. The provision is designed to publicize, and presumably discourage, the use of these instruments by members of management and the Board. The theory is that such instruments, by protecting against stock depreciation, can encourage risk-taking by management since they would be protected on the downside.

What does this mean for Compensation Committees? At the least, it means that any compensation design for employers and management should be reviewed with very careful consideration given to prohibiting the use of such instruments, at least by top management. The adverse publicity associated with such instruments, and the possible negative effects on say-on-pay voting are two reasons to seriously consider such a prohibition.


1. Background

One of the most significant features of the Dodd-Frank legislation is the mandatory clawback provision. The concept of a clawback for executive compensation is not new, since it was included in Section 304 of the Sarbanes-Oxley Act, and has become more common as Compensation Committees seek ways to minimize risk to the Company and encourage more conservative behavior from the Company’s executives. However, the new law significantly broadens the clawback policy, makes it mandatory, and applies it to a larger group of individuals than had been required or customary previously.10

2. The New Rules

The essential features of the new clawback legislation are as follows:

  • The SEC is required to adopt rules directing the national securities exchanges and associations to prohibit the listing of any security of a company that does not meet the new clawback standards. Although there is no specified effective date, the SEC is expected to issue explanatory rules in a timely fashion. The remedy for non-compliance is de-listing.
  • Each company is required to develop and implement a policy providing for disclosure of incentive-based compensation that is based on reportable financial information.
  • If the company is “required” to prepare an accounting restatement due to “material noncompliance” with any financial reporting requirement, there must be a recovery or clawback from any “current or former executive officer” who received “incentive based compensation.”
  • The clawback applies to any such compensation received during the 3-year period preceding the “date” on which the company is required to prepare the restatement.
  • The clawback applies to any excess amount of compensation received above the amount that would have been payable under the restatement.
  • The clawback includes stock options as incentive based compensation.

3. What is Troubling

There are many uncertainties surrounding the application of these rules – i.e., what is meant by “executive officers,” “material noncompliance,” when a restatement is “required” as opposed to desirable, the “date” the restatement is “required” for purposes of the 3-year clawback, and so on.

The policy is mandatory. Currently, clawbacks for most companies who use them are discretionary, allowing management judgment to enter into the compliance process.

The policy also applies to former executives – a rare feature of such policies by companies that use them. The “clawback” period in 3 years, as opposed to 1 year under the Sarbanes-Oxley rules, and the clawback applies even if there is no misconduct triggering the restatement, as was required under Sarbanes-Oxley.

4. What it Means for Compensation Committees

The following should be a checklist for Compensation Committees charged with insuring compliance with the new clawback rules:11

  • Review of the Committee charter to be sure it allows for clawbacks, and if not, make necessary revisions.
  • Take the lead, with the help of outside counsel and accountants, in preparing a revised and compliant clawback policy. The details of this will have to await final SEC regulations on the topic, hopefully by early 2011.
  • Review all severance policies and contracts and all employment contracts, with the help of outside counsel, to insure there is no conflict between buyout provisions, vesting and the new clawback rules.
  • Check company releases of executives to determine whether changes are necessary to comply with clawback rules. However, note that it is unclear whether the new rules will apply retroactively to pre-existing releases.
  • Consider compensation designs which provide for enhanced forfeiture provisions designed around the 3-year lookback rule, which may eliminate the need for applying a clawback.
  • In designing executive compensation, consider tying incentives to objectives which are not related to reported financial results, thereby eliminating the need for clawbacks.


The job of being in a public company Compensation Committee was tough before Dodd-Frank, due to Sarbanes-Oxley, shareholder provision, the Obama administration TARP legislation, and SEC disclosure proposals in 2009. The concepts of transparency, independence, and risk avoidance applicable to Compensation Committees before Dodd-Frank, continued after the passage of Dodd-Frank in more comprehensive, more specific, and more mandatory ways. A tough job just got tougher. Hopefully, the SEC’s mandate to issue explanatory regulations in many of these areas may at least provide clarification soon to Compensation Committee members, if not relief.

* Henry Blackiston, previously of Seyfarth Shaw LLP, is now a partner with Martin & Chioffi LLP.

1 “A New World for Compensation Committees,” Bloomberg Law Reports, November 23, 2009 (the “Bloomberg Article”).

2 Dodd-Frank Act, section 951, amending the Securities Exchange Act of 1934 (“the ‘34 Act”) by inserting new Section 14A.

3 Dodd-Frank Act, section 957, amending Section 6(b) of the ‘34 Act.

Dodd-Frank Act, section 953, amending Section 14 of the ‘34 Act.

5 Dodd-Frank Act, section 952, amending the ‘34 Act to add a new section 10C.

6 Id.: Section 10C(c)(1).

7 Id.: Section 10C(e).

8 See the Bloomberg Article referenced in footnote 1 above.

9 Dodd-Frank Act, section 955, amending the ‘33 Act by adding a new paragraph (j) to Section 14.

10 Dodd-Frank Act, section 954, adding a new section 10C to the ‘34 Act.

11 See discussion of these points in the August 18, 2010 Securities Litigation Alert of Pepper Hamilton LLP.

© 2010 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P. in the Vol. 3, No. 10 edition of the Bloomberg Law Reports—Executive Compensation. Reprinted with permission. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P.

The discussions set forth in this report are for informational purposes only. They do not take into account the qualifications, exceptions and other considerations that may be relevant to particular situations. These discussions should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Any tax information contained in this report is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. The opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content contained in this report and do not make any representation or warranty as to its completeness or accuracy.