Financial Industry Reforms for Everyone

Not long ago, I speculated that Senator Dodd’s decision to pass on taking over Senate leadership of the health care bill (by turning down Sen. Kennedy’s committee chair) suggested that financial industry reform had much better prospects than health care reform. Yesterday, just days after the House’s 1000+ page health care bill landed in the Senate with a thud, Sen. Dodd released the “Restoring American Financial Stability Act of 2009,” a 1000+ page bill that purports to regulate consumer finance, end “too big to fail,” guard against systemic risk and rationalize federal bank regulation. And of course regulate executive compensation at all public companies, whether or not connected to the financial sector. You might reasonably wonder what pay practices at tech companies, equipment manufacturers, commodity producers and indeed any company that’s not in the financial industry have to do with the stability of the nation’s banks. Well, the argument given in the summary of the bill says that Wall Street’s compensation practices contributed to the meltdown, therefore everyone’s compensation must be regulated. The non sequitur seems not to have bothered or even occurred to the drafters. So, it’s not surprising that virtually nothing in the bill has anything to do with Wall Street’s pay practices; it is instead drawn from decade old arguments about public company pay (e.g., shareholder access, director independence, misuse of consultants, etc.).

The Dodd bill will have to compete with similar legislation proposed by others this year, but in the past (including with TARP), Dodd’s committee has held sway, with Administration proposals in particular being mostly ignored. So, I consider this bill the one to watch.  That being said, you probably don't need to watch very carefully, at least for awhile.  Congress has less than 20 working days left in the year.  Health care will likely dominate that period, which means this will become the Restoring American Financial Stability Act of 2010.

In many respects, the bill is like all the others:

-Mandatory “say on pay” votes, as well as a separate advisory vote on golden parachutes

-Tightened independence standards on compensation committee membership

-Additional disclosure on the use of compensation consultants

-Outside of the comp arena, the bill also includes proxy access, majority voting on directors and other broad corporate governance changes


Some important differences though:

-Mandatory clawbacks. Every public company would be required to implement a clawback policy. The policy would have to provide that, in the event of a restatement, any compensation paid during the prior three years to any executive officer (including former officers) based on the erroneous data must be repaid. Although on the surface this looks like a dramatic expansion of the Sarbanes-Oxley statutory clawback, the bark here is worse than the bite. The clawback only applies to amounts that were paid based on flawed accounting. Those kinds of restatements are, on the whole, few and far between. They do not arise simply because a firm incurs losses. I’m not aware of any major bank or financial institution that had to restate its financials during the last couple of years; they just had losses.

-Consultants, attorneys and other advisors to the comp committee (if any) must be “independent” (to be defined by the SEC). The notion here seems to be that committees must choose between getting no direct outside advice or getting advice solely from independent advisors. Notably, the bill requires any committee that foregoes outside advice to disclose that fact in its proxy, which no one will want to do. The net effect being a strong encouragement to use independent advisors.  It remains to be seen whether this rule would require management retained advisors to be completely cordoned off from the board.

-Enhanced committee oversight over advisors. The bill includes an express requirement that committees be directly responsible for hiring, compensating and overseeing their advisors. Hard to know what this would translate into in practice, but it has the potential to drive a deeper wedge between comp committees and management.

-New pay disclosures. The bill would require companies to include in their proxy information that relates exec pay to financial performance, including a graph or chart that compares exec pay to financial performance over a five year period. Interestingly, the SEC considered this type of disclosure when it rewrote the proxy rules a few years ago. They rejected the idea because it would lead to an excessive focus on stock price, and thereby overshadow other performance metrics that were material to decision making. Given the long time lags in many types of compensation (e.g., options with a four year vesting period and ten year exercise period), there is a serious risk that this kind of disclosure would be misleading to investors, unless the SEC is very careful with the implementation.

-New hedging disclosures. The bill would require companies to disclose whether employees (not just officers) are permitted to hedge their equity compensation. This is another issue that was debated when the SEC revised the proxy rules. The current rules require disclosure of shares that are actually pledged (as is often the case when a hedge is put on), as well as Form 4 filings when officers enter into or close out most types of derivatives used in hedges. In addition, many public companies already have some sort of policy or guideline that restricts hedging. Its inclusion in the bill is interesting as I’m not aware of any allegation that Wall Street executives avoided stock losses thanks to hedging. If anything the opposite was true.