Compensation Committee Corner : Executive Compensation Lawyer & Attorney : Winstead Law Firm : Director Liability, Employee Benefit Arrangements

According to the SEC's Dodd-Frank rule-making schedule, proposed rules addressing clawbacks will be issued within the January-July 2012 time frame, and final rules will be adopted within the July-December 2012 time frame.  Assuming this time line remains unchanged, a current question is whether some form of clawback policy should be initiated by companies prior to the SEC's issuance of proposed/final rules.  Here are my thoughts:

Background

As background, Dodd-Frank requires national securities exchanges to implement clawback policies (a.k.a., recoupment policies) that are more expansive than current requirements under Section 304 of SOX.  Under Dodd-Frank:

• The clawback policy must be triggered any time the company prepares an accounting restatement resulting from "material" noncompliance with any financial reporting requirement (in contrast, Section 304 applies only when a financial restatement is "required" and is the result of "misconduct").
• Once the clawback policy is triggered, it would apply to all incentive-based compensation paid to current and former executive officers (in contrast, Section 304 applies only to the CEO and CFO).
• The look back period for which incentive-based compensation is subject to clawback is the three-year period preceding the date of restatement (in contrast, the look back period under Section 304 is twelve months).
• The amount subject to the clawback is the difference between the amount paid and the amount that should have been paid under the accounting restatement.

Issue to Consider until Final Rules are Adopted

Ensuring compliance with the Dodd-Frank clawback requirements is an issue between the company and the applicable exchange (e.g., NYSE), therefore, problems could arise with executives who have contractual rights.  For example, assume a fact pattern where the executive has contractual rights to a benefit that, if paid, would jeopardize the company's listing with NYSE because such payment would violate the Dodd-Frank clawback requirements.  If this fact pattern were to arise, it would create a tug-a-war for the company (i.e., complying with the listing requirements on the one hand, and complying with the executive's contractual rights on the other hand).  However, this issue could be resolved in a simple manner if a contractual arrangement with the executive mandated compliance with the company's Dodd-Frank policy.

Resolutions for the Gap Period

The above issue will resolve itself once proposed and final rules are adopted.  Until then (i.e., the gap period), a company could take the following actions:

• Do nothing by adopting a wait and see approach.  This may be acceptable if the executives and the board of directors have a warm relationship.  However, if a tug-a-war arises during the gap period . . . .
• Adopt a short policy that is expected to be amended in a more robust manner once final rules are adopted.  I am in favor of this approach.
• In conjunction with the above bullet, have executives sign a contractual arrangement under which each executive agrees (as to all then existing and future arrangements) to comply with the Dodd-Frank clawback requirements (when effective) and any clawback policy adopted by the company as such is amended from time to time.  I am in favor of this approach because it is easy and can be accomplished with a one-page document (including signature blocks!!).
• Adopt a formal and robust clawback policy.  I am less in favor of this approach since proposed rules have not been issued.

An example of a simple policy (referenced in the above second bullet) was adopted by Tractor Supply Company around May 3, 2011, that provides:

"Tractor Supply Company shall seek to recover incentive compensation paid to any executive as required by the provisions of the [Dodd-Frank Act] or any other 'clawback' provision required by law or the listing standards of the NASDAQ Global Select Market."

That policy, if used in conjunction with one-page arrangements that contractually bind the executives, is simple, easy to implement and should protect companies during the gap period.  I am a big fan!

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The purpose of this Post is to address some of the common issues that members of a Boards of Directors should consider when negotiating employment agreements with named executive officers.

Defining "Cause"

Consider defining the term "cause" to include a substantial under-performance of the executive (e.g., failure to achieve minimum financial goals for two consecutive fiscal years).

Additionally, consider the Board's use of after-acquired evidence to determine whether the executive terminated employment for "cause."  It could be that evidence supporting a termination of employment for cause is not found until after the executive has terminated employment for a reason other than cause.  Without an after-acquired evidence clause, the Board will not likely be able to change the characterization of the executive's prior termination of employment (and therefore the Company may remain contractually liable for associated severance pay benefits).  But if instead an after-acquired evidence clause were contained within the employment agreement, the Board could recharacterize and deem the executive's prior termination as one for cause (thus likely negating associated severance pay benefits).

Defining "Change in Control"

Ensure that the definition of "change in control" requires consummation of the transaction.  There are a few public examples where the term change in control was triggered upon execution of the underlying transaction document.  If such were the facts and the underlying transaction was not consummated (i.e., a failed deal), then the Board might see the makings of a shareholder derivative lawsuit, especially if the payouts to the executives were rich.

Implement Robust Clawback Provisions

Consider adding clawback provisions in addition to those required under Section 304 of SOX and the Dodd-Frank Act.  For example, consider adding a clawback for any breach of post-employment restrictive covenants (e.g., violation of a non-compete clause).  Additionally, but related, consider adding a clause that if the non-compete provision is ever judicially or administratively ruled to be unenforceable, then the executive must forfeit certain portions of his or her severance pay (including a return of any gains on equity awards that the executive sold after his or her termination of employment).

Require Automatic Resignation from the Board

It is surprising to me how many employment agreements I review that do not require the automatic resignation from the Board (and other Company-related entities) upon the termination of the executive's employment with the Company.  Failure to implement such a provisions provides the departing executive with "some" leverage at the time of his or her termination and, in instances where the executive does not resign from the Board, could be politically awkward until his or her term on the Board is complete.

Remember that Severance Pay Should be Bridge Pay, Nothing More

In setting the amount of any severance pay, keep in mind that severance pay packages should be designed to act as a bridge between jobs.  Therefore, consider limiting the amount of severance pay packages to 6 months base salary and bonus (or upward to 1 year base salary and bonus).  Additionally, consider whether it makes sense to offset the amount of any future severance pay by the amount of any income the executive earns from his or her new employer.

Design the Timing of Severance Pay as Salary Continuation

Absent a change in control of the Company, consider designing severance pay to take the form of salary continuation (as opposed to a lump sum payment).  Salary continuation is more friendly to the Board's position because it allows the Board to hold purse strings as a mechanism to enforce any post-employment restrictive covenants such as a non-compete clause.  However, the foregoing might not make sense if the executive's employment is being terminated in conjunction with a change in control.

Use Double Triggers for Change in Control Transactions (Try to Avoid Single Triggers)

Single trigger vesting events (i.e., accelerated vesting upon a change in control) are viewed disfavorably by institutional shareholder advisory services such as ISS.  For this reason consider using only double triggers (i.e., accelerated vesting only if there is both a change in control and a termination of the executive's employment).

Implement Non-Competes to Avoid Use of a 280G Tax Gross-Up

As background, executives generally prefer a tax gross-up for any change in control payments that would be subject to Section 280G of the Internal Revenue Code (absent a tax gross-up, the executive could be subject to a 20% excise tax on change in control payments).  However, tax gross-ups are highly disfavored by institutional shareholder advisory services.

Consider negating the need for any 280G tax gross-up by implementing a non-compete provision, the related compensation to which could act to reduce golden parachute payments subject to the 280G excise tax.  Keep in mind that the reduction is not on a dollar-for-dollar basis with the separation pay, rather, the reduction is generally based on the difference between the enterprise value of the company with and without the non-compete.  Thus, the value of the non-compete and the value of the 280G reduction could be a lot more than the severance pay directly associated with the non-compete (thus acting to also reduce other compensation subject to 280G, such as the present value of of equity awards that accelerate vesting upon the change in control).

To close, my experience is that Boards carefully consider the terms of executive employment agreements.  Hopefully the above is helpful with that endeavor.

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Over the last week I discussed clawbacks (Post 1 of 8), say-on-pay voting requirements and a new prohibition on certain votes from brokers (Post 2 of 8) under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Act"), signed into law by President Obama on July 21, 2010.  As stated in those prior posts, the Act contains significant executive compensation and corporate governance rules that apply to most public companies.  This Post 3 of 8 discusses a new requirement under the Act relating to golden parachute payments.

New Disclosure and Vote Requirement on Golden Parachute Payments

In addition to the new say-on-pay requirement discussed in a prior post (Prior Post), certain payments to named executive officers ("NEOs") in mergers and acquisitions must be adequately disclosed in the proxy or consent solicitation materials and submitted to the shareholders for their approval in the form of a non-binding shareholder resolution.  The disclosure must:

• Describe in clear and simple terms any compensation arrangements with NEOs that are related to the transaction.
• Describe the aggregate amount of all compensation that will or could be paid to the NEOs (including any conditions to payments).  AND
• Include a separate non-binding advisory vote to approve the payments (though a separate vote is not required if the arrangements were previously subject to a say-on-pay vote).

Effective Date

The above disclosure and vote requirements apply to shareholder meetings that occur after January 21, 2011.

Issues to Consider

Some of the issues a company should consider when implementing the above include:

• Consider reviewing current payment arrangements with NEOs to determine whether any golden parachute payments are aligned with the company's current compensation philosophy.  This should include a review of all prospective payments, including payments derived from employment agreements, incentive plans, bonus programs, etc.
• Once a list of prospective payments is compiled, the next step is to ensure the payments will be adequately disclosed in accordance with rules to be issued by the SEC.  It may be that the disclosure rules will resemble current requirements under Item 402(j) of Regulation S-K.
• Once the SEC issues disclosure rules, a determination should be made as to whether any prospective golden parachute payments should be disclosed and submitted to the shareholders for a say-on-pay vote prior to any known merger or acquisition.  Such prior disclosure and vote could avoid having to obtain additional disclosure and vote at the time of a merger or acquisition.

Over the next few months the SEC will likely provide guidance on the above disclosure and voting rules.  Until then, stay tune for more posts on the Act (Posts 4 through 8)!

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A few days ago I discussed clawbacks (Post 1 of 8) under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Act"), signed into law by President Obama on July 21, 2010.  As stated in that prior post, the Act contains significant executive compensation and corporate governance rules that apply to most public companies.  This Post 2 of 8 discusses a say-on-pay requirement under the Act (the other say-on-pay requirement applies to golden parachute payments and will be addressed in Post 3 of 8) and a new prohibition on the ability of brokers to vote on compensation-related matters.

New Say-on-Pay Requirement

Under the Act, shareholders of most public companies must be provided with a non-binding advisory vote on executive compensation as disclosed under SEC rules.  Specifically: 

• A vote is required at least once every three years, beginning with the first shareholder meeting that occurs after January 21, 2011.  In other words, say-on-pay will be required for many public companies this upcoming proxy season.
• At this first annual meeting, the shareholders must also decide on whether the vote should be held every one, two or three years (thereafter a vote on frequency must be held by a separate resolution no less often than every six years). 

New Prohibition on Certain Votes from Brokers

The Act requires national securities exchanges to prohibit brokers from voting on executive compensation matters (including say-on-pay), director elections and any other significant matter (as determined by the SEC). 

Effective Date

Say-on-pay votes apply to shareholder meetings that occur after January 21, 2011.  The rule prohibiting certain discretionary voting by brokers is effective July 21, 2010.

Issues to Consider

There are many issues a company should consider when implementing say-on-pay, and even more if the company has a large percentage of retail shareholders.  These include:

• How should a company revise its proxy statement to incorporate the mechanics of the say-on-pay mandate?  How should it frame the resolution?  Should the board of directors make a recommendation on the frequency of the vote? 
• Consider whether a company should make changes to its CD&A and tabular disclosure since shareholders will now be voting on its overall disclosure.
• Assuming retail shareholders typically vote with management, it would follow that the influence of institutional shareholder advisory services (e.g., RiskMetrics Group, Glass Lewis) could be disproportionately increased if the beneficial owners of the shares do not provide voting instructions to the retail shareholders.  This means a company may want to revisit its ability to comply with mandates set by shareholder advisory services (e.g., review change in control policies, employment agreements, separation pay arrangements, etc.).
• For those companies with a large percentage of retail shareholders, consider implementing ongoing educational campaigns with shareholders and beneficial owners to explain the company's compensation programs and educate beneficial owners that a failure to provide the broker with specific instructions would be the equivalent of a "no vote."
• Though say-on-pay is "nonbinding," keep in mind that compensation committee members would need to react to a failed say-on-pay proposal or risk receiving withhold votes during their reelection.  Last proxy season the shareholders of three companies voted against management say-on-pay proposals (KeyCorp, Occidental Petroleum and Motorola).  It could happen.

Given the number of action items a public company will need to consider or implement, the best advice is to prepare early, especially if shareholder educational campaigns need to be conducted.  Until then, stay tune for more posts on the Act (Posts 3 through 8)!

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The legislation I have been following (Prior Post 1, Prior Post 2) is no longer a bill sitting on the steps of Capitol Hill.  On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Act").  The Act represents significant legislation containing executive compensation and corporate governenance rules that apply to most public companies.  Due to the significance of the Act and the fact blog entries are not intended to be lengthy, I will address the Act in 8 separate entries, beginning with clawbacks.

New Clawback Requirement More Expansive than Section 304 of SOX

As a listing requirement, national securities exchanges will require companies to implement clawback policies (a.k.a. recoupment policies) that are more expansive than current requirements under Section 304 of the Sarbanes-Oxley Act (“Section 304”).  Under the Act:

• The clawback policy must be triggered any time the company prepares an accounting restatement resulting from material noncompliance with any financial reporting requirement (in contrast, Section 304 applies only when a restatement of financial statements is “required” and is the result of “misconduct”).
• Once the clawback policy is triggered, it would apply to all incentive-based compensation paid to current and former executive officers (in contrast, Section 304 applies only to the CEO and CFO).
• The look back period for which incentive-based compensation is subject to clawback is the three-year period preceding the date on which the restatement is required (in contrast, the look back period under Section 304 is twelve months).
• The amount subject to the clawback is the difference between the amount paid and the amount that should have been paid under the accounting restatement.

Effective Date

No deadline was provided within which national securities exchanges must implement this rule.

Issues to Consider

Previously (Prior Post) I set forth issues that should be considered in designing clawback policies.  Due to the Act's requirements, I am updating that Post with the following:

• Clawback policies should be revisited to determine what changes would be required under the Act.
• Determine “who” should be responsible for clawback enforcement (e.g., a risk assessment officer, the compensation committee, the full board of directors) and what repayment procedure should be used once a clawback is triggered.
• Determine whether the clawback policy should be more expansive than required under the Act.  For example, consider adding more events that would trigger the clawback than currently required under the Act, such as poor performance, violation of noncompetes, negligence, etc.  As I previously addressed (Prior Post), one reason for a strong clawback policy is that it can act as a mitigating factor to negate risk assessment disclosure under recent SEC rules (which require narrative disclosure of compensation policies and practices that are “reasonably likely” to have a “material adverse effect” on the company). Plus, a strong clawback policy acts as positive CD&A disclosure.
• The above should involve a current analysis and review of all compensation arrangements between a company and its executive officers (e.g., employment agreements, bonus arrangements, equity awards) to ensure proper integration between such arrangements and a company's new clawback policy.

 We will likely see more activity in this area as the national securities exchanges begin to implement this rule.  Until then, stay tune for more posts on the Act (Posts 2 through 8)!

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