The Act addresses the continuing public outcry over executive compensation in a number of ways. First, it requires that companies subject to the SEC’s proxy rules submit executive compensation to a non-binding shareholder vote at least once every three years.27 Secondly, at least once every six years, the company must ask shareholders whether the shareholders desire to vote on executive compensation every one, two or three years.28 Shareholders also have to be asked to approve golden parachute provisions in executive employment contracts (provisions that are contingent on a merger, consolidation, sale of the company or its assets).29 In none of the foregoing cases are the shareholder votes considered to be binding, but the results of the votes must be disclosed to the shareholders.30 The Act further provides that the shareholder vote additional fiduciary duties for the company or board or limiting the ability of shareholders to submit executive compensation proposals for inclusion in the company’s proxy materials. The SEC has authority to exempt companies from the say-on-pay requirements after taking into account, among other considerations, whether they would disproportionately burden smaller companies.

A company’s board of directors must establish a compensation committee consisting of independent directors before the company's securities can be listed on a stock exchange. Proxy statements and annual reports filed with the SEC31 must describe certain information about compensation committees where they exist. Section 952 of the Act adds § 10C to the 1934 Act to further define the requirements for an independent compensation committee. It also mandates that compensation committees shall have the right (and be allocated the necessary funding) for the retention of compensation consultants, legal advisors, and other advisors. The Act sets forth certain independence factors that the compensation committee must consider before selecting any such advisor – with Congress’ goal in all cases being to minimize or eliminate conflicts of interest between the advisors to the compensation committee and the other work, if any, the compensation consultant or its affiliated persons may perform for the company itself.32

In another provision regulating the disclosure of executive compensation, § 953 of the Act adds § 14(i) to the 1934 Act which requires the disclosure of compensation payable to executives and the relationship between executive compensation actually paid and the financial performance of the issuer and distributions to shareholders.33 In addition, Congress directs the SEC to amend its executive compensation disclosure rules34 to disclose the compensation of the chief executive officer as compared to the median annual total compensation of the issuer paid to all employees other than the chief executive officer, as well as the ratio thereof.35

Because performance compensation may be calculated on financial information that is later discovered to be incorrect, the Act also requires (as a listing standard) all listed companies to develop and implement a policy providing for the disclosure of incentive-based compensation and, if there is an accounting restatement, a provision to recover erroneously paid incentive based compensation.36

The Act also requires each issuer to disclose whether any employee or member of the board of directors, or any designee of any employee or board member, is permitted to purchase hedges – that is, financial instruments that are designed to hedge or offset against any decrease in the market price for the issuer’s securities.37

Herrick K. Lidstone, Jr., Burns Figa & Will, PC

_____________________________________________________________________________

27 Section 951 of the Act, adding § 14A(a)(1) to the 1934 Act. These votes (say on pay and the timing for future votes) are required at the first shareholder meeting occurring after six months from the date of enactment.
28 Section 951 of the Act, adding § 14A(a)(2) to the 1934 Act.
29 Section 951 of the Act, adding § 14A(b) to the 1934 Act. The say-on-golden parachute vote is required at the first shareholder meeting occurring after six months from the date of enactment.

30 Section 951 of the Act, adding § 14A(c) and (d) to the 1934 Act.
31 See Item 407(e) of Regulation S-K, incorporated into Form 10-K by Items 10 and 11 and into the proxy statement by Items 7 and 8 of Schedule 14A. A compensation committee is also a requirement of the NYSE Listed Company Manual (§ 303A05) and Rule 5605(d) of the Nasdaq Corporate Governance Requirements.
32 The Act requires the SEC to act within 360 days after enactment.

33 Section 953(a) of the Act. Compensation consultant disclosure must be included in proxy statements for any annual meeting occurring on or after one year from enactment – suggesting that the SEC must complete its rule making well before that date.

34 Found in Item 402 of Regulation S-K.
35 Section 953(b) of the Act.

36 Section 954 of the Act, adding § 10D to the 1934 Act.
37 Section 955 of the Act, adding § 14(j) to the 1934 Act.

The Act amends § 13(d) and § 16 of the 1934. Section 13(d) imposes certain reporting requirements on persons who own more than 5 percent of the outstanding securities of a company registered under Section 12 of the 1934 Act. Section 16 imposes other reporting requirements on officers and directors of companies that have securities registered under the 1934 Act (as well as persons owning more than 10 percent of the outstanding securities of such companies) and also imposes potential liability for trading in those securities within a six month period.38 Currently the requirements for an initial filing (made under § 13(d) in a Schedule 13D and under § 16(a) on a Form 3) is ten days after the event that imposes the reporting requirement.39 Section 929R of the Act gives the SEC the discretion to reduce the ten days to a lesser number of days under both § 13(d) and § 16(a).

Herrick K. Lidstone, Jr., Burns Figa & Will, PC

_____________________________________________________________________________

38 See general discussion in Lidstone, Securities Law Deskbook (Bradford Publishing Co.) at §§ 16.18 and 17.7.
39 1934 Act, § 13(d)(1) and § 16(a)(2)(B).

Since Wilko v. Swan40 (relating to the 1933 Act) and Shearson/Am. Express Inc. v. McMahon41 (relating to the 1934 Act), pre-dispute arbitration agreements in securities matters have unquestionably been enforceable, and most (if not all) agreements between broker-dealers and their customers contain mandatory arbitration provisions.42 In Peterson v. Beale,43 a brokerage client was required to arbitrate the claims even though the customer agreement was signed by his broker on the customer’s behalf (not by the customer). Section 921 of the Act gives authority to the SEC to “prohibit, or impose conditions or limitations on the use of” predispute arbitration agreements involving any broker, dealer, municipal securities dealer, or investment adviser.44

Herrick K. Lidstone, Jr., Burns Figa & Will, PC

_____________________________________________________________________________

40 346 U.S. 427, 74 S. Ct. 182, 98 L. Ed. 168 (1953).
41 482 U.S. 220, 107 S. Ct. 2332, 96 L. Ed. 2d 185 (1987).
42 See general discussion in Lidstone, Securities Law Deskbook (Bradford Publishing Co.) at §§ 14.2-14.3.
43 Fed. Sec. L. Rep. (CCH) ¶ 98,980, 1995 WL 479425 (S.D.N.Y. 1995).
44 Adding § 15(o) to the 1934 Act and § 205(f) to the Advisers Act.

As we have noted on this blog, opposition to access has been absolute and shrill.  As a result, opponents of access have lost at every stage.  Rather than accept the ridiculously narrow access bylaw proposed under the Cox Commission (perhaps with a 5% threshold), oponents now confront direct access at much lower thresholds.

Rather than accept the SEC's more recent access proposal (but perhaps seeking significant ownership thresholds), opponents threatened to sue.  The result was language in Dodd-Frank that is so broad, the SEC can do whatever it wants in the access area, including relying on the existing thresholds in Rule 14a-8 (the lesser of 1% or $2000) or eliminating any requirement that shareholder nominees be a short slate. 

The next stage of virulent opposition seems to be coming from JW Verrett in posts on Truth on the Market.  He is proposing a series of "defenses" designed ostensibly to minimize the significance of access. His "suggestions" have earned a spirited retort from James McRitchie at CorpGov and support from Steve Bainbridge (who actually doesn't support Verrett's analysis, only his right to propose methods of circumventing the access requirement). 

As we will show, the approach used by Verrett is both bad law and bad policy but frankly an invaluable service to anyone arguing for further federal preemption of federal law.  He for example proposes the following:

• The Delaware General Corporation Law gives Boards a wide authority to delegate matters to subcommittees of the Board.  The full Board must approve changes to the charter or bylaws, but otherwise nearly all matters considered by the Board can be delegated to Committees.  If the SEC’s last proposal on proxy access is approved pursuant to Dodd-Frank, including the rule that shareholders can nominate up to a quarter of the board, then Boards could simply create an Executive Committee of the Board consisting of the incumbent directors constituting the other 75% of the Board and delegate nearly every major decision to that Committee.  The insurgent directors could be barred from the Committee meeting.  They would be given the minutes of the meeting, prepared by the corporate secretary, and otherwise be excluded from the deliberations.

The proposal does not contradict or minimize access.  It is really a road map for boards seeking to minimize the influence of directors who in any way oppose management.  The same approach could be taken, for example, to eliminate from the board any director who demonstrates excessive amounts of independence or opposes the CEO in any significant manner.  In other words, its not about access but about eliminating dissent. 

The use of the executive committee in the manner suggested by Verrett is probably a violation of the board's fiduciary duties.  After all, it amounts to the full fledged exclusion of directors solely because the board does not like the way they were elected.  Moreover, the standard of review would likely not be the business judgment rule or even the duty of loyalty but the Blasius standard since this would effectively be an act of disenfranchisement.  As a result, the burden would be on the board to establish a compelling justification for the action, which it could not.

Moreover, the case is awfully close to Crown Emak Partners v. Kurz, 992 A.2d 377 (Del. 2010), where the Court invalidated a bylaw that reduced the size of the board, concluding that this was not an approved method of removing incumbent directors.  Verrett's proposal is tantamount to removal of the dissident directors by the board, something that Delaware law does not permit.  

And, while its true that the board can delegate to committees (see Brehm v. Eisner, 906 A.2d 27  (Del. 2005); 8 Del. C. § 141(c) (2010)), the Delaware Supreme Court struck down another circumvention of the board's authority in Quickturn.  Like in Quickturn, this provision would permanently divest the entire board of its authority. 

The legal uncertainty would also generate uncertainty over actions taken by the executive committee, probably damaging the company's business.  The legal uncertainty of the approach would likely cause third parties to avoid any transaction that otherwise required full board approval (signifcant contracts, the delegation of authority to officers, the sale of stock, significant loans, etc). 

Of course, any attempt to challenge the approach in Delaware would confront the pro-management approach of the courts.  As a result, its possible that the courts would find this approach legal. 

If so, it would be a windfall to shareholder groups.  The board's approach would likely generate support for a competing slate of directors in the next election cycle, resulting in displacement of the entire board.  It might generate an SEC response, such as allowing access for a majority of the board, at least where the incumbents effectively refuse to seat dissident directors. (This is, after all, something the SEC could do given the extraordinarily broad language of Dodd-Frank). 

Mostly, though, the approach is shortsighted, at least for anyone seeking to minimize additional preemption of Delaware law.  The obvious unfairness of the approach would be a red flag for Congress the next time talk of preemption surfaced.  Congress preempted Delaware in 2002 with SOX and again in Dodd-Frank.  Dodd-Frank in effect gave the SEC the authority to determine the definition of independent director, overturned Citigroup by forcing on the boards of financial institutions to take a role in the risk management process, and required independent compensation consultants, a step Delaware courts refused to take.

The pace of preemption is increasing.  Delaware has been reduced from the center of corporate governance to another interest group vying for a role in the governance process.  In those circumstances, congressional intervention is becoming easier and easier.  Upholding efforts by boards to eliminate dissident directors through broad delegation to the executive committee will merely hasten the next round of intervention.   

The Act amends Section 6(b) of the 1934 Act to require national securities exchanges to prohibit proxy voting by a broker in connection with the election of directors (other than a vote with respect to the uncontested election of a member of the board of any registered investment company), executive compensation or any other significant matter, as determined by the SEC, unless the beneficial owner of the security has specifically instructed the broker to vote in such way.(24) Broker discretionary voting was eliminated by the New York Stock Exchange (“NYSE”) Rule 452 for director elections starting in the 2010 proxy season. The Act extends the prohibition of broker discretionary voting to say-on-pay votes, among other matters.

The Act also provides that the SEC may adopt provisions for “proxy access,” allowing shareholders who want to propose a slate of directors to include their slate in the company’s proxy statement that also includes the slate proposed by the board.(25) Currently, unless companies voluntarily provide proxy access to their shareholders, shareholders must mount their own (usually quite expensive) proxy campaign if they desire to nominate even a single director in opposition to the company slate. If implemented, it will become easier for dissident shareholders to present their director nominees to the shareholders for consideration because the company will have to include the relevant information in its own proxy statement.

Implementation of “proxy access” provisions may require statutory amendments as was the case when (in 2009) Delaware added § 112 to the Delaware General Corporation Law.  The Act also requires the SEC to adopt rules requiring an issuer to disclose in its proxy statement why the issuer has chosen the same person to serve as chairman and CEO (if that is the case) or, conversely, why the issuer has chosen different persons to serve in those roles.(26) The Act requires the SEC to adopt these rules within 180 days.

Herrick K. Lidstone, Jr., Burns Figa & Will, PC

_____________________________________________________________________________

24 Section 957 of the Dodd-Frank Act, amending § 6(b) of the 1934 Act.
25 Section 971 of the Act, adding § 14(a)(2) to the 1934 Act.
26 Section 972 of the Act, adding § 14B to the 1934 Act.

Section 404 of the Sarbanes-Oxley Act of 2002, as originally enacted, imposed two requirements on all issuers filing periodic reports with the SEC. First, each issuer filing an annual report with the SEC must state that the issuer’s management was responsible for establishing and maintaining adequate internal control over financial reporting and also contain an assessment, as of the end of the most recent fiscal year of the issuer, of the effectiveness of the issuer’s internal control structure and financial reporting procedures.(18) The SEC adopted these rules in September 2002 and has amended them several times.(19)

Second, each auditor of an issuer filing reports with the SEC must attest to and report on management’s assessment of its internal controls.(20) In rulemaking to date, the SEC has exempted smaller reporting companies(21) from this attestation requirement through fiscal years ended June 15, 2010.(22)

Section 989G of the Act continues the exemption for smaller reporting companies permanently, stating that the attestation requirements “shall not apply with respect to any audit report prepared for an issuer that is neither a ‘large accelerated filer’ nor an ‘accelerated filer’”.(23) As a result, smaller reporting companies are no longer subject to the attestation requirement. Based on informal conversations with SEC staff, it appears that the SEC will issue an interpretation in the near future that this applies to companies with fiscal years ended between June 15, 2010, and the date the Act became law.

The Act also requires the SEC to study ways of reducing the burden of § 404(b) compliance on companies with market capitalizations between $75,000,000 and $250,000,000.

Herrick K. Lidstone, Jr., Burns Figa & Will, PC

_____________________________________________________________________________

18 Sarbanes-Oxley Act of 2002, § 404(a).
19 The SEC adopted Rules 13a-14, 13a-15, 15d-14 and 15d-15, and included the certification found in Exhibit 31 as a required exhibit for all annual and quarterly reports in Item 601 of SEC Regulation S-K.
20 This attestation report is specifically required in Item 9A to Form 10-K and Part I, Item 4 of Form 10-Q.
21 “Smaller reporting company” is defined in 1934 Act Rule 12b-2 means an issuer that is not an investment company, an asset-backed security issuer, or a majority owned subsidiary of a parent that is not a smaller reporting company that has a public float of less than $75,000,000 as of the last business day of its most recently completed second fiscal quarter (determined each year).
22 See Item 9A(T) to Form 10-K and Part I, Item 4(T) to Form 10-Q.
23 Section 989G adds subsection (c) to § 404 of the Sarbanes-Oxley Act of 2002 which contains the
exemption from the requirements of § 404(b).

Investor Protection – Amendments to the 1933 Act (footnote 11) and the 1934 Act (footnote 12)

Changes to SEC Regulation D The SEC adopted Regulation D in 1982 (footnote 13) to provide a safe harbor exemption from registration for certain securities offerings of securities. The operative provisions of Regulation D are Rules 504 and 505 which were adopted pursuant to the SEC’s authority under § 3(b) of the 1933 Act, and Rule 506, adopted under § 4(2) of the 1933 Act. The National Securities Markets Improvement Act of 1996 (“NSMIA”) provides that offerings conducted under Rule 506 are
exempt from state review and qualification. (footnote 14)

Among its several sections aimed at SEC Regulation D, § 413 of the Act requires the SEC to adjust the definition of “accredited investor”(footnote 15) so that (for natural persons) the net worth calculation specifically excludes the value of such persons primary residence. The Section makes that legislative determination effective immediately, notwithstanding the SEC’s rule making authority. Additionally, the Act requires the SEC to increase the net worth requirement for natural persons(footnote 16) within four years after the enactment of the Act. The basis for and the amount of the increase is not set forth in the Act, but is left to future SEC rule-making. The Act did not change the income alternative for determining accredited investor status ($200,000 annual income for an individual, $300,000 if joint with spouse). The SEC may make changes to this alternative part of the definition in the future.

Section 926 of the Act requires the SEC to adopt rules that prevent certain ‘bad actors’ from being able to use Rule 506 of Regulation D. The current “bad boy” rules only apply to Rule 505 offerings. The Act requires that the new rules expand upon the existing rules found in Rule 262 of Regulation A,(footnote 17)which are incorporated into Rule 505. The SEC must adopt these new rules within one year.

In connection with the changes to the definition of the term “accredited investor” for the purposes of Section 413(a) of the Dodd-Frank Act discussed above, on July 23, 2010, the Securities and Exchange Commission Division of Corporation Finance issued a new “Compliance and Disclosure Interpretation” 179.01 (and an identical CDI 255.47) to explain CorpFin’s interpretation of Section 413(a) when the value of an accredited investor’s residence is less than the mortgage(s) outstanding against that residence. 

The CDI states that, when “determining net worth for purposes of Securities Act Rules 215 and 501(a)(5), the value of the person's primary residence must be excluded.  Pending implementation of the changes to the Commission's rules required by the Act, the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor's net worth.”  In other words, the primary residence cannot be used as an asset when determining net worth for the accredited investor calculation; excess liabilities will be a reduction from net worth.

The CDI went on to say that the SEC will issue amendments to its rules to conform the SEC’s rules to the standards for accredited investors set forth in the Dodd-Frank Act.

Herrick K. Lidstone, Jr., Burns Figa & Will, PC

_____________________________________________________________________________

11 The Securities Act of 1933, found at 15 U.S.C. § 77a, et seq.
12 The Securities Exchange Act of 1934, found at 15 U.S.C. § 78a, et seq.

13 SEC Rel. No. 33-6389, 24 S.E.C. Docket 1166, 1982 WL 35662 (Mar. 8, 1982). When adopted, Regulation D consolidated and replaced former Rules 146, 240 and 242.
14 NSMIA amended § 18 of the 1933 Act to provide that states no longer have jurisdiction to require registration or qualification of any “covered security” or securities that “will be a covered security upon completion of the transaction.” § 18(a)(1). “Covered securities” include those issued pursuant to Rule 506. §18(b)(4)(D).  NSMIA also prohibits state review and critique of an offering document “that is prepared by or on behalf of the issuer.” SEC Rule 146 defines the term “by or on behalf of an issuer.” See discussion in Lidstone, Securities Law Deskbook (Bradford Publishing Co.) at §11.3.
15 See Regulation D, Rule 501(a).
16 Currently $1,000,000, excluding the value of the natural person’s primary residence.” Rule 501(a) as amended by § 413 of the Act. Before the Act, the $1,000,000 requirement had not changed since originally enacted in 1982. An early version of the Senate bill would have required the SEC to increase the definitions for inflation since 1982, which would have resulted in net income of up to $459,000 for an individual, $688,000 for a couple, or a net worth requirement of $2,300,000.
17 17 C.F.R. § 230.262.

On June 29, 2010, after months of wrangling, the House-Senate Conference Committee issued the conference report on the Dodd-Frank Wall Street Reform and Consumer Protection Act, a 2,319 page amendment to H.R. 4173 (the “Act”). The House of Representatives approved the bill on June 30, 2010, the Senate approved it on July 15, 2010, and it became law when President Obama signed it on July 21, 2010. This bill has its genesis in the financial crisis of 2007-2008 and the perceived abuses by financial institutions, investment advisors, and credit rating organizations with respect to asset backed securities, sub-prime mortgages, collateralized debt obligations, and other derivative securities, as well as a backlash against what was perceived to be excessive executive compensation in publicly traded companies and financial institutions.

There has been a large amount written in law firm memoranda and news articles on how the Act impacts major banks and broker dealers, attempts to control derivative securities, and otherwise impacts Wall Street’s financial practices. Other sections deal with mortgage-backed securities and mortgages in general which will be of significant interest to the real estate lawyer.  In this author’s experience, there has been little written on the Act’s impact on smaller public and private businesses, which is potentially significant. The Act implements a number of measures, from revising the definition of accredited investor, changing eligibility for Rule 506 and enhancing the Securities and Exchange Commission’s enforcement powers, to mandating a number of studies that may further impact small businesses. The following describes some of these measures and their potential impact both on smaller businesses and the lawyers who represent them.

Summary of the Act

A large part of the Act deals with matters that impact Wall Street and major financial institutions. For example, the Act establishes a Financial Stability Oversight Council with the authority to regulate non-bank financial companies and to resolve supervisory and jurisdictional disputes between various supervisory agencies (such as the Securities and Exchange Commission (the “SEC”), the Commodities Futures Trading Commission (the “CFTC”), and the Federal Reserve Board (the “FRB”)). The Act also:

• Modifies the existing provisions regarding liquidation of financial institutions and theSecurities Investor Protection Act,2
• Reorganizes powers among various governmental agencies,3
• Creates an office of national insurance4 and enacts improvements to regulation ofbank and savings association holding companies and depository institutions,5
• Improves the regulation of credit rating agencies,6 asset backed securities,7 and municipal securities,8
• Establishes the Bureau of Consumer Financial Affairs Protection with broad regulatory and enforcement powers,9 and
• Adopts the “Mortgage Reform and Anti-Predatory Lending Act.”10

The foregoing is a broad summary of some of the Act’s major provisions, each of which is worth discussing at length. The purpose of this article, however, is to focus on the provisions of the Act likely to be of interest to lawyers who represent public and private companies. These provisions are generally (but not solely) found in Titles IV (“regulation of advisors to hedge funds and others”) and IX (“investor protections and improvements to the regulation of securities”) of the Act. Many of the Act’s provisions will not become effective until the SEC completes its rule-making actions, but some of the provisions become effective on or shortly after enactment.

Herrick K. Lidstone, Jr., Burns Figa & Will, PC

_____________________________________________________________________________

1 Title I, Subtitle A.

2 Title II; Title IX, Subtitle B, Section 929H; among others.
3 Title III, entitled “Transfer of Powers to the Comptroller of the Currency, the [Federal Deposit Insurance]
Corporation, and the Board of Governors.”
4 Title V.
5 Title VI.
6 Title IX, Subtitle C.
7 Title IX, Subtitle D.
8 Title IX, Subtitle F.
9 Title X.
10 Title XIV.

Herrick Lidstone, a partner at Burns, Figa & Will, PC, here in Colorado, has written a thoughtful piece on the new finance legislation and its impact on smaller businesses.  We are privileged to publish the analysis on The Race to the Bottom.  

Recognizing that Delaware has seen its authority substantially weakened, where has it gone?  Mostly to the Securities and Exchange Commission, a process begun in ernest in SOX and continued in the DFA.

As we have already noted, the SEC has been placed in the center of say on pay.   It is the Commission, through its determination of the requirements of Item 402, that will determine which "executives" and what information about the compensation of those executives, will be subject to shareholder approval.

That is not the only shareholder voting authority given to the Agency.  Section 6(b) of the Exchange Act, 15 U.S.C. 78f(b), has been amended to give the SEC what amounts to almost plenary control over the right of brokers to vote the uninstructed shares of their account holders.  This authority has been within the exclusive control of the stock exchanges since 1937.   Interestingly, the provision prohibits the voting of uninstructed shares for the election of directors, a step already taken by the Commission but only over the opposition of two commissioners.

The SEC has received affirmative authority to define independent directors for purposes of the stock exchanges.  This will give a regulator with a decidedly pro-shareholder perspective significant control over the definition.  Some current weaknesses in the definition (the failure to take into account fees, for example), are likely to be addressed.  At least for public companies, the SEC's definition is likely to supplant those under state law. 

The SEC's authority with respect to access has been clarified, eliminating any meaningful legal challenge to rulemaking in the area.  The SEC can, therefore, use the proxy rules to facilitate the election of shareholder nominated directors.  Moreover, efforts by some in the Senate to limit access to 3% shareholders who met a two year holding period was successfully defeated.  The SEC's authority in the area is essentially plenary. 

The SEC has received substantial substantive authority in the area of corporate governance, authority mostly taken from Delaware.  The Commission will provide for a single, national law regulating corporate governance that is applicable to public companies.  The biggest concern in this area is the potential politicization of governance.  While the SEC is an "independent" agency, it is not immune from politics.  Moreover, if Justice Bryer had his way, there would be no "for cause" removal restriction on the President's ability to replace commissioners, further politicizing the agency's actions.  See FEF v. PCAOB, 561 US --- (2010)(Bryer, J. dissenting). 

Any regulator in the field of corporate governance will have strengths and weaknesses.  The SEC may yet make a hash of it.  But that is speculation while the role of Delaware and the Delaware courts has already been established.  It is time for a new sheriff in Dodge.

The Dodd-Frank Wall Street Reform Act and a short Summary of the legislation are posted online.

The provision on shareholder access also has preemptive effect. 

Shareholder access is probably the most important governance provision in the Dodd-Frank Wall Street Reform Act.  Had the Act been silence, the Commission had a strong argument that it had the authority to compel access.  After all, the requirement would have been nothing more than a disclosure obligation in the proxy statement.  The effect of the election remained a matter of state law.  Nonetheless, some within the legions opposing access made noises about suing should the Commission act.  As a result, explicit authority was inserted into both the House and Senate versions of the Act, eliminating the issue from litigation.

During conference, however, the Senate surprised many investor/shareholder advocates and inserted into the access provision a requirement that the authority be limited to shareholders owning 5% of the company's shares.  There was also a two year holding period.  Had this remained in the final legislation, access authority would have been almost useless.  It did show, however, that those opposed to access would probably have been more effective had they focused less on preventing access entirely (something that, due to changes in the dynamics of the market, had become increasingly inevitable), and instead tried to obtain high thresholds. 

Indeed, one has to go back to the Commission under Cox when the access proposal would merely have permitted access bylaws, bylaws that if they were adopted would allow for access in subsequent proxy solicitations.  Such a bylaw would have required proponents of access to first obtain enough support to pass the bylaw and then obtain enough support to elect their candidates, neither of which was guaranteed.  Yet the vociferous opposition to even this mild requirement put matters on hold (actually the Commission adopted an anti-access provision to reverse the AFSCME decision) until a more aggressive approach could materialize once Administrations changed.

The restrictions proposed by the Senate were ultimately deleted, with Congressman Frank and Congresswoman Waters refusing to relent.  As a result, the SEC received almost plenary authority to regulate access.  Specifically, the Dodd-Frank Act amended Section 14(a) of the Exchange Act, the source of the Commission's authority on the proxy rules, and provided explicitly that the Commission had the power to require an issuer to include in its proxy statement "a nominee submitted by a shareholder to serve on the board of directors of the issuer."  Likewise, the Commission could determine any procedures that must be followed by the company. 

The limits on the Commission's authority?  The rules can contain any "terms and conditions as the Commission determines are in the interests of shareholders and for the protection of investors."  The provision invites but does not require the Commission to consider exempting certain classes of smaller companies from the requirement.

How broad is this authority?  There is nothing that limits the Commission in its determination of the ownership threshold necessary to submit a nominee.  The Commission need not require that the number only be a short slate.  The provision gives the SEC rulemaking authority in connection with "solicitation materials," not just the proxy statement.  It could, therefore, require disclosure in follow up materials distributed by the company.

In short, opposition to access has been absolute, without leaving much room for compromise.  It was the vociferous opposition to access that resulted in the non-adoption of the weak access bylaw provision proposed back in 2006.  And, it was the vociferous opposition that resulted in the adoption by Congress of sweeping authority in the area for the Commission.  Had the focus been on limiting rather than eliminating the Commission's authority (the effort to squeeze in a 5% threshold was too late and too excessive), the outcome in Congress might have been different.

In any event, the Commission has the authority to adopt a rule governing access.  This will happen shortly.  The express grant of congressional authority has made it clear that any state law impediments will be preempted. 

The Dodd-Frank Wall Street Reform Act and a short Summary of the legislation are posted online.  We have reprinted the proxy access provision below.

SEC. 971. PROXY ACCESS.

(a) PROXY ACCESS. Section 14(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78n(a) is amended-

(1) by inserting "(1)" after "(a)"; and
(2) by adding at the end the following:

"(2) The rules and regulations prescribed by the Commission under paragraph (1) may include-
"(A) a requirement that a solicitation of proxy, consent, or authorization by (or on behalf of) an issuer include a nominee submitted by a shareholder to serve on the board of directors of the issuer; and

"(B) a requirement that an issuer follow a certain procedure in relation to a solicitation described in subparagraph (A)."

(b) REGULATIONS.-The Commission may issue rules permitting the use by a shareholder of proxy solicitation materials supplied by an issuer of securities for the purpose of nominating individuals to membership on the board of directors of the issuer, under such terms and conditions as the Commission determines are in the interests of shareholders and for the protection of investors.

(c) EXEMPTIONS.-The Commission may, by rule or order, exempt an issuer or class of issuers from the requirement made by this section or an amendment made by this section. In determining whether to make an exemption under this subsection, the Commission shall take into account, among other considerations, whether the requirement in the amendment made by subsection (a) disproportionately burdens small issuers.

Another place where preemption occurred was in connection with clawbacks.  Could there be any other place that demonstrates more clearly the weakness in Delaware law than the need for a federal provision that requires clawbacks of compensation based upon erroneous financial statements?  Nonetheless, no such requirement or practice has emerged under Delaware law.  As a result, the matter has become federalized.  Moreover, the approach shows that Congress will return to an area and deepen the preemptive effect if state law does not fill the breach. 

Congress stepped into the area of clawbacks in a mild and tentative way under SOX.  Section 304 of SOX provided for the forfeiture of bonuses but only in very narrow circumstances.  The provision applied to the CEO and CFO and only extended to bonuses paid within 12 months of the faulty financial statements. 

The forfeiture was triggered by a restatement "due to the material noncompliance of the issuer, as a result of misconduct."  The provision does not require the forefeiting officer to have actually engaged in the misconduct.  As one court has described:

• it was Congress's purpose to recapture the additional compensation paid to a CEO during any period in which the corporate issuer was not in compliance with financial reporting requirements. A CEO need not be personally aware of financial misconduct to have received additional compensation during the period of that misconduct, and to have unfairly benefitted therefrom. When a CEO either sells stock or receives a bonus in the period of financial noncompliance, the CEO may unfairly benefit from a misperception of the financial position  of the issuer that results from those misstated financials, even if the CEO was unaware of the misconduct leading to misstated financials. It is not irrational for Congress to require that such additional compensation amounts be repaid to the issuer.
  

SEC v. Jenkins, 2010 US Dist. Lexis 57023 (D. Arizona June 9, 2010).

Section 954 of the Dodd-Frank Wall Street Reform Act, however, substantially broadened the reach of the clawback provision.  The need for restatements due to misconduct was eliminated.  Instead, clawbacks are required where a restatement occurs due to "material noncompliance."  Moreover, Dodd-Frank expanded the reach from the CEO and CFO to "any current or former executive officer."  Finally, the look back period has been extended from one to three years.   The provision does provide, however, that the clawback will only apply to the amount paid "in excess of what would have been paid to the executive officer under the accounting restatement."

The provision addresses performance based compensation based upon mistaken financial statements.  It does not address performance based compensation that encourages short term earnings.  Thus, officers who receive substantial performance based compensation because of a good year (think 2007) only to see matters collapse the following year (think 2008) will not have to pay back the compensation.  The approach, therefore, puts a premium on financial accuracy rather than prudent management.

The Dodd-Frank Wall Street Reform Act and a short Summary of the legislation are posted online.  We've attached the provision below.  

SEC. 954. RECOVERY OF ERRONEOUSLY AWARDED COMPENSATION.

The Securities Exchange Act of 1934 is amended by inserting after section 10C, as added by section 952, the following:

SEC. 10D. RECOVERY OF ERRONEOUSLY AWARDED COMPENSATION POLICY.

(a) LISTING STANDARDS.—The Commission shall, by rule, direct the national securities exchanges and national securities associations to prohibit the listing of any security of an issuer that does not comply with the requirements of this section.

(b) RECOVERY OF FUNDS.—The rules of the Commission under subsection (a) shall require each issuer to develop and implement a policy providing—

(1) for 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; and

(2) that, in the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws, the issuer will recover from any current or former executive officer of the issuer who received incentive-based compensation (including stock options awarded as compensation) during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement.

So how has the compensation process been preempted?  

A new Section 10C of the Exchange Act mandates the use of a compensation committee for listed companies.  That step does not alter the existing landscape.  Stock exchanges already require a compensation committee, although now they will lose any discretion (and exemptive authority) over application of the requirement. 

Section 10C, however, gives to the committee the authority to pick its own consultants and determine their compensation.  In effect, as with the audit committee in SOX, the Dodd-Frank Act cleaves off a committee of the board and gives it board like authority. 

Section 10C, however, goes much further than SOX.  Dodd-Frank has extended to the Commission broad authority to define critical terms.  Thus, while the directors on the compensation committee must be independent, it is the Commission that gets to determine the "factors" that must be considered in determining independence.  In effect the stock exchange lost its authority to control the definition of director independence.  Moreover, Congress instructed the Commission in defining those factors to take into account: 

• the source of compensation of a member of the board of directors of an issuer, including any consulting, advisory, or other compensatory fee paid by the issuer to such member of the board of directors;

While not entirely clear, this suggests that the Commission will need to require consideration of the fees paid to directors for their service on the board.   Of course, the provision will potentially result in three different definitions of independent:  one for audit committee members, one for compensation committee members, and one for other non-management members.  Nonetheless, it is likely that the Commission will eventually craft together a unified definition of director independence that is not committee specific. 

WIth repect to compensation consultants (and counsel to the committee), the Commission is charged with identifying factors that must be considered by the compensation committee when selecting the consultant.  Among the factors that must be considered include: 

• (A) the provision of other services to the issuer by the person that employs the compensation consultant, legal counsel, or other adviser;

• (B) the amount of fees received from the issuer by the person that employs the compensation consultant, legal counsel, or other adviser, as a percentage of the total revenue of the person that employs the compensation consultant, legal counsel, or other adviser;

• (C) the policies and procedures of the person that employs the compensation consultant, legal counsel, or other adviser that are designed to prevent conflicts of interest;

• (D) any business or personal relationship of the compensation consultant, legal counsel, or other adviser with a member of the compensation committee; and

• (E) any stock of the issuer owned by the compensation consultant, legal counsel, or other adviser.

In other words, it is the Commission that effectively has the authority to define "independence" with respect to compensation consultants (and counsel) and directors.  As the Summary to the Conference Report described, the requirements give the committee the “authority to hire compensation consultants in order to strengthen their independence from the executives they are rewarding or punishing.”

While Congress specifically required consideration of fees in connection with director independence, it specifically required, with respect to compensation consultants, consideration of any “personal relationship” among the consultants and the members of the compensation committee.  The provision is narrow in the sense that it applies only to personal relationships with the members of the compensation committee.  Nonetheless, it makes explicit for the first time that personal relationships matter with respect to a determination of independence.  (The NYSE takes the position that personal relationships among directors matters for purposes of determining independence but the listing standard merely applies to  material relationships "with the listed company."  For a discussion of this language and the NYSE's interpretation, go here).   

As for payment, Section 10C specifically requires the company to “provide for appropriate funding, as determined by the compensation committee” for counsel or any consultants.  While the requirement to provide funding was imposed on the company and, perforce, the entire board, it is bound by the decisions of the committee. 

The Dodd-Frank Wall Street Reform Act and a short Summary of the legislation are posted online.  We have included Section 952 below.

SEC. 952. COMPENSATION COMMITTEE INDEPENDENCE.

(a) IN GENERAL.—The Securities Exchange Act of 1934 (15 U.S.C. 78 et seq.) is amended by inserting after section 10B, as added by section 753, the following:

SEC. 10C. COMPENSATION COMMITTEES.

(a) INDEPENDENCE OF COMPENSATION COMMITTEES.—

(1) LISTING STANDARDS.—The Commission shall, by rule, direct the national securities exchanges and national securities associations to prohibit the listing of any equity security of an issuer, other than an issuer that is a controlled company, limited partnership, company in bankruptcy proceedings, open-ended management investment company that is registered under the Investment Company Act of 1940, or a foreign private issuer that provides annual disclosures to shareholders of the reasons that the foreign private issuer does not have an independent compensation committee, that does not comply with the requirements of this subsection.

(2) INDEPENDENCE OF COMPENSATION COMMITTEES.—The rules of the Commission under paragraph (1) shall require that each member of the compensation committee of the board of directors of an issuer be—

(A) a member of the board of directors of the issuer; and

(B) independent.

(3) INDEPENDENCE.—The rules of the Commission under paragraph (1) shall require that, in determining the definition of the term ‘independence’ for purposes of paragraph (2), the national securities exchanges and the national securities associations shall consider relevant factors, including—

(A) the source of compensation of a member of the board of directors of an issuer, including any consulting, advisory, or other compensatory fee paid by the issuer to such member of the board of directors; and

(B) whether a member of the board of directors of an issuer is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer.

(4) EXEMPTION AUTHORITY.—The rules of the Commission under paragraph (1) shall permit a national securities exchange or a national securities association to exempt a particular relationship from the requirements of paragraph (2), with respect to the members of a compensation committee, as the national securities exchange or national securities association determines is appropriate, taking into consideration the size of an issuer and any other relevant factors.

(b) INDEPENDENCE OF COMPENSATION CONSULTANTS AND OTHER COMPENSATION COMMITTEE ADVISERS.—

(1) IN GENERAL.—The compensation committee of an issuer may only select a compensation consultant, legal counsel, or other adviser to the compensation committee after taking into consideration the factors identified by the Commission under paragraph (2).

(2) RULES.—The Commission shall identify factors that affect the independence of a compensation consultant, legal counsel, or other adviser to a compensation committee of an issuer. Such factors shall be competitively neutral among categories of consultants, legal counsel, or other advisers and preserve the ability of compensation committees to retain the services of members of any such category, and shall include—

(A) the provision of other services to the issuer by the person that employs the compensation consultant, legal counsel, or other adviser;

(B) the amount of fees received from the issuer by the person that employs the compensation consultant, legal counsel, or other adviser, as a percentage of the total revenue of the person that employs the compensation consultant, legal counsel, or other adviser;

(C) the policies and procedures of the person that employs the compensation consultant, legal counsel, or other adviser that are designed to prevent conflicts of interest;

(D) any business or personal relationship of the compensation consultant, legal counsel, or other adviser with a member of the compensation committee; and

(E) any stock of the issuer owned by the compensation consultant, legal counsel, or other adviser.

(c) COMPENSATION COMMITTEE AUTHORITY RELATING TO COMPENSATION CONSULTANTS.—

(1) AUTHORITY TO RETAIN COMPENSATION CONSULTANT.—

(A) IN GENERAL.—The compensation committee of an issuer, in its capacity as a committee of the board of directors, may, in its sole discretion, retain or obtain the advice of a compensation consultant.

(B) DIRECT RESPONSIBILITY OF COMPENSATION COMMITTEE.—The compensation committee of an issuer shall be directly responsible for the appointment, compensation, and oversight of the work of a compensation consultant.

(C) RULE OF CONSTRUCTION.—This paragraph may not be construed—

(i) to require the compensation committee to implement or act consistently with the advice or recommendations of the compensation consultant; or

(ii) to affect the ability or obligation of a compensation committee to exercise its own judgment in fulfillment of the duties of the compensation committee.

(2) DISCLOSURE.—In any proxy or consent solicitation material for an annual meeting of the shareholders (or a special meeting in lieu of the annual meeting) occurring on or after the date that is 1 year after the date of enactment of this section, each issuer shall disclose in the proxy or consent material, in accordance with regulations of the Commission, whether—

(A) the compensation committee of the issuer retained or obtained the advice of a compensation consultant; and

(B) the work of the compensation consultant has raised any conflict of interest and, if so, the nature of the conflict and how the conflict is being addressed.

(d) AUTHORITY TO ENGAGE INDEPENDENT LEGAL COUNSEL AND OTHER ADVISERS.—

(1) IN GENERAL.—The compensation committee of an issuer, in its capacity as a committee of the board of directors, may, in its sole discretion, retain and obtain the advice of independent legal counsel and other advisers.

(2) DIRECT RESPONSIBILITY OF COMPENSATION COMMITTEE.—The compensation committee of an issuer shall be directly responsible for the appointment, compensation, and oversight of the work of independent legal counsel and other advisers.

(3) RULE OF CONSTRUCTION.—This subsection may not be construed—

(A) to require a compensation committee to implement or act consistently with the advice or recommendations of independent legal counsel or other advisers under this subsection; or

(B) to affect the ability or obligation of a compensation committee to exercise its own judgment in fulfillment of the duties of the compensation committee.

(e) COMPENSATION OF COMPENSATION CONSULTANTS, INDEPENDENT LEGAL COUNSEL, AND OTHER ADVISERS.—Each issuer shall provide for appropriate funding, as determined by the compensation committee in its capacity as a committee of the board of directors, for payment of reasonable compensation—

(1) to a compensation consultant; and

(2) to independent legal counsel or any other adviser to the compensation committee.

(f) COMMISSION RULES.—

(1) IN GENERAL.—Not later than 360 days after the date of enactment of this section, the Commission shall, by rule, direct the national securities exchanges and national securities associations to prohibit the listing of any security of an issuer that is not in compliance with the requirements of this section.

(2) OPPORTUNITY TO CURE DEFECTS.—The rules of the Commission under paragraph (1) shall provide for appropriate procedures for an issuer to have a reasonable opportunity to cure any defects that would be the basis for the prohibition under paragraph (1), before the imposition of such prohibition.

(3) EXEMPTION AUTHORITY.—

(A) IN GENERAL.—The rules of the Commission under paragraph (1) shall permit a national securities exchange or a national securities association to exempt a category of issuers from the requirements under this section, as the national securities exchange or the national securities association determines is appropriate.

(B) CONSIDERATIONS.—In determining appropriate exemptions under subparagraph

(A), the national securities exchange or the national securities association shall take into account the potential impact of the requirements of this section on smaller reporting issuers.

(g) CONTROLLED COMPANY EXEMPTION.—

(1) IN GENERAL.—This section shall not apply to any controlled company.

(2) DEFINITION.—For purposes of this section, the term ‘controlled company’ means an issuer—

(A) that is listed on a national securities exchange or by a national securities association; and

(B) that holds an election for the board of directors of the issuer in which more than 50 percent of the voting power is held by an individual, a group, or another issuer.

We are examining the preemption of Delaware law in the Dodd-Frank Wall Street Reform Act.  One place where there has been an obvious preemptive effect is the process used in determining executive compensation. 

Delaware law extends to the board the authority to determine CEO compensation.  Because the CEO invariably sits on the board, there is a conflict of interest in the decision making process.  Ordinarily, this would require application of the duty of loyalty.  The duty of loyalty in turn places on the board the obligation to show that the transaction (in this case the CEO's compensation) was fair.  Fairness in turn requires that the compensation be typical of the industry, typical of what has been paid in the past, or justified by unique circumstances.  It is not a particularly tough standard (a standard that is discussed here). 

Yet even that relatively mild standard has been eviscerated by the Delaware courts.  They have replaced substantive fairness with process.  So long as the CEO's compensation is approved by a board with a majority of independent directors, it will be reviewed not under the duty of loyalty but the far more impenetrable duty of care.  Moreover, under the demand standard, a case challenging CEO compensation will generally be dismissed if the board has a majority of independent directors.

The approach ignores the fact that the interested influence is still in the board room (Delaware courts do not require that the CEO be uninvolved in the process).  It also is based upon a definition of director independence that does not ensure that in fact directors are independent.   The definition largely ignores fees, despite their often prodigious amount, friendship, and most outside business relationships among officers and directors.  Moreover, high pleading standards essentially prevent shareholders from obtaining discovery on the issue of independence, even when facts suggest that directors do not meet applicapble standards. 

As a result, there is no guarantee that the approval process has sufficient integrity to ensure the fairness of compensation.  Indeed, Delaware courts, in rare cases when they have allowed compensation matters to get to discovery, have uncovered serious problems with the process employed by the board. 

Unsurprisingly, therefore, Congress has intervened and largely preempted much of the process to be used in connection with executive compensation.  The DFA has sought to regulate director independence on the Compensation Committee, assigned specific responsibilities to the committee, and more or less required independent advisors.  We will discuss these requirements in the next post. 

The Dodd-Frank Wall Street Reform Act and a short Summary of the legislation are posted online.

The WSJ has reported that the Goldman settlement was approved by a 3-2 vote, with Commissioners Casey and Paredes dissenting.  The reasons?

• People familiar with the matter say Republican Commissioner Kathleen Casey questioned the SEC staff Thursday on their decision to abandon the strongest fraud charge and strike a settlement involving a lesser allegation, and given that, how the SEC could justify such a large penalty on a lesser charge.

Her complaint about the penalty is no big surprise.  It should be remembered that Commissioner Casey was one of the commissioners responsible for the policy during the Cox era that utterly hobbled the Division of Enforcement by requiring pre-approval of penalties imposed on issuers.  She's opposed to them but fortunately that era has passed.  

The negative vote is no great surprise for another reason.  Commissioners Casey and Paredes opposed the case from the very beginning, essentially arguing that it lacked merit.  Had the Commission been handed its head in litigation, they could have uttered a conclusive "I told you so."  Instead, the Commission has won a rich settlement, extracting a half a billion dollar penalty in the process.  Their prior position and characterization now looks embarrassingly wrong.  So does the continued opposition.    

So, in this context, its not accurate, as the WSJ writes, to contend that the "dispute also raises fresh questions about how strong a case the SEC had against Goldman."  It reflects the views of two Commissioners who have a deregulatory philosophy that was emphatically rejected with the adoption of FinReg by the Senate.  It does not reflect on the merits of the case.  

The problem is, thankfully, a temporal one.  Commissioner Casey's term expires in 2011, leaving Commissioner Paredes very isolated until the expiration of his term in 2013 (although its not uncommon for commissioners to resign before a term is completed).   The Commission cannot have more than three persons of the same party but the Chair, Mary Schapiro is typically labeled an independent so that means when Casey resigns, there is room for a third Democrat. 

Even if the appointment goes to a Republican (something the Senate minority might try to force), it will at least have to be a Republican that President Obama is willing to nominate.  Suffice it to say that someone with the views of commissioners Casey and Paredes will not qualify.

The WSJ has reported that the decision to accept the settlement in the Goldman case was only approved by a 3-2 vote.  This is an outrageous leak, to the extent true. 

This type of information is highly confidential and ought not to leak to the press.  When there were leaks that the Goldman case had been authorized by a 3-2 vote, we criticized the leak and recommended that the Commission rely more often on executive sessions. 

The article in the WSJ noted that the 3-2 vote occurred in a "30-minute closed-door session," an apparent reference to an executive session.  Executive sessions are closed to most of the staff and typically open only to those who are in a must know situation.

Despite the precaution, the leak occurred.  Given the smaller number of officials aware of what transpired at the meeting, the Agency should conduct an investigation and attempt to identify the source of the leak.  Indeed, we think that is an appropriate function for the Inspector General and a better use of his time than investigating whether whether the Goldman case was politically timed.

As the Dodd-Frank Wall Street Reform Act finally becomes law with the Senate's approval yesterday, we will discuss a number of the provisions, particularly in the realm of corporate governance.   These have largely been lost in the discussion over controversies raning from the new Consumer Bureau to the endu user exemption for trading swaps on an exchange.  Nonethless, they are important and deserve attention.

There has been a plethora of commentary over the Dodd-Frank Wall Street Reform Act in an effort to define the winners and losers.  One loser that has yet to be mentioned is the state of Delaware. 

This Blog has often criticized the approach taken by Delaware and the Delaware courts in determining the appropriate level of corporate governance.  Mostly, there has been an unwillingness to define duties of the board in a way that imposes meaningful obligations on directors.  Cases such as Citigroup suggest that the board has no role in risk management and cases like Amylin suggest that there is no affirmative duty of directors to inquire about contractual provisions that disenfranchise shareholders.  In a number of cases (ranging from Seinfeld to Axcelis), the courts have sharply limited shareholder access to information, making reasonable oversight all but impossible.  

The results have been obvious.  Executive compensation has no limits (discussed here) and directors have few specific oversight responsibilities.  Without board oversight, CEOs have much greater authority to act unilaterally, depriving him or her of what would often be sage advice that might warrant an alternative approach.  One wonders whether companies would have made many of the financial mistakes that led to the current crisis had top management consulted more often with the board about the appropriateness of the risks involved.

These weaknesses were not lost on Congress.  For the second time in a decade (SOX being the first), Congress stepped in and substantially rewrote the applicable governance requirements.  The approach taken by Congress can only be seen as a further preemption of the Delaware approach (and do a lesser extent a reduction in the authority of the stock exchanges).  The Commission, which in the 1990s had been told by the DC Circuit that it had no real role in the governance process (See Business Roundtable, discussed here), has now become, arguably, the dominant regulator in the governance process. 

In short, Delaware has seen its preeminence preempted.  Moreover, with Congress stepping in for the second time in a decade, it is clear that Delaware receives no particular deference in the reform process.  To the extent considered at all, it is simply one more interest group among competing interest groups in the determination of corporate governance standards. 

The reduction in Delaware authority has been rapid.  Back in 2008, VC Strine was quoted as saying: "There's a lot of things that keep me up at night related to my work, but the possibility of [a federal corporate law] isn't one of them."  Two years later, the very issue that wasn't keeping him up had largely come to pass.  Moreover, the decisions of the Delaware courts were largely responsible.  None of the provisions implemented by Congress would have been necessary had standards imposed under state law on boards been moderately more exacting.    

Over the next several posts, we will examine the areas where Delaware has been preempted by the Dodd-Frank Wall Street Reform Act. 

The SEC announced a settlement with Goldman Sachs in the case arising out of the Abacus deal.  The Company will pay $15 million in disgorgement and a civil penalty of $535 million.  The firm has also agreed to certain internal reforms that contemplate review of written materials by inside and outside counsel and review of deals by a specified committee within the firm.  Goldman's consent is here.  The proposed judgment is here. 

Goldman consented (without admitting or denying) to a violation of Section 17(a) of the 1933 Act.  Because Section 17(a) can be violated through either negligent or fraudulent disclosure, Goldman did not consent to a finding of fraud.  Indeed, the language of the settlement was carefully crafted to have Goldman admit only that it used marketing materials that contained "incomplete information." As the firm stated:

• Goldman acknowledges that the marketing materials for the ABACUS 2007-AC1 transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was "selected by" ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson's economic interests were adverse to CDO investors. Goldman regrets that the marketing materials did not contain that disclosure.

The SEC, therefore, received a penalty/disgorgement amount that meant business while Goldman avoided admitting to fraud.

The case is not finished.  The action against Fabrice Tourre continues.  The settlement today did not include him. 

For comments on CNBC assessing whether the financial regulatory bill will prevent another financial crisis, with Jay Brown, Corporate & Securities Law Professor and CNBC's Eamon Javers, go here. 

With say on pay for top executives about to become law (something we will examine, along with the other corporate governance provisions in Dodd-Frank, over the next series of posts), we note some growing sentiment for say on pay director pay. 

As we have noted time and time again, directors in many companies are well paid, sometimes receiving in the vicinity of $700,000 in total compensation.  These amounts have become clearer with the compensation reforms in 2006 that now require companies to disclose "total compensation" paid to directors.  The amount of compensation can be large enough to create an economic incentive to support the policies of the CEO (particularly the ones governing his/her compensation) and avoid risking the lucrative sinecure on the board. 

Ted Allen at RiskMetrics has reported on the latest batch of companies where shareholders have voted in favor of a say on pay proposal.  It has happened at Target (52%) and TJX (53.9%) and, most recently, at Chesapeake Energy (56%), the 12th company so far this year to see majority support for such a proposal.  It is evidence of the growing desire by shareholders to have a greater voice in the compensation process.  Of course, these votes are advisory and the board can ignore them.  That will change when the financial reform bill passes.  After that, it will be mandatory say on pay.

The most interesting thing about this spate of approvals, however, concerns the one at Chesapeake.  In addition to the usual say on pay proposal, a second one called for annual shareholder approval of the compensation paid to directors.  As the proposal provided:

• Resolved:  That the shareholders of CHESAPEAKE ENERGY CORPORATION request its Board of Directors to adopt a policy that provides shareholders the opportunity, at each annual meeting, to vote on an advisory resolution, prepared by management, to ratify the compensation of named-executive officers listed in the proxy statement’s Summary Compensation Table and compensation awarded to members of the Board of Directors as disclosed in the proxy statement.

It passed.   The vote totals for Chesapeake can be found in the Company's current report.  Why?  Chesapeake has a well paid CEO (total compensation in 2008 of around $112 million, a more modest $18.5 million in 2009).  See Summary Compensation Table of 2009.  They also have well paid directors, with total compensation somewhere around $530,000 in 2009 and somewhere in the vicinity of $700,000 for 2008. 

How many times did the board meet in 2009?  Four in person and six by telephone.  To the extent that this looks meager, the proxy statement did point out that "management frequently discusses matters with the directors on an informal basis." 

Moreover, that is not all.  As the proxy statement discloses:

• In assessing director independence, the Committee considered the business the Company conducted in 2007, 2008 and 2009, including payments made by the Company to National Oilwell Varco, Inc. (NOV), for which Mr. Miller serves as Chairman, President and Chief Executive Officer, and payments made by the Company to BOK Financial Corporation (BOK), for which Mr. Hargis served as Vice Chairman until March 2008 and since then has served as a director. The Company’s business transactions with NOV and BOK were all conducted in the ordinary course of business. Payments made to NOV represented approximately 1% of NOV’s gross revenues during each of the last three years, well below the NYSE’s 2% of gross revenues threshold, and the Company’s payments to BOK were nominal during the review period. The Committee also considered transactions and relationships with Oklahoma State University, for which Mr. Hargis has served as President since March 2008, including contributions and support for scholarships and faculty chair endowment, university athletics and various sponsorships and training programs. The Committee specifically considered the employment by the Company of Governor Keating’s son and daughter-in-law during 2009 in non-executive positions. The Committee determined that all transactions and relationships it considered during its review were not material transactions or relationships with the Company and did not impair the independence of any of the affected directors.

This is a well paid board that does not meet in person very often.  How does it respond to shareholder initiatives?  In 2009, shareholders voted to recommend majority voting for directors and the elimination of the staggered board.  How did the directors respond?

• The Company and our Board take seriously shareholder proposals, especially proposals that receive majority votes from our shareholders. As a result, over the past year our independent Nominating and Corporate Governance Committee and the Board have consulted with outside experts and actively considered the proposals. The Board believes strongly that it is not advisable, in light of the unique circumstances of our industry, to adopt majority voting or to declassify our Board. The oil and natural gas industry is highly cyclical due to short term volatility in commodity prices, which are outside our control. For a number of reasons (some apparent and some not apparent) the volatility in energy prices is magnified in the stock price for independent exploration and production companies, such as us. The Board believes that the resulting cyclical nature of our business exposes independent exploration and production companies, more so than companies not operating in extractive industries, to short-term opportunism that arises from the divergence between the shorter term focus of the stock market and the longer term focus of industry participants. The Board believes the risks from implementing these proposals far outweigh any benefits and that implementing these proposals would be detrimental to the long-term interests of the Company and its constituencies. For these reasons, the Board has decided to implement neither annual elections nor a majority voting standard.

As say on executive pay becomes more common, pressure for the right to have a say on director pay will likely grow.  If past patterns are any evidence, widespread adoption will have to wait for the next instance when Congress dips into the corporate governance area.