The Unified Agenda and the SEC: Shifting SEC Priorities (Dodd Frank and Executive Compensation)

We are discussing the list of anticipated rulemakings and "long term" projects recently submitted to OIRA by the Commission.  One thing is for certain.  In the area of rulemaking, 2014 will be a year devoted to compensation issues. 

Dodd-Frank also remains at the forefront of the regulatory agenda, with particular emphasis on executive compensation. The Unified Agenda includes two compensation proposals, Compensation Clawback and Pay for Performance, and one final rule, pay ratio disclosure. In addition, the Commission lists as a "long term" project the completion of "Rules Regarding Incentive Compensation," the provision in Dodd-Frank that gave rulemaking authority to financial regulators with respect to large financial institution's incentive-based compensation practices.     

Compensation clawbacks has been on the Unified Agenda since the Spring of 2011.  Another Dodd-Frank provision, the Commission is required to adopt listing standards that mandate the adoption of policies by companies that require clawbacks of incentive based compensation paid to executive officers following an "accounting restatement due to the material noncompliance of the issuer . . . ." See Section 954 of Dodd-Frank. The provision has not been free from controversy within the Commission. Similarly, Pay for Performance (disclosure required by Section 953(b) of Dodd-Frank) has been on the Unified Agenda since the Spring of 2011.  

Given the pruning that took place between the Spring 2013 version of the Unified Agenda and the current version, the fact that these two provisions survived suggests that rule proposals will emerge during the next 12 months.  Both will likely generate substantial controversy.  

As for pay ratio disclosure, the Commission proposed a rule in 2013.  Proposing and adopting are, of course, two different things.  The Unified Agenda suggests that the Commission will move to a final rule during the next 12 months (the Unified Agenda lists October 2014).  This also reflects a highly debated and controversial rule.  

To the extent these projects move forward as suggested by the Unified Agenda, 2014 will be a year dominated by debates over executive compensation.  With the advent of "say on pay," the issue is already very much on the front burner in the governance area.  These rules will heighten the discussion.  


The PCAOB and Structural Changes to the Auditor Report

The PCAOB does not always receive a great deal of press.  Created in Sarbanes-Oxley, the Board oversees auditors for public companies and broker dealers (the latter added by Section 982 of Dodd-Frank). For much of its early history, its very existence was uncertain and only resolved in a 2010 Supreme Court ruling.

The PCAOB has been earnestly overseeing auditors, particularly through regular inspections.  The PCAOB is also, however, in a position to conduct outreach and engage in fact finding to determine whether structural changes to the existing system are necessary.

In that regard, the PCAOB has just proposed a new auditing standard, The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, that, if adopted, would overhaul the structure of the auditor opinion. 

As currently formulated, auditors issue an opinion that mostly says thumbs up or thumbs down on the company's financial statements.  As the PCAOB described:

  • As it exists today, the auditor's report identifies the financial statements that were audited, describes the nature of an audit, and presents the auditor's opinion as to whether the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the company in conformity with the applicable financial reporting framework. This type of auditor's report has been commonly described as a pass/fail model because the auditor opines on whether the financial statements are fairly presented (pass) or not (fail).

As a result of the approach, investors only know that the financial statements (for the most part) passed but otherwise remain unaware of difficult issues that may have arisen.  The approach also, however, sometimes puts the auditors in a bind.  Management may take positions that the auditors view as lacking in adequate support.  Auditors preferring an alternative treatment have only the nuclear option (failing the financial statements) as a recourse, something they may be hesitant to invoke.  

The new standard would alter the existing structure.  It would retain the pass/fail approach but require disclosure of "critical audit matters."  This would require disclosure of "those matters the auditor addressed during the audit of the financial statements that involved the most difficult, subjective, or complex auditor judgments or posed the most difficulty to the auditor in obtaining sufficient appropriate audit evidence or forming an opinion on the financial statements."

In discerning "critical audit matters," independent accountants will need to consider a number of factors, including: 

  • The degree of subjectivity involved in determining or applying audit procedures to address the matter or in evaluating the results of those procedures;
  • The nature and extent of audit effort required to address the matter;
  • The nature and amount of available relevant and reliable evidence regarding the matter or the degree of difficulty in obtaining such evidence;
  • The severity of control deficiencies identified relevant to the matter, if any;
  • The degree to which the results of audit procedures to address the matter resulted in changes in the auditor's risk assessments, including risks that were not identified previously, or required changes to planned audit procedures, if any;
  • The nature and significance, quantitatively or qualitatively, of corrected and accumulated uncorrected misstatements related to the matter, if any;
  • The extent of specialized skill or knowledge needed to apply audit procedures to address the matter or evaluate the results of those procedures, if any; and
  • The nature of consultations outside the engagement team regarding the matter, if any.

In a number of cases, these categories would provide accounting firms with additional leverage vis-a-vis management with respect to accounting issues.  Where the firm felt that there was inadequate support or disagreed with subjective judgments of management, the PCAOB standard would presumably permit the firm to disclose the matter.  Companies may alter their accounting treatment in order to avoid disclosure.   

The list could undergo significant revision before being finalized.  Moreover, even if implemented, it will take time to see whether the requirement provides meaningful disclosure or something that more closely resembles boilerplate.  Nonetheless, the approach reflects a significant potential shift in the nature of auditor reports.    


Unfinished Business from Dodd-Frank: Pay Ratio Disclosure

Mary Jo White, in becoming chair of the SEC, promised to move along the rulemaking endeavors that were left over from an assortment of earlier laws.  As she testified:

  • First, I would work with the staff and my fellow Commissioners to finish, in as timely and smart a way as possible, the rulemaking mandates contained in the DoddFrank Act and JOBS Act. The SEC needs to get the rules right, but it also needs to get them done. To complete these legislative mandates expeditiously must be an immediate imperative for the SEC.

The first step in the fulfillment of this commitment occurred with the adoption of a final rule permitting general solicitations in connection with offerings to accredited investors under Rule 506. See Securities Act Release No. 9415 (July 10, 2013). The provision was adopted over the vigorous oppositionof Commissioner Aguilar.  Other rules under the JOBS Act were promised, including Reg A Lite and Crowdfunding. 

The commitment, however, also extended to Dodd-Frank.  Perhaps the most controversial provision yet to be proposed concerns the requirement that companies disclose the pay ratio between the total compensation of the CEO and the median employee. See Section 953(b) of Dodd-Frank. The position has engendered considerable opposition (some letters are here), even absent a rule proposals.

Back in the middle of July, Bloomberg reported that a proposed rule on pay ratios would emerge from the Commission in a month.  As a proposal, the action would commence "a lengthy public-comment period before the commission would vote on a final version." The article stated that a proposal could emerge by as soon as August 21.  Thereafter, the chair of the SEC testified in late July that the pay ratio proposal will be "completed in the next month or two."

Apparently matters are moving forward. According to BNA, Keith Higgins, the newly appointed head of Corp-Fin, indicated that the "real challenge" to the rule was coming up with a method of calculating income of the median employee. See Yin Wilczek, Executive Compensation New Director Says SEC Corp Fin Wrestling With Calculation Methodology for Pay Ratios. Higgins did not, however, provide a time frame for any rule proposal.

A proposal is a step forward.  It will provide specific language to debate, moving the discussion from the ethereal to the wordly.  Yet this does not mean that ratio disclosure will occur anytime soon.  Not only will there likely be a lengthy comment period, but a final rule will take considerable political will and detailed economic analysis.  Even then, a final rule will need to survive the inevitable legal challenged that will follow. 


Too Big to Fail: Dodd Frank Three Years Later

I had the pleasure of participating in a discussion on Minnesota Public Radio (on the Daily Circuit) with Gretchen Morgensen from the NYT about Too Big to Fail and Dodd Frank.  The discussion is here.  The format is particularly appealing because it is not a matter of short excerpts but permits more detailed responses to questions.

Too Big to Fail is a complicated issue that requires unpacking before a straightforward discussion can occur.  The doctrine presupposes that there are some financial institutions that, if they fail, will have a damaging effect on the US financial system.  Most view the big four (JP Morgan Chase, BofA, Citigroup and Wells Fargo) with the occasional addition of #5 (Goldman) as financial institutions that qualify as too big to fail.

There are three very different approaches that can be taken with respect to the issue.  First, the banks can be downsized so that they are not too big to fail.  Second, banks can be regulated in a manner that reduces the risk that they will fail.  Third, requirements can be put in place that minimize the consequences should a failure occurs.   

It is important to distinguish among these issues.  Thus, for example, the big four have only grown larger since the adoption of Dodd Frank.  This suggests that Dodd Frank has not put downward pressure on size.  Of course, much of Dodd-Frank has not been put in place, with the Volcker rule perhaps the most significant example, so the effects of Dodd-Frank can't be fully judged.   Nonetheless, even when fully implemented, Dodd-Frank will not eliminate the problem of too big to fail. 

That does not mean, however, that Dodd-Frank has had no impact on the issue.  Dodd-Frank had two significant effects.  First, it created a mechanism designed to minimize the impact of any failure by ousting the bankruptcy rules and replacing them with a system of Orderly Liquidation that gives the FDIC the power to oversee the liquidation.  While the FDIC cannot use taxpayer funds (this is specifically prohibited in Dodd-Frank), it can borrow from Treasury if necessary to keep profitable pieces of the holding company in operation.

There is an ongoing debate about whether the FDIC should be assigned the task of overseeing the liquidation or whether the process should be left to the bankruptcy laws.  There seems to be general agreement, however, that the bankrutpcy provisions, as currently formulated, are not up to the task.  Creditors in the Lehman bankruptcy have apparently not yet been fully repaid and testimony at a recent congressional hearing suggested that, had the Orderly Liquidation been in place, creditors would have received a greater payout.  (See the live testimony of Sheila Bairat “Examining How the Dodd-Frank Act Could Result in More Taxpayer-Funded Bailouts” House Committee on Financial Services, June 26, 2013).      

Other steps taken in Dodd Frank were designed to limit the consequences of any failure.  The Swaps Pushout Rule (section 716 of Dodd Frank), when implemented, will essentially prohibit banks (those handling federally insured deposits or that have access to the discount window) from acting as swap dealers.  The intent was to push most swap activities out of the bank subsidiary into a non-bank affiliate.  The provision is presumably designed to shield deposits from risks associated with most swaps.  If a bank holding company fails, the pushout rule facilitates continuation of the bank subsidiary even if it does not reduce the overall risk to the holding company.  The provision has, however, been criticized and the effectiveness questioned.

The Volcker Rule is not designed to limit the consequences of a failure but is more appropriately seen as a provision designed to reduce the risk of failure.  The Rule is designed to limit short term proprietary trading by the large banks.  As the London Whale episode shows, trading losses can be significant and occur quickly.  The provision is therefore designed to reduce the risk profile of large commercial banks, something that presumably reduces the risk of failure. 

Dodd-Frank, therefore, mostly sought to reduce the risk of failure and permit greater flexibility in management should a failure occur.  Dodd-Frank did not seek to reduce the size of banks.  As a result, it is not correct to see the continued growth of the largest banks as a failing of Dodd-Frank.  Moreover, the continued growth of these banks arguably explains new pieces of banking legislation that would go beyond Dodd-Frank.  The bills seek to reinstate Glass Steagall or impose significantly higher capital requirements.  Both would both not only reduce the risk of failure (by reducing the risk profile in the former case and providing a greater cushion from failure in the latter case) but also result in a reduction in the size of the largest banks. 

Thus, Dodd-Frank can be questioned or criticized for what it tried to do (reduce the risk of large banks and make their collapse less disruptive) but not for what it did not try to do (reduce the size of the largest banks). 


Another Rule Mandated by Dodd-Frank is Vacated by the DC Circuit

In a blow to banks, but also a blow to rule-making under Dodd-Frank, on July 31st the DC Circuit Court vacated and remanded a Federal Reserve rule on the fees banks can charge merchants when consumers use debit cards at their establishments.  The rule, mandated by Section 1075 of Dodd-Frank, imposed various standards and rules governing debit fees and transactions and applied only to issuers with assets exceeding $10 billion.   Although the Fed initially proposed a 12 cent per transaction fee the final rule ultimately set the cap at 21 cents.  Prior to the rule banks were charging on average 44 cents per transaction, but charged less for smaller transactions (the fee was 1 to 2 percent of each transaction).

After the final rule went into effect it was challenged by NACS (formerly, the National Association of Convenience Stores), the National Retail Federation, the Food Marketing Institute, and the National Restaurant Association among others who claimed that the rule was “arbitrary, capricious, an abuse of discretion, and otherwise not in accordance with the law.”  (the all too familiar language used by plaintiffs challenged rule-making under the Administrative Procedures Act). 

In a strongly worded opinion by Judge Richard Leon, the DC Circuit Court found that the Federal Reserve interpreted Congressional directive in a “utterly indefensible” way and that the final rule “runs completely afoul of the text, design and purpose” of the statute.  The Court took specific exception to two aspects of the rule—first, the Fed’s treatment of interexchange transaction fees, defined as "any fee established, charged or received by a payment card network for the purpose of compensating an issuer for its involvement in an electronic debit transaction" and second, its handling of the regulation of network fees through rules relating to network non-exclusivity for routing debit transactions

Interexchange Transaction Fees

 Dodd-Frank states that the fee charged by the issuer "with respect to an electronic debit transaction shall be reasonable and proportional to the cost incurred by the issuer with respect to the transaction" and directs the Board to establish standards to determine what fee satisfies this test.   Importantly, in making this determination the statute requires the Fed to distinguish between (i) the incremental cost incurred by an issuer for the role of the issuer in the authorization, clearance, or settlement of a particular electronic debit transaction, which cost shall be considered and (ii) other costs incurred by an issuer which are not specific to a particular electronic debit transaction, which costs shall not be considered.  Plaintiffs claimed that this language limited the Fed’s consideration of “allowable costs” to the "incremental cost" of "authorization, clearance and settlement of a particular electronic debit transaction."  They therefore asserted that because the Fed included other costs in the fee standard (including among others (1) fixed authorization, clearing and settlement (ACS} costs, (2) transaction monitoring costs,(3) an allowance for an issuer's fraud losses, and (4) network processing fees) it "acted unreasonably and in excess of its statutory authority.

The Fed argued that the statutory language was ambiguous and therefore it was left to the agency to determine how best to implement Congressional intent.

Judge Leon had no time for the Fed’s argument.  Stating that “the Board's interpretation is utterly indefensible” the Court found that “the statute is not silent or ambiguous” but rather that it “is quite clear that the statute did not allow the Board to consider the additional costs factored into the interchange fee standard.”  After an exhaustive consideration of the text of the statute and the supporting legislative history the Court concluded “the plain text ….and the statutory structure and legislative history …clearly demonstrate that Congress intended for the Board to exclude all "other costs" not specified in the statute.”  Therefore, for Judge Leon “the text and structure of the Durbin Amendment, as reinforced by its legislative history, are clear with regard to what costs the Board may consider in setting the interchange fee standard: Incremental ACS costs of individual transactions incurred by issuers may be considered. That's it!”

Net-Work Non-Exclusivity Rules

The Federal Reserve fared no better when the Court considered its treatment of net-work non-exclusivity rules.  The court noted that the statute requires the Board to adopt rules prohibiting issuers and networks from entering into exclusivity arrangements or imposing restrictions on the networks through which merchants may route a transaction. Specifically, the regulations must provide that issuers and networks "shall not directly or through any agent ... restrict the number of payment card networks on which an electronic debit transaction may be processed" to one such network or two or more affiliated networks or "inhibit the ability of any person who accepts debit cards for payments to direct the routing of electronic debit transactions for processing over any payment card network that may process such transactions."

In its final rule, the Fed determined that the statute required only that issuers and networks make available two unaffiliated networks for each debit card, not for each method of authentication (signature and PIN).  This interpretation meant that networks and issuers could make only one network available for many transactions and still be in compliance with the rule.

Plaintiffs argued that this interpretation contravened the statute's language and purpose.  They asserted that merchants must be given a choice between multiple unaffiliated networks not only for each card, but for each transaction.  The Court agreed, finding that “Congress adopted the network non-exclusivity and routing provisions "to inhibit the continued consolidation of the dominant debit networks' market power and to ensure competition and choice in the debit network market." In light of this purpose, the Court found that “it defies both the letter and purpose of the [statute] to read the statute as allowing networks and issuers to continue restricting the number of networks on which an electronic debit transaction may be processed to fewer than two per transaction.” 

Vacatur is the Proper Remedy

The Court found that that the proper remedy was to remand to the Board with instructions to vacate the s interchange transaction fee and network non-exclusivity regulations because each was fundamentally deficient. Because the Court concluded that the Fed “completely misunderstood” statutory directive and “interpreted the law in ways that were clearly foreclosed by Congress” vacatur was appropriate.  However the Court was “mindful that interchange and network fees are critical components of the debit card system, and that the Board's Final Rule has been in effect since October 1, 2011, such that regulated interests have already made extensive commitments in reliance on it.” Therefore the Court stayed the vacatur and requested supplemental briefing on (1) the appropriate length of the stay; and (2) whether current standards should remain in place until they are replaced by valid regulations or the Board should develop interim standards sufficient to allow the Court to lift the stay. The Federal Reserve Board is “reviewing the judge’s opinion,” according to spokeswoman Barbara Hagenbaugh.


So Who Won?

The decision deals a blow to big banks and is welcomed by retailers.  We “today's ruling and the opportunity to ensure the law is finally implemented as intended," said Bill Hughes, senior vice president for government affairs at the Retail Industry Leaders Association. "The flawed Federal Reserve rules have muted the law's intended benefits to merchants and consumers and resulted in further distortions in the already broken electronic payments market."  Conversely, the banking industry expressed disappointment with the ruling, claiming that it will affect negatively banking revenues. “We’re deeply disappointed in today’s court decision, which will harm banks of all sizes and make it more difficult for institutions to serve their customers,” says Frank Keating, president of the American Bankers Association.

Of more interest is what the decision means for the rule-making processes that various agencies are required to engage in pursuant to Dodd-Frank.  Other posts have discussed the outcome of rule-making by the SEC relating to conflict minerals and resource extractive industries payments.  While those rules were promulgated by the SEC and the rule involved in this case was crafted by the Federal Reserve the standards applied by the DC Circuit in evaluating the results should be the same.  Each decision purportedly applies the same analytic process, testing whether the agency complied properly with the APA by applying the two-step Chevron analysis.  What is notable is the radically different outcomes that this analysis has resulted in.  The inconsistent outcomes suggests that unless and until the appellate courts provide some more definitive standards by which to assess agency rule-making, legal challenges to such rule-making are likely to continue apace.  Implementation of Dodd-Frank has already taken far longer than was intended.  The likelihood of on-going legal challenges will continue to delay the process and increase uncertainty for regulated issuers.