The origins of the Dodd-Frank Reform Act
by Berna Kamyar, J.D
As the financial crisis of the late 2000s proceeded through its worst stages, numerous accounts emerged detailing the reluctance of executives to moderate their lavish pay packages. Despite hard times, boards of directors continued to approve highly lucrative payments for executives while paying little regard to the plights of rank-and-file workers.
Professor Shivaram Rajgopal, a professor at the Goizueta Business School of Emory University whose research activities center on executive compensation, put the situation this way: “Look at Larry Ellison (CEO of Oracle). He earns so much money, does he need another billion dollar option grant to keep him motivated? I find it hard to believe.”
As public outrage reached its height in 2009, Congressman Barney Frank and Senator Chris Dodd proposed a law, the Dodd-Frank Reform Act, seeking to achieve widespread reform in the financial sector.
Legislators included provisions within the act directed at encouraging firms to incorporate greater shareholder input prior to approving pay packages. However, the non-binding nature of shareholder votes and the lack of adequate enforcement mechanisms guarantee that astronomical levels of executive compensation will continue to be approved by some public companies, even amid widespread shareholder disapproval.
Despite this, the law had high profile proponents, such as Joseph Bachelder III, member of the advisory board of the Program on Corporate Governance at Harvard Law School. In an article titled “Dodd-Frank: Selected Provisions Applicable to Executive Pay,” Bachelder argued that the “provisions in Dodd-Frank that affect the executive pay process quite arguably will have the broadest and most significant impact on that pay process of any set of new rules ever contained in one law.”
No supporter was more high profile than President Obama, who signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law on July 21, 2010.
The Resulting Shift to Performance-Based Compensation
The act requires that public companies disclose the relationship between the amount of executive compensation paid and financial performance. The rationale for mandating such disclosures is that issuers may be more inclined to moderate the level of compensation they provide to executives if it appears unwarranted by the firm’s performance. These requirements are sensible insofar as stockholders should be provided with more information to judge whether a CEO’s pay is reasonable in light of whether his or her direction increased the company’s competitive position.
One drawback of associating pay with performance is that some companies undertake long-term strategies in which payoffs, shown by financial indicators, are observable. It is reasonable to conclude that shareholders who are sufficiently motivated to examine CEOs’ pay in light of financial performance will also take into account whether chief executives are adopting short-term or long-term strategies.
However, there may be other issues. For instance, in his Reuters article titled “U.S. Firms Prepare Pay Plans for Dodd-Frank,” Erik Krusch points out that the legislation merely requires “information that shows the relationship between executive compensation actually paid and the financial performance of the issuer.” The law provides little guidance concerning how extensive the disclosures must be or what form the disclosures must take.
Comparing Executive Compensation to Other Employees
For clarity, public companies are now required to disclose the total annual compensation of CEOs, the median total annual compensation of all other employees and the ratio of the median employee compensation to the compensation of the CEO. Some speculate that Congress mandated these disclosures in order to appeal to labor unions that have historically cited widening disparities between compensation of CEOs and that of other employees as evidence that pay practices are unfair. Irrespective of the motivations underlying these provisions’ inclusion, it is likely that this set of disclosure requirements may induce moderation of CEO compensation.
Critics of the relative payment disclosures argue that compiling compensation data on all employees will prove excessively burdensome and result in significant administrative costs. Yet, given the array of disclosures already required of public companies and the lack of empirical data supporting the view that widespread compensation disclosure is excessively costly, these criticisms are unpersuasive.
A weakness associated with the relative payment disclosure requirements is that the payment of CEOs is to be compared to all other employees, including other named executive officers. Since these non-CEO executive officers are likely to be considerably better compensated than rank-and-file employees, firms’ figures for median employee compensation may be skewed.
Who Has Say-on-Pay?
A central feature of the legislation as it relates to executive compensation is the “say-on-pay” voting requirement. Say-on-pay mandates public companies to permit their shareholders to place a non-binding vote on the compensation of their executives and on “golden parachute” packages triggered upon mergers.
The act requires that shareholders be given two votes at the company’s first shareholder meeting following the six-month anniversary of the act’s enactment into law. First, shareholders must be granted the right to approve the compensation of executive officers as disclosed in the proxy statement in a non-binding vote. Second, shareholders can vote on whether future votes on executive compensation should take place annually, biannually or triennially. The act further requires that companies hold shareholder votes concerning the frequency of say-on-pay votes at least once every six years. Companies will be permitted to state their preferences with respect to how often say-on-pay votes should take place. Firms with multiple-year incentive compensation plans will likely lobby shareholders to hold votes every two or three years.
Say-on-pay as mandated by the act seeks to provide shareholders with a voice without substantially infringing upon the power of the board. Should a firm proceed with a compensation package without shareholder approval, negative publicity would likely follow. There is a chance that if dismissal of say-on-pay votes becomes widespread, then the only “teeth” that such measures have – namely, public embarrassment of companies ignoring their shareholders – would be lost. The non-binding nature of this vote ensures ultimate board discretion. Nonetheless, directors will have reason to create reasonable executive compensation packages that are increasingly related to performance, especially when the chief executive’s pay is considerably greater than that of the median worker.
Shareholders Vote on Golden Parachutes
As a result of this legislation, shareholders will now also be permitted to place non-binding votes on payments in connection with acquisitions, mergers, consolidations or the disposition of firm assets. Companies are required to disclose agreements made regarding compensation stemming from the transaction. This set of requirements is aimed at preventing situations in which executive officers provide themselves with lavish severance payments, despite shareholder disapproval. While this measure increases transparency associated with major transactions and potentially reveals incentives underlying lobbying efforts by executives, it is ultimately an advisory vote that directors will be free to ignore.
In a hearing before the House Financial Services Committee, Brookings Institution Senior Economic Fellow Martin Neil Baily asserted that, although shareholders are now required to have non-binding votes on executive compensation and golden parachutes, “this may further align shareholder and management interests, but…this is not the same as alignment with taxpayer interests.”
What is a Claw Back?
Companies are required to adopt policies to recover compensation when it is shown that the compensation was based on erroneous financial results. The “claw back” policy mandates that if the company has to restate its financials due to noncompliance, the company will recover incentive-based compensation from any current or former executive officer during the three-year period preceding the date of the restatement.
This set of requirements imposed by the act is notable insofar as its reach is broader than clawback provisions included in the Sarbanes-Oxley Act of 2002. The act’s more stringent stance induces companies to police themselves and decreases the likelihood that executives will develop lavish “golden parachutes” that permit them to disproportionately benefit from transactions dramatically altering the nature of the firm.
There are commentators, such as Professor Rajgopal, who suggest that more drastic departures from previous compensation practices are necessary to achieve any meaningful change. For example, he cites proposals holding that “incentive compensation should be put away in a bank so that if things went wrong you actually take that money back,” yet they have not received enough support from the legislature or business community to be implemented.
How Do Companies Move Forward?
Firms must assess the practical implications of these new regulations and take steps to prepare for their implementation. For example, firms may include a review of executive compensation disclosures in the proxy statement, actively engage with institutional investors and proxy advisory services in anticipation of the say-on-pay vote and revise incentive-based compensation and severance plans.
Public outrage stemming from accounts detailing the exorbitant pay of some executives is particularly understandable during this period in which the financial sector is only beginning to recover. Shareholder criticism of director-approved pay packages is similarly comprehensible when multi-million dollar executive payments are not matched by firms’ financial performance.
The Dodd-Frank Act initiated needed reform in this politically difficult arena. However, unless increased enforcement mechanisms are available to shareholders, little will substantially change from the status quo.
The ultimate effect of the provisions discussed in this article is well assessed by Rossen Valkanov, professor of finance at the Rady School of Management of the University of California, San Diego. “While the new disclosure rules are of definite benefit to shareholders, it is unlikely that top CEO compensations will decrease significantly. Rather, we are likely to see the compensations of under-performing CEOs shrink.”
Berna Kamyar, J.D. (Rady Full-Time MBA ’12), a San Diego native, attended UCLA as an undergraduate, during which time he studied at the University of Barcelona for a year. He then studied law at the University of Minnesota, where he served as a member of the Law Review and interned in the chambers of Chief Judge Michael Davis of the U.S. District Court of Minnesota. He intends to practice law in Southern California upon graduation from Rady in 2012.