Dodd-Frank: Short Title, Short-Termism
The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law by President Obama on July 21, 2010. Of its hundreds of sections and 16 titles (the catchiest of which is "The Pay It Back Act"), only a tiny fraction of the Act addresses governance and compensation of executives of Main Street corporations, as opposed to financial institutions. And yet, those nine sections relating to governance and executive compensation will have a profound effect on corporate America, perhaps one more significant than the Act's effect on financial institutions.
Along with countless others in the corporate advisory field, from law firms to banks to accounting firms, Jones Day soon will publish a full explication of Dodd-Frank. But in the meantime, what does Main Street really need to know? We offer herein a few critical points to remember about Dodd-Frank, as well as a few trivia points that you may use at your next board meeting or cocktail party.
Most critically and unfortunately, Dodd-Frank portends an increased trend toward short-termism. This is perhaps the greatest legislative irony of recent times, given that the bill originally was named the "Restoring American Financial Stability Act." Proponents of Dodd-Frank give lip service to the noble idea that its governance and executive compensation reforms will preserve stability and will encourage management to focus on long-term growth, rather than short-term results. Nothing could be further from the truth.
Proxy Access: The Centerpiece of the Misguided Shift to a "Shareholder Democracy" Model
By far the most troubling provision of Dodd-Frank is effectively mandating "proxy access," whereby shareholders, without significant effort or expense, will be permitted to put competing candidates for election to the board of directors in any company's proxy statement. This ease of access—in combined effect with the waning of classified boards, shareholders' increased ability to convene meetings mid-year, and the imposition of majority voting—creates a clear opportunity for activists to readily reconfigure or eventually replace a board. Many will say, what's wrong with this? The shareholders, after all, own the companies, and at least the politicians and pundits believe that failures by corporate boards contributed directly to the recent financial crisis. What's wrong is that proxy access will supercharge the already existing pressures for companies to focus on short-term quarter-to-quarter results, rather than the kind of long-term investment for sustainable growth that is essential in a rapidly changing, globalizing world.
While there are, of course, many notable exceptions, in general, institutional investors are more renters than true owners—the average hold period of an NYSE-listed company's stock is a mere nine months. As such, the economic interest of those investors is not served by long-term, delayed-return investment, but precisely the kind of pedal-to-the-metal, short-term orientation that brought down many of the country's major financial institutions. In addition, other problems abound. The SEC's last turn at the proxy access wheel was predicated on a first-come, first-served system—the first shareholder to propose nominees for up to one-fourth of the directors prevailed, regardless of qualifications, experience, or even potential conflicts of interest of its nominees. Finally, the activist hedge funds, an increasing proportion of the institutional investor community, will have a field day with proxy access: sell or bust up the company, institute a massive stock buy-back, or jack up the dividend, or there will be a new sheriff in town.
In short, proxy access, thrice previously proposed by the SEC and overwhelmingly opposed, is a profoundly bad idea at precisely the wrong time, and it inevitably will produce the kind of short-termism Dodd-Frank was supposedly passed to counteract.
Say-On-Pay: Another Step Down the Shareholder Democracy "Path"
Dodd-Frank will require that management's performance be tested periodically through so-called "say-on-pay," or advisory votes on compensation. Any CEO in her right mind knows that if she is subject to a vote of confidence—or no confidence—on an annual basis, she will be focused relentlessly on producing short-term results to avoid the substantial potential adverse internal and external consequences that would result from a no-confidence vote by shareholders. This short-term focus will necessarily be, again, at the expense of long-term strategic investment and other initiatives. The advisory nature of the vote will not be sufficient to change a CEO's motivation to succeed by all measures, including this clumsy one. And remember, boards will be similarly motivated, because a negative say-on-pay vote presages action against the board in the ensuing year, if not before, from the "activist" investment community, spearheaded by RiskMetrics and the other proxy advisory firms.
Dodd-Frank requires that annual proxy statements include a table showing the relationship between executive compensation and the financial performance of the company, including changes in stock price. Such a simplistic presentation—and one that correlates mismatched data points—will once again invite management and board-level decisions designed to shore up short-term performance at the possible expense of long-term enhancement.
Disenfranchising the "Small People"
Perversely, Dodd-Frank will bar broker discretionary voting on executive compensation or "any other significant matter." This disenfranchisement of retail investors (those who hold their shares through brokers) exacerbates short-termism because brokers rarely will be able to exercise voting discretion given them by retail holders, who generally are longer-term, pro-management investors. The likely result is that retail votes simply will disappear, thereby amplifying the voting power of institutional holders with a more short-term investment focus. Further, the duration of investor horizons in the U.S. seems to be ever-shrinking; the average NYSE holding period in 2009 was about nine months, down from more than eight years in 1960 and two years in 1990. Among institutional holders, the average holding period declines to four months. Some might say this will not matter much with the heavy institutionalization of share ownership, but that is simply not true: about 18 percent of the S&P 500 companies' stock is held in "street name" by retail holders. By disenfranchising these shares, the effective voting power of the short-term, "renter" owners will increase proportionately. Another victory for short-termism.
Of course, Dodd-Frank imposes a number of other new requirements that will affect corporate behavior, including mandatory separate votes on so-called golden parachutes, required clawback policies, and disclosures of the independence of executive compensation advisors. These provisions, while based on the misguided one-size-fits-all policy that dominates Washington-think in the 21st century, are not particularly troublesome. The unholy trinity of proxy access, say-on-pay, and the disenfranchisement of retail voting will, however, have profound and, we believe, damaging effects on corporate America.
Here are some other fun facts about Dodd-Frank:
"Accredited Investors" Can't Count on Home Values
The long-standing definition of "accredited investor," a status of wealth and sophistication that is presumed to lessen the need for the SEC's investor protection, is revised to exclude a person's primary residence in the calculation of the required $1 million net worth. The reason for this is unknown, but it is presumably based on the theory that real estate values will remain unstable and unreliable, a perhaps predictable event given that Fannie Mae, Freddie Mac, and others that played key roles in the real estate bubble at the core of the financial crisis, were left essentially untouched by Dodd-Frank—go figure.
Credit Rating Agencies: Of Foxes and Hen Houses
Credit rating agencies will become subject to heightened regulation and supervision through the oversight of a new agency within the SEC to be known as the Office of Credit Ratings. Its mission is comparable to the oversight of accounting firms afforded by the Public Company Accounting Oversight Board ("PCAOB") established by SOX. Amusingly, this agency is charged with eliminating the inherent conflict of interest in the "issuer pays" structure of the credit ratings industry, not by changing who pays but by establishing rules that say marketing considerations should not influence the ratings themselves—presumably, this will become known as the fox-guarding-henhouse provision.
Dodd-Frank requires that companies disclose "internal pay equity"—that is, the ratio of CEO to median employee pay. This is an idea dreamt up by unions that would like their constituents to get more money and better benefits, and academics who think CEOs simply make too much. But there's an apparent drafting glitch: as written, this would be required disclosure in any Exchange Act report—10-Ks, 10-Qs, registration statements, and even tender offers. While it is hard to imagine that this was intended, absent a legislative correction, companies will be calculating, and we'll all be talking about this, constantly. Good news for bean counters.
Boom Times for Lawyers
Whistleblowers will not only enjoy more protection from retaliation, but they will have opportunities to be rewarded for their efforts. The SEC is authorized to pay rewards for any information that leads to a successful enforcement action and sanctions that exceed $1 million. Previously, such rewards only applied to insider trading. Because civil penalties in financial fraud or even FCPA cases often are quite large, these changes may create a cottage industry in whistleblowing, thereby opening the floodgates for more investigations and enforcement, and bolstering the already booming business of the plaintiffs' bar. And with the new mandatory clawback policies including a private right of action, plaintiffs' firms have more than one path to reward.
The Kitchen Sink
One of the countless studies commissioned by Dodd-Frank is a study of the effect on residential foreclosures of the presence of drywall imported from China. Similarly, the Act requires a report on mine safety. And more than half of the number of pages devoted to governance reforms are devoted to a statement of the sense of Congress on the exploitation and trade of conflict minerals in the Democratic Republic of the Congo. While the violence in the Congo is undoubtedly tragic, one questions the relevance of these provisions here.
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Dodd-Frank is indeed breathtaking, in its length, the silliness of many of the topics covered, its failure to come to grips with the root causes of the financial crisis (many, if not most, of which were Washington-mandated housing, monetary, and tax policies), and in the very fact that it cannot in any real sense be said to be likely to avert the next financial bubble. But the most breathtaking, truly tragic aspect of it is that its greatest effect will be to create pressures on nonfinancial companies across America to move to a more aggressive, short-term orientation. It makes you wonder what, or whether, the legislators who voted for its passage were thinking.
Huge companies, or at least most of them, need not worry much. But the vast majority of companies will need to approach their annual proxy process in ways that are fundamentally different from the past. Those who do not will do so at their peril.
For further information, please contact your principal Firm representative or one of the lawyers listed below. General email messages may be sent using our "Contact Us" form, which can be found at www.jonesday.com.
Robert A. Profusek
Lyle G. Ganske
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 One irony inherent in the Act is that while much attention has been paid to its length, the Act itself may turn out to be a molehill in relation to the mountain of rulemaking it will spawn. The Act explicitly calls for more than 240 rulemaking efforts by 11 regulatory bodies, and of course other rulemaking is possible as well. The SEC is charged with 95 of those rulemaking efforts, in addition to 17 studies and five new periodic reports. And you thought you were buried in SEC compliance in the wake of SOX?