Dodd-Frank's Say on Pay Rules Pose Triple Threat to Directors

Two fists would seem sufficient, but publicly traded financial institutions and other companies that report to the Securities and Exchange Commission should beware of three threats arising from the Dodd-Frank Act's say on pay requirements.

The common "one-two" begins with agitating shareholders through executive compensation disclosures, and ends with directors being sued due to either a perception of pay unjustified by performance, or a failed say on pay vote.

A more subtle risk emerges at the time a public company is acquired, because its shareholders must then receive "say on golden parachute" disclosures and a vote concerning the change-in-control benefits that its named executive officers will receive.  Already, in the case of Encore Bancshares, a disclosure of this kind has triggered shareholder derivative litigation alleging board members have breached their fiduciary duties.

Most boards of directors have adjusted operationally to the SEC's 2006 overhaul of its executive compensation disclosure rules.  It has been no small feat to develop systems that produce a compensation discussion and analysis and a variety of tables for the annual proxy statement.  Board fatigue with this issue would be understandable.

However, the increasingly toxic nature of executive compensation has shifted the battle lines, from merely covering the full gamut of SEC demands to assuring that the proxy statements convince shareholders that pay appropriately reflects corporate performance. Disconnects have emerged as the primary drivers of public outrage and shareholder discontent. The recent headline "Occupy Boardroom" captures the sense that corporate directors are the primary targets for accountability.

With personal reputations and wealth at risk, outside directors need an activist paradigm for their approach to executive compensation. The Dodd-Frank Act requires that they act with independence, and makes that possible by requiring corporate funds sufficient to provide compensation committees with full access to independent consultants and independent legal counsel. Having been provided with the tools and the mandate, directors should fully engage in all stages of the executive compensation process: from analysis, to decision-making, to assuring that public disclosures have a tone and substance that directors endorse.

Beginning last year, the Dodd-Frank Act required that larger U.S. public companies hold say-on-pay votes by which their shareholders could vote "yea" or "nay" on whether they approved of the executive compensation as generally disclosed in the underlying proxy statement.  The votes are advisory and nonbinding, and only a small percentage of companies failed to obtain majority support from their shareholders. But those "failed" say on pay votes triggered derivative litigation against directors in about 20% of the cases.

So far in 2012, the pace of failed say on pay votes has accelerated by about 50% (based on about 40 failed votes in 2011, and over 20 during the first third of 2012). Shareholders remain quick to launch derivative litigation, with Citigroup's directors being struck within a week after its failed vote.

With the potential for bank M&A to heat up, directors should brace for the Dodd-Frank Act's say on golden parachute vote and its associated requirement that targets disclose the change-in-control benefits that named executive officers will receive. While no one expects transactions to derail, the recent complaint against Encore Bancshares could be symptomatic of what to expect.  

In a nutshell, Encore (not a client of mine) filed its merger-related proxy statement on April 12th, and the shareholder derivative action soon followed– with allegations drawn directly from its say on golden parachute disclosures. Board members should expect the same scrutiny in future transactions, and accordingly should be sensitive to how shareholders are likely to react to any disclosures of change-in-control benefits.

There is no doubting that Dodd-Frank's say on pay requirements come packed with litigation risks for those who make executive compensation decisions.  Outside directors cannot afford to underestimate the volatility of this risk. Indeed, say on pay votes in 2012 have seen shocking swings. Some who failed in 2011 doubled their favorable vote in 2012, while others have experienced disastrous crashes … and resulting shareholder derivative litigation.

From now on, directors of public financial institutions should approach executive compensation with an eye to Dodd-Frank's triple threat. Otherwise, they may be blindsided and knocked down for a count measured in hundreds of thousands.

Mark Poerio is a partner at the law firm of Paul Hastings LLP, where he co-chairs its Executive Compensation and ERISA practice. Scott Lieberman is a senior associate in the firm's securities practice group.