On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Financial Reform Act” or the “Act”). The provisions of the Financial Reform Act include many regulatory reforms that affect a wide range of financial service providers. This Special Alert highlights the most significant impacts of the Financial Reform Act on publicly-held companies, hedge and private equity funds, investment advisors and brokers. For further details, please follow this link.
Our experienced securities and finance attorneys are available to help you determine the impact of these new regulations on your business and implement the changes required by the Financial Reform Act.
Non-binding Shareholder Approval of Executive Compensation and Golden Parachutes Now Required for All Publicly-Traded Companies. Federal law requires any company that received financial assistance under the Troubled Asset Relief Program (“TARP”) to implement a non-binding, advisory vote by shareholders to approve compensation for the most highly compensated executives until the company has repaid all TARP funds. The Financial Reform Act extends this requirement to all publicly-traded companies, regardless of whether they participate in TARP. The Act also extends the vote requirement to compensation arrangements made in connection with any merger, sale of assets or other significant transaction that is already subject to binding shareholder approval under state law. Thus, issuers must now disclose any golden parachutes or other compensation-related aspects of such a transaction in its proxy statement and submit such compensation arrangements to their shareholders for a non-binding vote. Companies must begin complying with these aspects of the Act for any meeting held on or after January 21, 2011.
Three-Year Look-back/Take-back of Executive Pay, Regardless of Fault. In the event that an issuer is required to file an accounting restatement due to material non-compliance with SEC financial reporting requirements, the Financial Reform Act now requires the issuer to recover any incentive-based compensation that was erroneously paid to current and former executive officers on the basis of the non-compliant financial reports during the three years prior to the restatement, regardless of whether the executive officer was responsible in any way for the erroneous financial statements. Whether this aspect of the Act may be enforced by a shareholder in a private right of action is unclear, although a federal appellate court has ruled that a similar clawback under the Sarbanes-Oxley Act does not support such an action.
Comparison of CEO Compensation to Financial Performance and Median Employee Compensation. The Financial Reform Act requires issuers to make two additional comparative disclosures in their proxy statements and reports on Form 10-K. Issuers must now include a “clear description” of the relationship between executive compensation paid and the financial performance of the issuer, including changes in the value of stock and dividends of the issuer, as well as disclose the ratio of the median compensation of all employees other than the CEO to the CEO’s compensation. The SEC must amend its current compensation rules to implement these aspects of the Act, at which time the requirements will become effective. Therefore, companies may be required to include the new disclosures in their 2011 proxy statements or even late 2010 proxies.
Independence of Compensation Committee Members is Now a Matter of Federal Law. Currently, stock exchange rules require members of the compensation committee to be independent, but the Financial Reform Act makes independence a requirement of federal law. The listing rules of the major exchanges already define “independence” broadly for purposes of serving on a compensation committee, but under the Act the SEC may require the exchanges to further expand those definitions. The Act also requires that issuers provide a reasonable amount of funds to the committee to select and employ independent legal counsel, compensation consultants and other advisors.
Proxy Access Debate Comes to Rest – Shareholder Access to Issuer’s Proxy to Nominate Directors is Now Required. Currently, federal law permits issuers to exclude from their proxy materials proposals by shareholders relating to the election of directors, including director nominations, meaning shareholders had to bear the significant expense of distributing their own proxy materials in attempting to elect directors. The Financial Reform Act now authorizes the SEC to require issuers to include in their own proxy materials any nominees submitted by shareholders. The SEC proposed proxy access rules in 2009 that contained a procedural framework for proxy access. The proposed rules require that a shareholder who desires proxy access have held at least 1% of the company’s shares outstanding (5% for smaller reporting companies) for at least 1 year prior to seeking proxy access. The proposed rules also contained provisions for selecting which nominees would be included if a large number of shareholders seek proxy access with respect to the same election. Although final rules are not yet in place, they appear imminent. As a result of these changes, public companies should expect increased activism by shareholders and proxy advisory firms on proxy matters and an acceleration of the trend towards contested director elections, and prepare accordingly.
Exemption for Small Issuers is Now Permanent. For several years, the SEC has postponed requiring smaller reporting companies (issuers with a market capitalization of less than $75 million) to comply with Section 404(b) of the Sarbanes-Oxley Act, which requires an attestation by the issuer’s public accounting firm concerning the issuer’s internal controls over financial reporting. The Financial Reform Act permanently exempts smaller reporting companies from Section 404(b).
Further Reducing Broker Discretionary Voting. In 2009, New York Stock Exchange Rule 452 was amended to prohibit brokers from granting proxies to vote shares in the election of directors unless the beneficial owner of the shares had instructed the broker how to vote. The Financial Reform Act makes this prohibition a federal law for all stock exchanges and expands it by prohibiting broker discretionary voting on executive compensation matters and any other matters that the SEC determines, by rule, should not be subject to discretionary voting.
Registration of Investment Advisers
Increase in Assets under Management Threshold for Federal Registration. The assets under management threshold for federal regulation and registration of investment advisors will increase to $100 million from $25 million. This move is expected to significantly increase the number of advisors under state supervision, since they will now likely be required to register at the state level and in potentially more than one state. As a result, many small to mid-size investment advisers who have seldom or never been audited by the SEC may find themselves subject to regular audits by state securities regulators, thereby increasing their compliance costs. For instance, the Ohio Department of Securities typically examines Ohio-based investment advisors at least once every two years.
Elimination of Exemption for “Private” Investment Advisers. Under previous federal law, an investment adviser with fewer than 15 clients that did not generally hold itself out to the public as an investment adviser was exempt from federal registration and certain other regulatory requirements. These “private” investment advisers will now be required to register with the SEC if they have at least $100 million in assets under management. Time will tell whether states will require smaller private advisers to register under state law.
Registration of Advisers to Private Funds Also Required. Many advisers to private funds will now be required to register with the SEC as investment advisers and provide information about their trades and portfolios as deemed necessary by the SEC to assess systemic risk. The Financial Reform Act retains the definition of a “private fund” under previous federal law (namely, funds that would be considered investment companies under the Investment Company Act of 1940 but for certain exemptions, which include funds with less than 100 investors, or funds not making or proposing to make a public offering, or funds where the fund investors are either all qualified purchasers or include qualified purchasers and fewer than 100 investors who are not qualified purchasers). Investment advisers that act solely as an adviser to such private funds and have less than $150 million assets under management are exempt from the registration requirement but will, however, still be subject to record-keeping requirements. The Financial Reform Act authorizes the SEC to adopt regulations imposing such reporting requirements as the SEC deems necessary or appropriate in the public interest or for the protection of investors.
Exemption from Registration for Advisers to “Venture Capital” Funds. The Financial Reform Act exempts from registration investment advisers that act solely as investment advisers to one or more venture capital funds, but does not specifically define what it means by “venture capital fund.” Instead, the Act directs the SEC to issue a final rule within a year defining the term “venture capital fund” for purposes of the Act. Depending upon the definition contained in that final rule, additional private equity funds with greater than $150 million in assets under management could be afforded an exemption; however, it is worth noting that a general exemption for “private equity funds” was proposed in an earlier version of the Act but was ultimately not included in the final version of the Act signed into law.
Imposition of Fiduciary Duties on Broker-Dealers
Currently, securities brokers are not subject to the same fiduciary duties as investment advisors, despite the fact that they perform many of the same functions. Under the Financial Reform Act, the SEC will first conduct a six-month study analyzing the differences between the fiduciary duty standard currently applicable to investment advisers and the less stringent suitability standard applicable to brokers. The SEC will then have the authority to have authority to impose on brokers the same fiduciary standard that applies to investment advisers. The most likely impact of this is that brokers would be required to disclose any conflicts of interest inherent in their performance of services for their clients. In addition, brokers are likely to become subject to lawsuits from dissatisfied clients alleging breaches of fiduciary duty.
Tightening of Accredited Investor Standard
Regulation D under the Securities Act of 1933 exempts certain issuances of securities from registration. Certain of these exemptions, which are widely relied on in private placements of securities, depend on whether the investors qualify as “accredited investors.” One of the tests for determining whether an investor qualifies as an accredited investor is whether the investor has a net worth of at least $1 million. Effective immediately, the Financial Reform Act narrows the definition of accredited investors by excluding the value of a potential investor’s primary residence from the net worth calculation. The result of this change is that investors who would have met the net worth test under the previous accredited investor definition no longer qualify, thereby reducing the pool of potential investors for private placements.
In addition, the Act leaves the door open for further modifications directing the SEC to periodically review and modify the definition of “accredited investor” as appropriate and by directing the Comptroller General of the Government Accountability Office to conduct a study as to the financial thresholds and other criteria needed to qualify for “accredited investor” status.
Restrictions on Bank Investment in Hedge and Private Equity Funds
Under the so-called “Volcker Rule,” banks and other banking entities will generally be prohibited from investing more than 3% of their capital in hedge funds and private equity funds and from owning more than 3% of any such fund. However, the Volcker Rule will give banking entities time to divest themselves of any prohibited interests in such funds. Overall, the Volcker Rule is expected to result in a net shrinkage in private funds’ access to investment capital.
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We hope you find this information helpful. If you have any questions about this Special Alert or what tax incentives may be available to you or your business under the Financial Reform Act, please reply to this email message or contact any of the attorneys listed below.