The Permanent Solution: HR 3269 and the Regulation of Executive Compensation (Part 2)

We are examining HR 3269, corporate governance legislation that recently passed the House of Representatives by a vote of 230 to 185.  

The broad approach of the legislation is to solve the excessive compensation problem by reforming the process.  It is a solution of a sort but ultimately will not have much impact.  This is the case for two reasons. 

First, by characterizing the requirements as listing standards, Congress has more or less eliminated any private right of action.  The current state of the law is that there is no private right of action for violation of listing standards (although much of that law developed in the 1970s and does not reflect the massive amount of change that has occurred or the shifting attitudes of the courts).  The Commission can effectively create a private right of action by requiring disclosure of conformity with the requirements, thereby turning misstatement about meeting the listing standards into a possible antifraud cause of action which can be brought by private investors.  These claims, however, must meet the elements of Rule 10b-5, with materiality and caustion likely to be significant barriers. 

The absence of a private right of action is significant.  There are already concerns that with respect to director independence and other shareholder protections, the exchanges are not particulary strong on enforcement.  Moreover, HR 3269, like SOX, provides a right to correct before penalties for non-compliance can be imposed on the companies.  In effect, they can violate the listing standards until caught.  Then they can avoid sanctions by complying. 

Second, the provisions are not likely to change board behavior.  The audit committee changes in SOX were successful mostly because they imposed a duty that had not previously existed.  By specifically assigning oversight of financial matters to a board committee and giving the members the authority to hire and fire the outside auditor (matters not required under state law), Section 301 of SOX effectively increased the duties of directors and the information flow to the board. 

Increasing the information flow is more than cosmetic.  While directors have anemic duties under state law, they must act in the face of known red flags or confront the risk of liability (conscious disregard can equal bad faith and bad faith is not subject to waiver of liability provisions).  Moreover, by broadening the financial disclosure oversight process, they probably made fraud easier to detect. 

The compensation provisions, however, are different in that regard.  Listed companies already have compensation committees that consist of independent directors.  These committees typically make compensation decisions.  Most probably use consultants.  The Bill, therefore, changes existing practice only by tightening slightly the definition of independent director and by requiring that compensation consultants be independent.  The latter is the most significant and may improve the advice given to the board.  Nonetheless, consultants viewed as too harsh on top officers such as the CEO will likely find that this impacts their ability to get business with other companies.  In other words, its not clear that independent consultants will materially improve the process. 

So what will happen?  This isn't the first time that Congressman Frank has gotten corporate governance legislation beyond the talking stage. His efforts a year or so ago saw the adoption by the House of a mandatory say on pay provision. The effort, however, died in the Senate, despite endorsement from then Senator Obama. This effort, however, will likely have stronger legs. For Congress to do nothing merely condemns history to repeat and the excessive bonuses and risk taking to return, something that will likely not be unnoticed by some segment of the voting public. 

Aspects of the approach are amenable to business interests.  Most likely accept that "say on pay" will become law one way or the other.  Similarly, while more controversial, the changes to the board with respect to the compensation committee will likely also garner bipartisan support.  Stock exchange regulation can be viewed as regulation lite, with the alternatives potentially more intrusive and severe.  In fact, the Chamber of Commerce supported this approach in SOX.  

The controversy centers on Section 4, the provision that requires substantive regulation of compensation practices among financial institutions that encourage excessive risk.  It means that financial institutions will be subject to substantive rules and the rules will not be universally applicable.  Thus, financial institutions that compete with non-financial institutions (for example, Citigroup has been competing in the energy trading area).  To the extent a provision drops out, this is the most likely candidate.  Of course, the approach suffers only from a failure to go far enough.  In fact, provisions ought to regulate compensation practices that encourage excessive risk for all companies, not just those in the financial sector. 

Of course, when things get to the Senate, everything may change.  The ability to filibuster provides greater opportunity for changes from the minority party.  Moreover, there is still room to blend in the Shareholder Bill of Rights which, while using listing standards as the source of regulation, would require other changes such as the separation of CEO and chairman.