Federal Securities Law Blog : Federal Securities Lawyer & Attorney : Porter Wright Law Firm : Securities Exchange Law : Serving Ohio, Washington DC, Florida

On Friday the Cleveland Plain Dealer reported that members of the U.S. House Financial Services Committee bought and sold financial stocks last fall, at the same time that the Committee was approving the bailout, and in the same companies that the Committee would later criticize for incompetence and greed. The article points out two potential problems:

1. The potential for conflicts of interest; and
2. The potential for trading on material, non-public information.

Some of the trades resulted in avoiding significant losses; while perhaps more troubling, some trades resulted in increased losses, which may at least be proof there was no impropriety.

In any event, such trades do not appear to violate Congressional ethics rules (although, arguably they could violate broad rules against using one’s office for “improper advantage”); however, the securities rules are more troublesome. If a member of Congress trades in securities based on material, non-public information provided by a corporate insider, the representative faces possible liability under a tipper/tippee theory assuming other elements of the offense are met. But, if the representative trades based on material, non-public information that results from the representative knowing about a new regulation or government program that will affect a company, liability depends on whether the representative has breached a duty to the source of the information, presumably Congress or some other source to which no duty is owed.

Congressional staffers are not so lucky, as they potentially owe a duty to their representative, the source of the information.

This is not a new issue. The Stop Trading on Congressional Knowledge Act aims to close this loophole but has failed to pass despite annual tries since 2006. Also interesting is the fact that two SEC lawyers got in trouble about a month ago for trading in the securities of issuers under investigation, and the Commission quickly enacted rules to stop the practice. Congress has been at least 3 years slower.
 

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A variety of sources are now proposing new rules for financial markets and corporate governance. Just recently President Obama released a “white paper” for financial regulatory reform. Before that, Congressman Gary Peters introduced the Shareholder Empowerment Act of 2009, and before him, Senator Charles Schumer touted a “Shareholder Bill of Rights.”

Tangentially related to all such proposals (and an easy way to resonate with constituents), is the idea that executive compensation needs to be revamped as well. The SEC has not ignored this issue. Most recently, On June 10, 2009, Chairman Mary Schapiro issued a statement considering several proposals requiring greater proxy disclosure of the following:

• How a company and its board manages risk
• What is the company’s overall compensation approach? (the goal of this question being to discourage incentive structures that reward short-term risk taking without accounting for long-term effects)
• Potential conflicts with compensation consultants; and
• Board of director leadership structure

Such proposals are likely to have the same effect as the rules of the past few years requiring a Compensation Discussion & Analysis. The rules are instituted under a mantle of protecting investors by ensuring they have information needed to make investment decisions, but they are also passed with an eye toward influencing issuer behavior and pushing it in a particular direction. For example, a requirement that a board disclose its overall compensation approach has the same effect as a requirement that a board actually have an overall compensation approach (which it may in fact have but not discuss in those terms). Such proposals may encourage desirable behavior, but the SEC risks entrenching flawed compensation systems as opposed to simply requiring accurate disclosure about a compensation system that is fully within the purview of each individual company.
 

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On Wednesday, June 10, Secretary of the Treasury, Timothy Geithner outlined the Obama administration’s new proposals on executive compensation. The proposals focused on greater independence of corporate compensation committees and giving shareholders a nonbinding vote on executive compensation, commonly known as ‘say on pay’ provisions. Geithner outlined five guiding principals for executive compensation, namely:

1. compensation plans should properly measure and reward performance;
2. compensation should be structured to account for the time horizon of risks by aligning executive (and highly compensated individual) pay with long-term value creation;
3. compensation should be aligned with sound risk management;
4. golden parachutes and supplemental retirement packages should properly align the interests of executives with the interests of shareholders; and
5. the compensation setting process should promote transparency and accountability.

Geithner promoted the administration’s support for legislation requiring greater compensation committee independence for companies listed on the national securities exchanges. The proposed legislation would require compensation committee members to meet the stringent independence standards required of audit committee members under the Sarbanes Oxley Act. In addition, the proposed legislation would provide compensation committees with the right to (i) hire compensation consultants, (ii) hire legal counsel, and (iii) require each company to “appropriately” fund the compensation committee to allow it to execute its independent compensation oversight responsibilities.

In addition, Geithner promoted the administration’s support for legislation requiring non-binding ‘say on pay’ votes by shareholders. The legislation would require all public companies to include a proposal to allow shareholders to approve or disapprove of the compensation arrangements listed in a company’s annual proxy statement. It is unclear whether the proposed legislation would require annual non-binding shareholder votes to affirm previously approved executive compensation plans.

Noticeably absent from the newly announced proposals were the threatened executive compensation caps similar to those that the Treasury Department imposed on the largest recipients of TARP funds in February. According to Geithner, the proposed legislation seeks to avoid compensation caps or precise prescriptions for how companies should set compensation.

Less than a day after Geithner announced the administration’s executive compensation proposals, however, Rep. Barney Frank, Chairman of the House Financial Services Committee, and other committee Democrats indicated that they were less interested in merely reforming the independence of the compensation committee and requiring non-binding resolutions. Rep. Frank stated that he would prefer a bill that altered the structure of executive pay. Rep. Frank flatly rejected the administration’s “hope” that compensation committee independence would lead to greater oversight and curtail excessive risk taking. In addition, Rep. Brad Sherman voiced his support for binding ‘say on pay’ shareholder votes.

To its credit, the administration’s proposals have the full support of both FED Chairman Ben Bernanke and SEC Chairman Mary Schapiro. In addition, many commentators have voiced relief and support for the seemingly modest executive compensation proposals. It is clear, however, that some of the Congressional Democrats will require more convincing before they can sign-off on the executive compensation proposals.
 

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The SEC is pursuing a slew of investor protection measures:

• In public remarks earlier this year, SEC Commissioner Elisse Walter and Chairman Schapiro expressed support for say-on-pay proposals. Officially, the Staff does not object to say-on-pay resolutions in proxy materials if non-binding and advisory.
• On May 20, 2009, the SEC voted to solicit public comment on proposed rules that will allow shareholders to nominate directors for election by using the company proxy materials. Depending on market capitalization, shareholders of 1-5% could nominate up to a quarter of board seats.
• On June 3, 2009, the SEC announced the creation of an Investor Advisory Committee “to give investors a greater voice in the Commission’s work.”
• Finally, also on June 3, 2009, Commissioner Luis A. Aguilar gave a speech at the Compliance Week Annual Conference calling for a shift in regulatory focus from financial institutions to “what is best for investors.” As examples of investors, Aguilar evokes individuals feeling pain “in their retirement nest eggs, their college savings plans and in their brokerage accounts.”

While there is no doubt that institutional investors are in favor of initiatives like say-on-pay and proxy access (perhaps as a tool to pressure boards) and the Investor Advisory Committee (numerous institutional investors are represented on the Committee), it remains to be seen whether such initiatives will provide any real benefits to retail investors like the individuals Commissioner Aguilar mentions.  As Commissioner Aguilar pointed out in a speech earlier this year, the percentage of retail investors who read proxy materials and vote has significantly declined in the past two years, which is perhaps attributable to e-proxy.  In any event, retail investors are either apathetic about their investments (unlikely) or attribute less value to increased shareholder power than the institutional investors.  
 

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