On June 8, 2017 the United States House of Representatives passed H.R. 10, the Financial Choice Act (the “FCA”), along party lines. The nearly 600-page bill includes numerous measures to repeal or roll back regulations impacting the United States financial system, but primarily targets the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). The bill contains provisions that have the potential to greatly impact the interests of institutional investors. The FCA faces long odds to pass in the Senate in its current form due to the Democratic filibuster, but there is a chance that the bill or a modified version of the bill may pass.
FCA Implications for Market Risk
The FCA removes many of the regulatory safeguards that were imposed under Dodd-Frank in an effort to monitor and reduce perceived risks to the United States financial system. Among other things, the FCA eliminates Dodd-Frank’s mechanisms for supporting or winding down failing financial institutions in favor of a federal bankruptcy regime, repeals the Volcker Rule’s prohibition on speculative investments by financial institutions, exempts certain institutions from Dodd-Frank era regulations and stress tests, and eliminates the Financial Stability Oversight Council’s authority to designate certain entities as systematically important. The FCA also restricts the rulemaking and enforcement power of federal agencies, including the Securities and Exchange Commission (the “SEC”), and would require such agencies to engage in rigorous cost-benefit analyses before proposing or issuing new regulations. In many cases, the FCA would require Congressional approval for new regulations of any significance. These changes to the Dodd-Frank era regulatory scheme have the potential to greatly decrease the costs associated with regulatory compliance by institutional investors’ portfolio companies and could have the effect of increasing such investors’ return on investment.
FCA Implications for Investor Influence on Corporate Governance and Management
The FCA limits institutional investors’ ability to make shareholder proposals that can influence the governance and management of their portfolio companies. Under current rules, any holder of at least $2000 or 1% of a company’s stock for at least a year can make shareholder proposals. In contrast, Section 844 of the FCA would require shareholders to hold at least 1% of the subject company’s registered securities for a minimum of three years to be able to make a proposal. Moreover, Section 844 of the FCA would also increase the existing thresholds for resubmission of shareholder proposals, and eliminate the ability for a shareholder proposal to be submitted by proxy, representatives, agents or other persons acting on behalf of a shareholder. Section 844 of the FCA could reduce costs of defense against frivolous or ill-advised shareholder proposals which may be beneficial for institutional investors’ investment returns.
FCA Implications for Director Elections
The FCA would repeal Section 971 of Dodd-Frank, eliminating the SEC’s ability to issue rules on proxy access. However, ever since the SEC’s original proxy access rules were vacated on administrative grounds in July 2011, more than 350 public companies, including more than half of the companies in the Standard & Poor’s 500 index implemented a proxy access bylaw in response to shareholder proposals.[i] Due to such private ordering, the FCA’s repeal of Section 971 of Dodd-Frank may have limited impact.
Institutional investors may feel the impact of Section 845 of the FCA, which prohibits the SEC from mandating that issuers use universal ballots that would permit investors to choose to support both management and dissident director nominees. Accordingly, Section 845 of the FCA would gut the SEC’s proposed Rule 14a-19 that would require issuers to use such universal ballots. If the FCA is enacted, institutional investors seeking a universal ballot would need to use private ordering to obtain such ballots for elections of the directors of their portfolio companies.
Section 972 of Dodd-Frank is also slated for repeal under Section 857 of the FCA. Section 972 of Dodd-Frank requires annual disclosure of why issuers have chosen to have one person serve as both chairman of the board and chief executive officer or why two different people serve in such roles. However, this disclosure is quite similar to the disclosure required by Item 407(h) of Regulation S-K, and, accordingly, repeal of Section 972 of Dodd-Frank should not have a significant impact on the ability of institutional investors to obtain this information about management.
Implications for Proxy Advisory
Section 482 of the FCA requires proxy advisory firms to register with the SEC to be able to provide proxy voting research, analysis or recommendations. Section 482 of the FCA would require proxy firms to permit companies that receive proxy advisory firm recommendations to have access to and opportunities to comment on drafts of the recommendations, and would also require proxy advisory firms to employ an ombudsman to address complaints from such companies pertaining to accuracy of voting information. Section 482 of the FCA also directs the SEC to establish rules and procedures that would prohibit unfair and coercive practices by proxy advisory firms, including conditioning or modifying a vote recommendation based on whether an issuer purchases services or products. Certain investors have publicly decried Section 482 of the FCA, arguing that, among other things, its registration requirements and regulations would increase the cost of proxy advice, would inhibit the objective nature of proxy advice, would hamper the ability of institutional investors to make informed voting decisions during the hectic proxy season, and would ultimately be inequitable to dissident shareholders in the context of contested elections.[ii]
FCA Implications for Institutional Investor Influence Over Compensation
The FCA would also eliminate the statutory authority under Dodd-Frank for certain compensation disclosure rules that may be of interest to institutional investors. For example, Section 857 of the FCA would repeal the statutory basis for the SEC’s pay ratio disclosure rule under Section 953(b) of Dodd-Frank. Compliance with this rule is required for most reporting entities beginning in 2018; however, in February of 2017, the Acting Chairman of the SEC directed staff to reconsider implementation of the rule and established a 45 day comment period. Repeal of Section 953(b) of Dodd-Frank would eliminate future compliance costs for companies, which would remove the potential for negative pressure on investor returns. However, certain investors have voiced support for the rule.[iii]
Section 857 of the FCA would repeal Section 956 of Dodd-Frank, which requires federal regulators to issue rules that would restrict certain incentive compensation arrangements that could encourage inappropriate risk-taking by employees of certain financial institutions, and repeal Section 955 of Dodd-Frank, which is the basis for the SEC’s proposed rule which requires issuers to disclose whether employees and directors may hedge fluctuations in the issuer’s securities. Repeal of these Dodd-Frank provisions may impact investors’ ability to evaluate risks associated with employee and compensation policies and monitor risk-taking by management.
Additionally, Section 843 of the FCA would modify the say-on-pay rules under Section 951 of Dodd-Frank. Dodd-Frank currently requires shareholders to vote on executive compensation packages at least once every three years and to determine the frequency of such votes at least once every six years. The FCA would amend the rule to require say-on-pay votes only when there are material changes to executive compensation and would eliminate the vote on say-on-pay frequency entirely. More than 90% of S&P 500 companies have adopted annual say-on-pay votes and proxy advisory firms like ISS and Glass-Lewis support proposals for annual say-on-pay votes.[iv] Accordingly, the modification of these rules would have little practical effect for many public companies, given that most public companies are likely to retain annual voting.
Section 849 of the FCA also targets for modification Section 954 of Dodd-Frank which would require national exchanges to cause issuers to claw back incentive-based pay from executives in the event of an accounting restatement that would have delivered lower incentive-based compensation. Section 849 of the FCA would narrow this claw back requirement to apply only to the executive officers with control or authority over the financial reporting that resulted in the accounting restatement. The SEC has not yet finalized its proposed claw back rule; accordingly, institutional investors may not feel the impact of the FCA’s modification of Section 954 of Dodd-Frank.
Implications for Specialized Disclosures
Section 862 of the FCA would repeal requirements codified in Sections 1502, 1503 and 1504 of Dodd-Frank that address required investigation and disclosure related to conflict minerals, disclosures on mine safety health issues, and disclosures pertaining to payments made to governments by issuers in resource extraction industries. Institutional investors may obtain higher returns on investment if issuers are not burdened by costs of compliance with these provisions.
Outlook for Institutional Investors and the FCA
It is highly unlikely that the FCA will be enacted in its current form. The bill lacks bipartisan support, and given that at least eight Democratic votes will be required to overcome any filibuster, the FCA may well be dead on arrival in the Senate. However, it is possible that portions of the bill could be passed in the Senate by Republicans through appropriations measures which will only require 51 votes. Additionally, Republicans may be able to pass portions of the FCA that have some bipartisan appeal. In any case, investors should expect Republicans to continue efforts to roll back the reach of Dodd-Frank and other statutes with regulatory requirements that impact the United States financial system. If those efforts are successful, institutional investors will stand to benefit from any boost to investment returns associated with portfolio companies’ reduced regulatory burden, but will have to rely on private ordering to protect other interests associated with managing risk and influencing corporate governance and management of their portfolio companies.
[i] See, “Proxy Access by Private Ordering.” Council of Institutional Investors, (February 2017). Retrieved from http://cii.membershipsoftware.org/files/publications/misc/02_02_17_proxy_access_private_ordering_final.pdf.
[ii] See Letter from Jeff Mahoney, General Council, Council of Institutional Investors, to The Honorable Jeb Hensarling, Chairman, Committee on Financial Services, United States House of Representatives et al. (Apr. 29, 2017), available at http://www.cii.org/files/issues_and_advocacy/correspondence/2017/04_29_17_letter_cmte_fin_serv.pdf.
[iii] California Public Employees’ Retirement System. (2017). CalPERS Joins Other Investors in Continued Support of “Pay Ratio” Disclosure Requirement [Press release]. Retrieved from https://www.calpers.ca.gov/page/newsroom/calpers-news/2017/calpers-joins-other-investors