Canada: Dodd-Frank: Application of Corporate Governance, Securities Reform and Disclosure Requirements to Public Companies

Overview

The scope of the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank" or the "Act") extends beyond regulating the financial industry and includes a number of corporate governance, securities reform and disclosure requirements that will apply to public companies, including Canadian companies, with securities registered or traded in the United States. While certain provisions of the Act are effective immediately, a majority of the reforms will be implemented through regulatory action by the U.S. Securities and Exchange Commission (the "SEC") or U.S. national securities exchanges. In most cases, the Act directs the regulatory agencies to adopt the implementing rules over the course of the next year. After adoption of these rules, the scope of the Dodd-Frank regulatory changes, as well as their application to Canadian companies, should become clearer.¹

Most of the SEC and stock exchange rules mandated by Dodd-Frank will not apply to foreign private issuers ("FPIs"). For example, the Act includes substantial changes to U.S. proxy rules, especially with regard to disclosure of executive compensation matters and permitting proxy access for shareholders. Because FPIs are not subject to the U.S. proxy rules, these changes will not impose these obligations on FPIs. However, we anticipate that it will be advantageous for Canadian and other FPIs to keep abreast of the shifts in the regulatory environment that are generally applicable to the U.S. securities markets.

Other provisions of the Act will have a direct effect on FPIs and other non-U.S. issuers, including those relating to: (i) limitations on discretionary broker voting; (ii) changes to beneficial ownership reporting; (iii) whistleblower incentives and protections; (iv) credit rating agency reforms; and (v) new disclosure requirements directed at issuers in the mining industry. Whether Dodd-Frank's executive compensation "clawback" provisions will apply to FPIs will remain unclear until the SEC and the stock exchanges adopt their rules implementing the clawback provisions of the Act. A provision mandating independent compensation committees applies on its face to all public companies, including FPIs, but permits FPIs to satisfy the requirement through disclosure rather than compliance with its substantive requirements. Finally, this memorandum discusses some changes to rules regarding anti-fraud enforcement that we expect will be of interest to non-U.S. issuers. We have included at the end of this memorandum a chart listing the provisions of the Act discussed in this memorandum, the corresponding section references to the Act, a note indicating whether they apply to FPIs, the rulemaking deadlines regarding such sections imposed by the Act, and any corresponding dates from the SEC's recently announced (anticipated) rulemaking timeline.

Shareholder "Say" on Executive Compensation

"Say on Pay," "Say When on Pay" and "Say on Golden Parachutes"

The Act directs the SEC to adopt proxy rules that will provide shareholders with new advisory rights regarding various elements of executive compensation. Beginning with the first annual or other shareholder meeting occurring after January 21, 2011, and at least once every three years thereafter, companies subject to the U.S. proxy rules must submit a resolution on executive compensation to a non-binding shareholder vote (sometimes referred to as a "say on pay" vote). In addition, the frequency of the "say on pay" vote – whether every one, two or three years – will be subject to a separate shareholder vote (a "say when on pay" vote) that must occur at least once every six years. It is unclear from the Act whether the result of the "say when on pay" vote will also be non-binding.

Similarly, after January 21, 2011, any proxy materials relating to a business combination transaction must provide for a separate non-binding vote approving any "golden parachutes" that are part of the transaction (unless they were previously approved in a separate "say on pay" vote). The proxy statement must set out certain material terms of the golden parachutes, as specified by the disclosure rules to be adopted by the SEC. Like the "say on pay" and "say when on pay" votes, "golden parachute" votes will not overrule prior decisions of the company or the board of directors, nor will they create, change or imply any additional fiduciary duties. These voting requirements are also not intended to otherwise restrict shareholder proposals about executive compensation matters. Dodd-Frank expressly grants the SEC the authority to exempt an issuer or class of issuers from these voting requirements, and in making any such determination, the SEC is directed to take into consideration the possibility of a disproportionate burden on small issuers.

Institutional investment managers who are subject to reporting requirements under Section 13(f) of the U.S. Securities Exchange Act of 1934 (the "Exchange Act") must report, no less frequently than annually, how they voted on these executive compensation matters.

Independent Compensation Committees

Dodd-Frank requires the SEC to issue by July 16, 2011, rules requiring U.S. national stock exchanges to prohibit listing by any issuer that does not have an independent compensation committee. The SEC rules must define "independence," and directors will be required to satisfy that definition to serve on the compensation committee. The Act also provides that compensation committees must have authority to hire advisors and consultants, and are required to consider the independence of such advisors and consultants prior to engaging them.

This independence requirement will not apply to FPIs that provide annual disclosure to their shareholders of the reasons for not having an independent compensation committee. Certain other issuers, including controlled companies, limited partnerships and companies in bankruptcy proceedings, are also exempt from these independence requirements.

In addition, proxy statements for any meeting occurring after July 21, 2011, must disclose whether a compensation committee has obtained advice from a compensation advisor and, if so, whether the advisor was independent. If a conflict of interest exists, the proxy statement must disclose the conflict and discuss how it was addressed. As with the other amendments to the U.S. proxy rules, these changes will not apply to FPIs.

Pay versus Performance and Internal Pay Ratio Disclosures; Disclosure of Issuer's Hedging Policy

Dodd-Frank directs the SEC to amend the U.S. proxy rules to require additional executive compensation disclosures. In any proxy or consent solicitation materials for annual shareholder meetings, issuers must now include "information that shows the relationship between executive compensation actually paid and the financial performance of the issuer." The new rules will also require issuers to disclose: (i) the annual total compensation of the issuer's CEO (or CEO equivalent); (ii) the median annual total compensation of all other employees; and (iii) the ratio of the former to the latter. Beyond these few guidelines, the SEC has considerable discretion in structuring the internal pay ratio disclosure requirement, and some analysts have expressed concerns that gathering the data and performing the calculations to fulfill this requirement may place a considerable burden on issuers.

The new proxy rules will also require issuers to disclose in their annual proxy statements or consent solicitation materials whether any director or employee is permitted by the issuer to purchase financial instruments designed to hedge or offset decreases in the market value of directly or indirectly held issuer equity securities.

No specific timeframe is provided in the Act for implementation of the pay versus performance, internal pay ratio or hedging policy disclosure requirements. However, according to the SEC's recently announced timeline, these rules will not be in place for the 2011 proxy season. As noted above, these changes to the U.S. proxy rules will not apply to FPIs.

Compensation Clawback

Dodd-Frank directs the SEC and the stock exchanges to adopt rules requiring "clawback" of certain executive compensation by issuers that restate their financial statements. It is not clear from the Act whether such rules will apply to FPIs

Although the clawback provision of the Act does not exclude FPIs or any other issuer, the SEC and the stock exchanges may elect to create an express exemption for FPIs.

The Act directs the SEC to require that issuers of all listed securities include in their compensation policies a mandatory clawback of incentive-based compensation tied to reported financial information, and that these policies be disclosed. The clawback will be triggered automatically by a restatement of financial statements due to material noncompliance with financial reporting requirements under U.S. securities laws. Furthermore, the clawback policy must provide that, based on the corrections to the misstated financials, the issuer will recover any overpayment of incentive-based compensation to an executive officer during the three-year period prior to the date on which the issuer was required to prepare the restatement that triggered the clawback.

Dodd-Frank notably departs from the clawback rule in the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley"), which applies when a company must restate its financial statements due to noncompliance with SEC reporting rules. While the Sarbanes-Oxley clawback applies only to the CEO and CFO associated with the noncompliant filing, Dodd-Frank expands the class of covered executives to include all present and former executive officers. In addition, while Sarbanes-Oxley requires disgorgement of incentive-based compensation and profits from sales of the issuer's securities within the 12-month period following the issuance or filing of the incorrect financial statements, Dodd-Frank applies retroactively to all incentive-based compensation paid over a three-year period. Moreover, unlike Sarbanes-Oxley, Dodd-Frank does not require any misconduct to trigger the clawback. A mere accounting error, if found to be materially non-compliant, will be sufficient to trigger the clawback remedy under Dodd-Frank. Commentators have suggested that, with as many as 650 companies filing restatements on an annual basis, the clawback provision may emerge as one the most consequential of the Act's securities reforms.

Shareholder Voting

Although Dodd-Frank includes a number of provisions regarding shareholder voting, the provision in the bill initially passed by the U.S. Senate requiring election of directors of U.S. public companies by majority vote was not included in the final version of the Act. Consequently, director election standards will continue to be governed by state corporate law. Other aspects of shareholder participation, however, will be governed by new Federal standards, as described below.

Proxy Access

Prior to the adoption of the Act, the SEC's authority to adopt rules that, for example, required proxy statements to include shareholder nominees, remained an open question. The Act confirms the authority of the SEC to make such rules but does not mandate SEC action in this area. In one of its first definitive responses to Dodd-Frank, the SEC exercised this discretionary authority by issuing shareholder proxy access rules on August 25, 2010.

However, these rules are not applicable to FPIs, which will continue to be governed by the proxy rules in their own countries.²

Discretionary Voting by Brokers ("Broker Non-Votes")

In a provision that does apply to FPIs, the Act directs the SEC to require national securities exchanges to adopt rules prohibiting brokers from voting shares without the beneficial owner's instructions in connection with: (i) director elections (except for uncontested elections at registered investment companies); (ii) votes on matters of executive compensation; or (iii) resolutions concerning "any other significant matter" as determined by the SEC. By way of example, under this provision, brokers will no longer be able to cast votes on "say on pay" resolutions, which were previously considered "routine" under stock exchange rules, without affirmative direction from the beneficial holders. In addition, the Act reserves for national securities exchanges the ability to prohibit broker discretionary voting on shareholder matters not covered by the Act. This provision, which is not conditioned on the adoption of SEC rules, became effective with the enactment of the Act.

Positions of Board Chairperson and CEO

The SEC is required to issue rules no later than January 17, 2011, requiring issuers to disclose in their annual proxy statements why they have chosen to combine or separate the positions of the board chairperson and the CEO. This change to the U.S. proxy rules will not apply to FPIs.

Additional Securities Laws Reforms

Beneficial Ownership Reporting

Dodd-Frank broadens the current beneficial ownership reporting requirements under Section 13 of the Exchange Act by providing that beneficial ownership may be obtained through the purchase or sale of a security-based swap, as the SEC may determine in accordance with rules that it is required to adopt. The SEC must also adopt rules providing for monthly disclosure of short positions by certain institutional investors.

The Act also authorizes, but does not require, the SEC to adopt rules accelerating the current 10-day filing deadline under Section 13(d) following acquisition of beneficial ownership of securities and for filing initial statements of beneficial ownership under Section 16 of the Exchange Act. The same provision of the Act eliminates the requirements in Sections 13(d) and 16 that beneficial ownership reports be provided to the issuer and the applicable stock exchange on which the securities are traded.

The changes to Section 13 of the Exchange Act will apply to shareholders of FPIs. Section 16 of the Exchange Act, however, does not apply to insiders of FPIs.

Whistleblower Incentives and Protections

As part of its efforts to strengthen enforcement measures, the Act creates a whistleblower "bounty fund" (the "Securities and Exchange Commission Investor Protection Fund"). Persons who voluntarily provide original, independently derived information to the SEC relating to U.S. securities law violations that result in penalties of greater than $1 million will be entitled to receive between 10 and 30 percent of the amount of those penalties, as determined by the SEC.

Whistleblowers are also granted enhanced protections against retaliation, including a private right of action and, under certain circumstances, extended limitations periods and provisions for jury trials. In addition, the Act reinforces the SEC's rules prohibiting the disclosure of any information regarding the whistleblower's identity until the start of enforcement proceedings.

The Act also amends Section 806 of Sarbanes-Oxley to include employees of consolidated subsidiaries and affiliates of public companies under the whistleblower protections already provided for employees of public companies.³ As the Act places no restrictions on the types of persons who will be protected, both U.S. and non-U.S. affiliates and their employees will presumably be included in these whistleblower protections.

These whistleblower incentive and protection rules are to be implemented by the SEC by April 18, 2011. Unless expressly exempted, FPIs will be subject to those rules.

Other Securities Reforms

Please see our September 7, 2010 Perspective, "Effects of Dodd-Frank on Advisors to Private Investment Funds," for a discussion of certain amendments to the U.S. Investment Advisers Act of 1940, as amended, and the rules under the U.S. Securities Act of 1933, as amended (the "Securities Act"), including those relating to the changes in the definition of "accredited investor" for purposes of the U.S. private placement rules.

Credit Rating Agencies

In connection with its reforms in credit rating agency regulation, the Act removes the exemption under Regulation FD under the Exchange Act, which prohibits the selective disclosure of information by public companies, for information conveyed to such agencies. As a result, information delivered to credit rating agencies may have to be disclosed contemporaneously to the public. We note that Regulation FD does not apply to FPIs.

More significantly, the Act nullifies Rule 436(g) under the Securities Act, which had exempted credit agencies that qualified as "nationally recognized statistical rating organizations" from the liability provisions of the Securities Act applicable to "experts." As a result, subject to certain limited exceptions, issuers may refer to a credit rating in a registration statement or prospectus filing only if the credit agency provides a written consent to the issuer's disclosure of that information and the consent is filed as an exhibit to the registration statement. By so consenting, a credit agency will be deemed an "expert" for purposes of the Securities Act, and thus will be subject to the same enhanced liability standards under the Securities Act for material misstatements or omissions as apply to other experts, such as public accounting firms and geological and other technical experts, whose reports are included or cited in prospectuses. In addition, the credit rating agency would be subject to the same enforcement and penalty provisions as those already applying under Federal securities laws to other experts.

In contrast with the U.S. rules, applicable Canadian securities laws expressly require credit rating disclosure in all prospectuses where the offered security has been rated and exempt credit rating agencies from providing their consent to that disclosure (which consent would make them "experts" for liability purposes). In the context of public cross-border securities offerings, particularly offerings conducted under the Canadian-U.S. Multijurisdictional Disclosure System (often referred to as "MJDS"), this disparity creates a legal tension in offering the securities in both jurisdictions. It remains to be seen how this potential tension will be resolved.

Mining Industry

High profile events in the mining industry influenced the inclusion of additional industryspecific reporting requirements in Dodd-Frank. These requirements generally apply to FPIs, although in some instances only to the issuer's mines that are located in the U.S., as explained further below.

Mine Safety

The Act requires disclosure by issuers and their subsidiaries regarding the operation of any mine that is subject to the Federal Mine Safety and Health Act of 1977 (the "FMSHA"). As FMSHA regulates only U.S. mines, this particular disclosure requirement applies only to mines located in the U.S. that are not otherwise exempt from the FMSHA. Most of the required disclosures involve violations cited, or sanctions imposed, by the Mine Safety and Health Administration pursuant to the FMSHA. Issuers subject to this provision must also report any legal actions pending before the Federal Mine Safety and Health Review Commission (the "Mine Safety and Health Commission"). The Act's mining safety disclosure provisions became effective on August 20, 2011.

Most of the Act's mine safety-related disclosure requirements will apply to each periodic filing by the issuer, which, for most FPIs, will be their annual reports on Form 20-F or 40-F. Certain events, however, such as the receipt of an imminent danger order issued under the FMSHA or a written notice from the Mine Safety and Health Commission detailing a pattern of safety violations, require the issuer to make disclosures within four business days on a Form 8-K. Because FPIs are not required to file current reports on Form 8-K, the SEC is likely to require FPIs to provide this disclosure in their annual reports on Form 20-F or Form 40-F.

Extraction Payments

By April 17, 2011, the SEC must adopt rules requiring issuers to disclose in their annual reports filed with the SEC all taxes, royalties, fees and other material benefits, beyond de minimis amounts, paid or given by the issuer to any government, including the U.S. government, for the purpose of commercial development of oil, natural gas or minerals. The Act directs that issuers must make such disclosure with respect to payments to each country and in respect of each project. In further defining the types of payments to bedisclosed, the SEC is directed to consider the standards set by the Extractive Industries Transparency Initiative.

The required information is to be submitted in an "interactive data format," according to standards established by the SEC. The Act directs the SEC to make the reported information publicly available online "to the extent practicable."

Conflict Minerals

As part of a larger strategy to "promote peace and security in the Democratic Republic of the Congo (the "DRC")," the Act requires the SEC to issue rules mandating additional disclosure requirements for all reporting companies that manufacture a product whose functionality or production depends on "conflict minerals" (which are defined as coltan, cassiterite, gold, wolframite or any other minerals or mineral derivatives whose trade is deemed by the U.S. Secretary of State to be funding the conflict in the DRC). The SEC must require companies to include in their annual reports filed with the SEC an independently audited report that describes the due diligence measures taken to ascertain the source and chain of custody of the covered minerals. This report must also be posted on the company's website. The "conflict minerals" rules must be issued by the SEC no later than April 17, 2011

Other Provisions of Interest

Exemptions from Auditor Attestation Reports:

Non-accelerated filers and smaller company issuers (generally, those with worldwide market capitalization of less than $75 million), including FPIs, are permanently exempted by the Act from the requirement to provide an auditor attestation report on internal controls pursuant to Section 404(b) of Sarbanes-Oxley. On September 15, 2010, the SEC amended its rules to effect this exemption. In addition, the SEC is to complete a study by April 11, 2011, identifying ways to reduce the Section 404(b) compliance burden on mid-sized companies, i.e., those with market capitalizations of between $75 million and $250 million.

Broader Enforcement of Anti-Fraud Provisions: The Act expands the jurisdiction of the SEC and the U.S. Department of Justice in actions alleging violations of the U.S. Federal securities laws where the impugned conduct (i) takes place within the U.S. and constitutes "significant steps in furtherance of the violation," even if the securities transaction itself occurs outside the U.S. and involves only foreign investors, or (ii) occurs outside the U.S. but has "a foreseeable substantial effect" within the U.S.⁴

The Act also expands the SEC's enforcement authority by amending the standard of liability for aiding and abetting securities violations. Prior to the enactment of Dodd-Frank, establishing a claim of aiding and abetting securities fraud required proving that the actor knowingly provided assistance to another person's violation. That standard has been revised to include persons who knowingly or recklessly provide such assistance. The Act also confirms the SEC's ability to bring an enforcement action on the basis of "control person" liability.

Conclusion

As discussed above, Dodd-Frank includes a significant number of changes to the U.S. Federal securities laws and corporate governance rules in the United States. In light of the substantial role that the SEC and the stock exchanges will play in implementing and enforcing the rules required by Dodd-Frank, much of the ultimate impact of the Act will remain unclear until the rule-making deadlines approach. Even beyond those deadlines, as securities regulators and stock exchanges in other countries begin to consider similar reforms, the Act's consequences may affect non-U.S. issuers in unanticipated ways

Dodd-Frank Timeline and Section References

Footnotes

1. In general, the Act's provisions that are directed primarily at financial institutions are beyond the scope of this memorandum, although some of the Act's provisions may extend to financial institutions that are foreign private issuers. For a discussion of other aspects of Dodd-Frank applicable to private investment funds, please see our September 7, 2010 Perspective, "Effects of Dodd-Frank on Advisors to Private Investment Funds."

2. The key aspects of these new rules are discussed in our "FLASH: SEC Adopts Final Rules for Shareholder Proxy Access" (Aug. 26, 2010

3. Previously, some courts had declined to extend these protections to the subsidiary level.

4. Because the provision applies only to actions brought by governmental agencies, it does not affect the U.S. Supreme Court's recent decision in Morrison v. National Australia Bank, Ltd., slip op. No. 18-1191 (U.S. June 24, 2010), which concerned the scope of private rights of action over non-U.S. securities transactions. The Court ruled that private party fraud claims could be brought under U.S. securities laws only where the transaction either occurred in the U.S. or involved the purchase or sale of a security listed on a U.S. stock exchange. Although Dodd-Frank does not overturn this decision, it does provide for an SEC study of whether it should be overturned to extend the extraterritorial jurisdiction of U.S. courts over securities fraud cases to private rights of action as well. Several commenters have noted that, even with regard to actions brought by governmental agencies, the Act's expansion of "jurisdiction" may not address the Morrison majority's conclusion that the substance of the Exchange Act's anti-fraud provisions, rather than a lack of jurisdiction, precluded a private right of action with respect to a non-U.S. transaction involving non-U.S.-listed securities

5. Timeline through July 2011, as posted by the SEC on its website on September 23, 2010.

6. The provision does not apply to FPIs if an alternative disclosure is made, as described above.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.