Proxy Access Proposals
Where Are We Now?
As reported in our 2015 proxy alert, some activist shareholders and institutional investors have been pushing companies to allow long-term shareholders to use management’s proxy materials to propose candidates for election to a company’s board of directors. These “proxy access” proposals seek to push the board to establish a mechanism allowing qualified shareholders to place their director nominees in the company’s proxy statement and proxy card, thereby avoiding the cost to a shareholder of preparing, filing and sending their own proxy materials. To date, these proxy access proposals have been advisory in nature, requiring further implementation by the company’s board of directors and shareholders. Nevertheless, shareholder approval of an advisory proxy access proposal often results in pressure from institutional investors and proxy advisory firms on the company’s board of directors to implement the proxy access proposal in response to the shareholders’ expressed will.
In 2010, the SEC approved Rule 14a-11, giving any shareholder or group of shareholders holding at least 3 percent of a public company’s stock for at least three years the right to include in the company’s proxy statement candidates for election comprising up to 25 percent of the board. The new proxy rule was later vacated by the D.C. Court of Appeals in 2011, and the SEC withdrew the rule without issuing any revised rules. However, a companion change to Rule 14a-8, which expanded shareholders’ ability to submit shareholder proposals relating to proxy access, was left undisturbed by the court and the SEC, opening the door to shareholder initiatives to push for proxy access through so-called “private ordering.”
While only a handful of proxy access shareholder proposals found their way into proxy statements in the next three years, more than 100 such proposals were made during the 2015 proxy season, including 75 proposals submitted by the New York City Comptroller’s office on behalf of the pension funds it oversees. Nearly all of the 2015 proposals tracked the principal provisions of the vacated SEC rule (3 percent/3 years). Following the SEC’s announcement in January 2015 withdrawing its prior interpretation of the primary Rule 14a-8 exception then being used to exclude proxy access proposals from proxy statements (conflict with a proposal by the company - Rule 14a-8(i)(9)), many of these proposals found their way into proxy statements in 2015 and nearly two-thirds were approved by shareholders. In Staff Legal Bulletin 14H, the SEC’s Division of Corporation Finance in October 2015 adopted a much narrower interpretation of the “conflicting proposal” exception that sharply curtails its usefulness to companies seeking to exclude proxy access proposals, leaving these companies with very few means of excluding a proxy access proposal.
Proxy Access Proposals Today
According to information posted by the Council of Institutional Investors, 120 companies have adopted some form of proxy access as of mid-December 2015, including Goldman Sachs Group, McDonald’s Corp. and Coca-Cola Co. Apple Computer recently amended its bylaws to allow proxy access for a shareholder or group of up to 20 shareholders owning at least 3 percent of Apple's shares for three years to nominate up to 20 percent of Apple's directors, despite a similar shareholder proposal receiving only 39 percent support at Apple’s last annual meeting. Interestingly, Apple received, and was forced to include in its 2016 proxy statement, a shareholder proposal from James McRitchie recommending that the board modify the proxy access bylaw to increase the number of directors from 20 percent to 25 percent of Apple’s directors and to eliminate the limitation on the number of shareholders that may aggregate their holdings toward the 3 percent threshold.
In January 2016, the New York City Comptroller announced that it had submitted proxy access proposals to 72 companies in the 2016 proxy season, including 36 companies from last year’s target list which had not yet enacted a proxy access bylaw with the desired 3 percent/3 year terms. Some of the latter group had enacted proxy access bylaws, but had included a 5 percent ownership threshold rather than the requested 3 percent. Of the 36 proposals filed against new targets, 25 percent have been withdrawn after the company enacted or agreed to enact a proxy access bylaw with a 3 percent ownership threshold.
Others who are active in submitting shareholder proposals each year have publicly indicated their intention to increase their activity in this area. Mr. McRitchie has published a template proposal on his corporate governance website to facilitate submission of these proposals by others. All indications point to a substantial number of proxy access proposals being submitted to companies and coming to a vote in the 2016 proxy season.
In December 2015, Institutional Shareholder Services, a major proxy advisory firm, issued guidance with respect to how it will evaluate a board’s implementation of proxy access in response to a majority-supported shareholder proposal, as well as how it will evaluate proxy access nominees. With respect to shareholder proposals, Institutional Shareholder Services (ISS) indicated that it may issue an adverse recommendation to a management implementation if it contains “material restrictions more stringent” than those included in the original shareholder proposal. Further, a proposal that contains restrictions or conditions on proxy access nominees such as prohibitions on resubmission of failed nominees or restrictions on third-party compensation of proxy access nominees, among others, will be viewed by ISS as potentially problematic, especially in combination.
Companies Receiving a Proxy Access Shareholder Proposal in 2016
A company that receives a proxy access proposal should first assess whether the basic procedural requirements of Rule 14a-8 are satisfied, such as submission prior to the deadline, not exceeding the length limitation, owning the requisite amount of stock and providing proof of ownership. These gating items are read literally by the SEC staff and missing one or more of them by the proponent will usually result in the exclusion of the proposal from the company’s proxy solicitation materials. But assuming these procedural requirements are satisfied and that the company’s board does not wish to adopt a proxy access bylaw with substantially the same terms as included in the proposal, a company is not likely to have valid grounds to exclude the proposal from the proxy statement. A board that believes proxy access is not in the company’s best interest has limited options when faced with a proxy access proposal recommending action by the board to adopt a proxy access bylaw for approval by shareholders at the next annual meeting.
- Include the shareholder proposal in the proxy statement with a recommendation against it and a statement in opposition. Even if the proposal is approved by shareholders, a proxy access bylaw need not be adopted until early 2017 for shareholder approval at the 2017 annual meeting and would not be usable by shareholders until the 2018 annual meeting even if the board’s proposal to adopt the bylaw is approved by shareholders in 2017. But if the proposal is approved in 2016, the board’s flexibility to choose terms that differ from those in the proposal may be somewhat limited. Material variations could be viewed by ISS as board unresponsiveness and result in a recommendation against the board’s nominees in 2017.
- Include a proposal in the proxy statement to approve board-preferred terms for a proxy access bylaw to be adopted prior to the 2017 annual meeting, along with the shareholder proposal with a board recommendation against and a statement in opposition. This option gives shareholders the ability to choose, while leaving open the possibility that neither proposal will be approved and proxy access will not be adopted. If the board’s proposal is approved by shareholders, the bylaw would be usable by shareholders at the 2017 annual meeting, which may encourage shareholders to vote for the board’s proposal. The board’s proposal with terms tailored to the company and supporting reasoning may be more persuasive than arguing against the “one size fits all” shareholder proposal with no alternative.
- Adopt a proxy access bylaw with board-preferred terms and include the shareholder proposal in the proxy statement with a recommendation against and a statement in opposition. Adopting the bylaw strengthens the company’s argument against voting for the proposal (especially for retail investors) and implements terms that the board finds acceptable at a time when it has more flexibility to do so. However, this option concedes the applicability of proxy access and does not necessarily insulate the board from having to modify the bylaw to conform to the terms included in the shareholder proposal, especially if the proposal is approved by shareholders.
- Negotiate with the proponent for withdrawal of the shareholder proposal, offering to adopt a proxy access bylaw with more board-preferred terms prior to the 2017 annual meeting. Many proponents are unwilling to negotiate and it is unlikely that the board would be able to reach a compromise that does not involve the terms included in the most common form of the shareholder proposal (3 percent/3 years). However, if negotiations fail, the board is free to pursue one of the other options noted above.
- Include a proposal in the proxy statement for approval of a proxy access bylaw with board-preferred terms and seek a declaratory judgment from a U.S. District Court that the shareholder proposal may be excluded under the Rule 14a-8(i)(9) exception, and that the exception should be interpreted consistent with the Division’s prior position.After the recent publication of Staff Legal Bulletin 14H, it seems likely that a court would defer to the Division’s recently considered interpretation and rule against exclusion of the shareholder proposal. The litigation involved with this option is also likely to increase the company’s cost of addressing the shareholder proposal while still resulting in at least one proxy access proposal in the company’s proxy statement.
In addition to considering the effects of a proxy access bylaw and whether adoption would be in the company’s best interests, another key consideration in deciding how to respond to a proxy access proposal is whether the proposal is likely to receive majority shareholder support. As noted above, proxy advisory firms such as ISS and Glass, Lewis & Co. (Glass Lewis) will expect the board to be appropriately responsive to the shareholders’ expressed will, such as by adopting a compliant proxy access bylaw or disclosing why it did not, taking into account the factors ISS and Glass Lewis think are important.
Companies That Have Not Received a Proxy Access Shareholder Proposal
Given the momentum that is building behind the proxy access issue, public companies and their boards should prepare as if they will eventually receive a shareholder proposal to adopt proxy access. These companies should consider the following, among other issues:
- Increase shareholder outreach efforts. Subject to limitations imposed by the proxy rules, companies should maintain and increase dialogue with their key shareholders to understand shareholders’ views on proxy access, the terms they believe are preferable and how they are likely to vote on a proxy access proposal. Some institutions have publicized their views on proxy access, while others take a case-by-case approach.
- Keep the board informed. Ensure that the board understands proxy access, its related issues and the views of the company’s key shareholders so that the board can make an informed choice as to whether to proactively adopt a proxy access bylaw or, if it chooses not to, can act quickly if faced with a shareholder proposal.
- Consider what a proxy access bylaw might look like. Even if the board decides not to proactively adopt a proxy access bylaw, the board may wish to consider the principal terms of such a bylaw it would find acceptable or even direct counsel to prepare a proxy access bylaw “for the shelf” that the board would be willing to approve if circumstances later dictate that doing so is in the company’s best interest. The terms of any such bylaw should reflect the company’s unique circumstances, prevailing market practice, feedback received from shareholders during the company’s outreach efforts and the published position of any proxy advisory firms likely to be influential on any related shareholder vote.
- Review advance notice bylaws. Public companies should also review their advance notice bylaws to be sure they appropriately address the nomination process and to determine whether any changes would be necessary to coordinate with a proxy access bylaw. For example, companies may wish to coordinate the information and timing requirements in their advance notice bylaw for director nominations by shareholders with the requirements of SEC Schedule 14N, which would be required to be filed by any shareholder proposing nominees to be included in the company’s proxy statement.
ISS and Glass Lewis 2016 Policy Updates
Every year, proxy advisors ISS and Glass Lewis update their proxy voting policies for the upcoming proxy season. ISS’s updates take effect for annual meetings held on or after February 1, 2016, while Glass Lewis’s apply to annual meetings on or after January 1, 2016. The major policy changes of each for the 2016 proxy season are summarized below.
Institutional Shareholder Services
Proxy Access Proposals. ISS issued new FAQs in December 2015 to provide guidance on whether ISS is likely to recommend a vote against directors after a company has adopted a proxy access bylaw in response to a majority-supported shareholder proposal. In this regard, ISS will evaluate the board’s responsiveness by looking at whether the major points in the proposal have been or are being implemented and whether additional provisions unnecessarily restrict use of the proxy access right. A perceived lack of responsiveness by the board may result in a negative vote recommendation with respect to some or all of the directors. Where provisions differ from those in the approved shareholder proposal, a lack of disclosure regarding shareholder outreach and engagement may also result in a negative vote recommendation.
If management includes its own proxy access proposal in the proxy statement or has implemented a proxy access policy, ISS indicated that it will continue to review and make recommendations on a case by case basis, but views the following restrictions or conditions as potentially problematic, especially when used in combination:
- Prohibitions on resubmission of failed nominees in subsequent years;
- Restrictions on third-party compensation of proxy access nominees;
- Restrictions on the use of proxy access and proxy contest procedures for the same meeting;
- How long and under what terms an elected shareholder nominee will count towards the maximum number of proxy access nominees; and
- When the proxy access right will be fully implemented and available to qualifying shareholders.
The following restrictions are considered especially problematic:
- Counting individual funds within a mutual fund family as separate shareholders for purposes of an aggregation limit; and
- The imposition of post-meeting shareholding term requirements for nominating shareholders.
Director Overboarding. ISS is concerned that directors serving on too many boards may be unable to devote the necessary time and attention to each board in order to carry out their duties effectively. Last year, ISS issued recommendations against or recommendations to withhold votes for individual non-CEO directors who served on more than six public company boards, and CEO directors who served on more than two public company boards (not including their own). For 2016, ISS has lowered its “overboarding” threshold to five public company boards for non-CEO directors; leaving its policy regarding CEO directors unchanged. This policy change, however, includes a one-year grace period. As such, public companies with overboarded directors under the new standard will not start receiving adverse vote recommendations until the 2017 proxy season.
Unilateral Governance Changes. ISS generally disfavors unilateral board actions and has, in the past, recommended against actions taken by a board that significantly reduces shareholder rights without shareholder approval. For 2016, ISS has updated its policy to distinguish between unilateral board adoptions of bylaw or charter provisions made prior to or in connection with a company’s initial public offering (IPO) and those made after a company’s IPO. According to ISS, this was done in order to more accurately reflect the different expectations shareholders have for new companies versus established ones.
For post-IPO companies, ISS’s policy will remain the same: it will recommend voting against directors of a board that unilaterally approves adoptions of bylaw or charter provisions until such actions are reversed or submitted to the shareholders for approval. For unilateral actions of the same kind taken by companies in the pre-IPO stage or in connection with an IPO, ISS will take a more lenient “case-by-case” approach in determining whether an adverse vote recommendation is warranted.
Compensation Disclosures by Externally Managed Issuers. In order to encourage more adequate disclosures about the pay practices related to externally-managed issuers (EMI), ISS has adopted a new voting policy under which it will generally recommend against say-on-pay when the EMI fails to provide sufficient compensation disclosure to allow investors to make a reasonable assessment of pay programs and practices for the EMI’s named executive officers. In this regard, ISS has added “Insufficient Executive Compensation Disclosure by External-Managed Issuers” to the list of practices that may result in an adverse vote recommendation. ISS has not yet provided details regarding what will be considered “sufficient” disclosure.
Conflicting Shareholder Proposals. SEC Rule 14a-8(i)(9) permits companies to exclude a shareholder proposal if it directly conflicts with one of management’s proposals to be submitted to shareholders at the same meeting. SEC Staff Legal Bulletin No. 14H clarified the application of Rule 14a-8(i)(9) to indicate that a management proposal directly conflicts with a shareholder proposal only if “a reasonable shareholder could not logically vote in favor of both proposals,” leaving open the possibility that competing management and shareholder proposals may be submitted at the same meeting.
While ISS has not addressed how it will evaluate competing management and shareholder proposals, in its 2016 Proxy Voting Polices, Glass Lewis stated that it will consider the following factors when reviewing conflicting proposals (in no particular order of importance): (i) nature of the underlying issue; (ii) benefit to shareholders by implementing the proposal; (iii) materiality of the differences between the terms of the conflicting proposals; (iv) appropriateness of the provisions considering your shareholder base, corporate structure and other relevant circumstances; and (v) the company’s overall governance profile, specifically responsiveness to shareholders evidenced by response to previous shareholder proposals and adoption of progressive shareholder rights provisions.
Director Overboarding. Like ISS, Glass Lewis has updated its policy on director overboarding to decrease the number of boards on which public company executives and other directors may serve before receiving a negative vote recommendation. For 2016, Glass Lewis will recommend voting against public company executive director candidates who serve on more than two boards and other director candidates who serve on more than five boards. There is a one-year grace period, and overboarded director candidates will start receiving negative votes in the 2017 proxy season.
Exclusive Forum Provisions. In prior years, Glass Lewis has recommended voting against the chairman of the nominating and governance committees when companies include exclusive forum provisions in their governance documents in connection with an IPO. Beginning in 2016, however, instead of recommending a vote against such provisions in all instances, Glass Lewis will consider the provision on balance with the other provisions in the company’s governing documents, and may recommend a vote in favor if the company makes a compelling case for inclusion of such a provision.
Environmental and Social Risk Oversight. For 2016, Glass Lewis formalized its policy regarding director responsibility for oversight of environmental and social risk. Under its new policy, Glass Lewis may recommend voting against directors in cases where it believes the directors did not properly address or mitigate the risks associated with environmental or social risks, and such failure may negatively impact shareholder value.
Nominating Committee Performance. Glass Lewis clarified that it may recommend a vote against the nominating committee chair when the chair has failed to ensure that the board has appointed directors with relevant experience, and such failure has resulted in poor corporate performance.
Compensation Updates. Glass Lewis has traditionally taken a cautious approach to evaluating one-time awards granted to newly-hired executive officers, such as signing bonuses and “make-whole” payments, but acknowledges that such payments may be warranted under certain circumstances. In its 2016 updates, Glass Lewis encourages issuers of one-time awards to provide shareholders with a thorough description of the terms of the awards, including the reason why the awards are necessary and the process by which the terms of the award were reached.
FAST Act Amends JOBS Act
On December 4, 2015, President Obama signed into law the Fixing America’s Surface Transportation Act (FAST Act). The FAST Act is a bipartisan five-year fully-paid legislative plan to improve the Nation’s roads, bridges, transit systems and rail transportation network. Buried within this legislation, however, are changes to the Jumpstart Our Business Startups Act (JOBS Act), which amended various provisions of federal securities laws. Just like the JOBS Act, the changes made by the FAST Act are meant to facilitate capital formation for smaller companies.
As required by the FAST Act, the SEC has now adopted interim final rules amending Forms S-1 and F-1, as well as Item 512 of Regulation S-K, to permit an emerging growth company to omit certain financial information from a registration statement and to permit a smaller reporting company to incorporate by reference into a Form S-1 any reports or materials filed with the SEC subsequent to its effective date, as discussed further below.
Emerging Growth Companies
The FAST Act implemented three significant changes affecting emerging growth companies (EGCs). First, the FAST Act reduced the number of days that an EGC must wait after publicly filing with the SEC a previously submitted draft registration statement before it may commence a road show from 21 to 15. In this regard, the JOBS Act permitted EGCs to confidentially submit a draft registration statement to the SEC for review, rather than publicly filing it, as long as the EGC publicly files the draft registration statement and all amendments with the SEC within a certain timeframe before any road show began, which is now 15 days.
Second, the FAST Act clarified a broadened grace period for changes of status of an EGC. Previously, an EGC that initiated the IPO process, either by submitting a draft registration statement or by filing it publicly, could lose its EGC status if it crossed the $1 billion revenue threshold while the registration statement was under review. In such an event, the SEC provided that the issuer may continue to rely on the EGC rules through the effective date of the registration statement. The FAST Act extends this grace period by providing that if the issuer was an EGC at the time it submitted a confidential IPO registration statement or publicly filed the registration statement and ceases thereafter to be an EGC, it will continue to be treated as an EGC until the date on which it consummates its IPO or, if earlier, until the end of the oneyear period beginning on the date it ceased to be an EGC.
Third, the FAST Act required the SEC to revise its general instructions on Form S-1 or Form F-1 to reduce or omit certain financial information from a filed or confidentially submitted registration statement for historical periods that are otherwise required by the SEC’s Regulation SX. This accommodation will permit EGCs to omit from their IPO registration statements historical financial information for fiscal periods that will not have to be included in the registration statement at the time the offering commences. For example, a calendar year-end EGC that initially files or submits its IPO registration statement in December 2016 (which would ordinarily require audited financial statements for 2015 and 2014), believing that its offering will not occur until after it would have to include audited financial statements for a new fiscal year (2016), may omit from the initial filing or submission the audited financial statements for the fiscal year (2014) that it believes will not be required at the time of the offering.
Simplifying Form 10-K and Regulation S-K
The FAST Act directs the SEC to issue regulation to simplify its disclosure requirements by permitting issuers to submit a summary page in its Form 10-K so long as each item on the summary page includes a cross-references to the content contained in the body of the Form 10-K. Further, the FAST Act directs the SEC to revise Regulation S-K to scale disclosure rules for EGCs and smaller issuers, and to eliminate duplicative, outdated, or unnecessary Regulation S-K disclosure requirements for all issuers in order to simplify and modernize Regulation S-K disclosure rules. The SEC is required to submit a report to Congress within 360 days of the law’s enactment (June 1, 2016) that details the findings of its Regulation SK study, its recommendations on modernizing and simplifying Regulation SK, and its recommendations on ways to improve the readability of disclosure documents.
New Private Resales Exemption
The FAST Act adopted new Section 4(a)(7) of the Securities Act, which provides a registration exemption for resales of privately held securities, similar to the case law derived hybrid exemption known as Section 4(1½). While Rule 144 provides a safe harbor for selling restricted securities in the public market, there was not a similar safe harbor to selling such securities privately. Now, new Section 4(a)(7) provides a statutory legal framework for private resales of restricted securities, even by affiliates of the issuer. This new exemption became effective upon enactment and does not require the SEC to issue any revised rules or regulations.
Conditions of Section 4(a)(7). The new exemption requires compliance with general conditions and, if the issuer of the securities is neither subject to Exchange Act reporting requirements nor a foreign private issuer exempt from those requirements, compliance with an information delivery condition. In this regard, Section 4(a)(7) will exempt transactions which meet the following general conditions:
- Accredited Purchasers Only. Each purchaser of restricted securities pursuant to Section 4(a)(7) must be an accredited investor as defined in Rule 501(a) of Regulation D.
- No General Advertising. Neither the seller nor any person acting on the seller's behalf may use any form of general solicitation or general advertising.
- Issuer Business Requirement. The issuer must be engaged in business and not in the organizational stage, in bankruptcy or receivership, nor considered a blank check, blind pool or shell company.
- Information Sharing. Generally, a non SEC-reporting company will be required to furnish certain information to the seller and prospective purchaser, upon request of the seller. The information provided by the company must be reasonably current and includes, among others, the following:
- information about the officers, directors, and transfer agent;
- the exact titled and class of security and the applicable par or stated value;
- the number of shares or total amount of the securities outstanding as of end of most recent fiscal year;
- a statement of the nature of the business of the company and products and services it offers; and
- the company’s most recent balance sheet and profit and loss statements for the two preceding fiscal years (in accordance with GAAP).
- Disqualified Sellers. The seller of such securities cannot be a direct or indirect subsidiary of the issuer.
- Seller Limitations-Bad Actor Prohibition. Neither the seller, nor any person that has been or will be paid directly or indirectly for their participation in the transaction, is subject to any of the disqualifying events under Rule 506(d)(1) of Regulation D (the bad actor prohibition) or is subject to statutory disqualification under Section 3(a)(39) of the Exchange Act.
- Securities Limitations.
- The securities must not be part of an unsold allotment to, or a subscription or participation by, a broker or dealer acting as an underwriter or a redistribution; and
- The class of securities for the respective shares must have been authorized and outstanding for at least 90 days prior to the transaction.
Similar to the so-called Section 4(1½) exemption, securities acquired in reliance on Section 4(a)(7) will be restricted securities subject to transfer restrictions. On the other hand, unlike Section 4(1½), Section 4(a)(7) does not impose a holding period on an acquiring purchaser before it may resell the securities. Moreover, affiliates of the issuer (other than subsidiaries), including control persons that satisfy the requirements of Section 4(a)(7) will be able to sell their restricted securities under the new exemption without regard to the volume and manner of sale restrictions imposed on affiliates under Rule 144.
Small Company Simple Registration
The FAST Act directed the SEC to simplify the registration process by amending the Form S-1 registration statement to allow smaller reporting companies to incorporate by reference any documents filed with the SEC after the effective date of the Form S-1. A smaller reporting company is any issuer that (a) has a common equity public float of less than $75 million or (b) if that float is zero, had revenues of less than $50 million for its most recent fiscal year. The ability to incorporate by reference all Exchange Act filings will make it easier for smaller reporting companies to maintain a continuous primary offering of securities off the shelf or resale offerings by security holders. In the absence of forward incorporation, companies had to file an amendment to their registration statement (and wait until it was declared effective by the SEC staff), to add the information contained in their periodic and current reports made under the Exchange Act to its offering prospectus.
Registration Threshold Changes for Savings and Loan Holding Companies
The FAST Act also raised the threshold for mandatory SEC registration of savings and loan companies. In this regard, savings and loan holding companies were previously required to register their securities as a class with the SEC if the company has total assets exceeding $10 million and its securities are “held of record” by either 2,000 persons or 500 or more non-accredited investors. After the FAST Act, savings and loan holding companies will be subject to the same threshold that applies to banks and bank holding companies. As such, the threshold for mandatory SEC registration for savings and loan holding companies has been raised from 500 shareholders of record to 2,000 shareholders of record, regardless of how many of those holders are non-accredited investors.
Pay Ratio Disclosure Requirements Coming
On August 5, 2015, the SEC adopted its pay ratio disclosure rules, which require most public companies to disclose the ratio of their CEO’s total compensation to that of their median employee beginning in 2018. Generally, the pay ratio disclosure rules will require the calculation and disclosure of the following:
- The annual total compensation of the CEO;
- The median of the annual total compensation of all employees of the company, other than the CEO; and
- The ratio of these two amounts.
The pay ratio disclosure will need to be included in filings that require executive compensation disclosure pursuant to Item 402 of Regulation S-K. This includes annual reports on Form 10-K, proxy and information statements and registration statements. Smaller reporting companies, emerging growth companies, foreign private issuers and U.S. Canadian Multijurisdictional Disclosure System filers are not subject to the pay ratio disclosure rules.
The first reporting period for the pay ratio disclosure is the company’s first fiscal year commencing on or after January 1, 2017. Thus, for companies with a fiscal year ending on December 31, the pay ratio disclosure will need to be included in its proxy statement and Form 10-K during the 2018 proxy season.
Presenting the Pay Ratio
The proxy rules allow companies to express the pay ratio disclosure in one of two ways. It can either be disclosed (i) with the median employee compensation equal to one and the CEO’s compensation compared to one or (ii) narratively by stating how many times higher or lower the CEO’s compensation is compared to the median employee. For example, if a CEO’s compensation is $4 million and the median compensation for employees is $40,000, the ratio could be disclosed as “100 to 1” or “the CEO’s annual compensation is 100 times higher than the median annual compensation paid to all employees.”
Definition of an Employee
In calculating its pay ratio disclosure, a company must identify the median of the annual total compensation of all employees of the company, other than the CEO. As such, all individuals employed by a company or its consolidated subsidiaries (other than the CEO), including employees outside the United States (with two limited exemptions discussed below), part-time employees, temporary employees and seasonal employees are considered as employees for purposes of finding the median annual total compensation of all employees. Individuals whose compensation is determined by an unrelated third party, such as independent contractors, are not considered employees under the pay ratio disclosure rule.
The company may annualize compensation for full-time or part-time employees that were employed for only part of the year. Companies are not permitted, however, to annualize compensation for temporary or seasonal employees or to adjust compensation for part-time employees to full-time equivalent.
Limited Exemptions for Certain Non-U.S. Employees
The pay ratio disclosure rule includes two limited exemptions, a data privacy exemption and a de minimis exemption, which allow companies to exclude certain employees located outside the United States from the pay ratio disclosure calculation.
The data privacy exemption allows companies to exclude non-U.S. employees from its pay ratio calculation if the employees are employed in a jurisdiction with data privacy laws that the company would violate by complying with the pay ratio disclosure requirements. If a company relies on this exemption for a particular jurisdiction, it must exclude all employees from that jurisdiction, identify the excluded jurisdiction, and provide an estimate of the approximate number of employees in that jurisdiction. Moreover, the company must explain how compliance with the pay ratio disclosure rule would violate the data privacy laws in that jurisdiction and describe the company’s efforts to obtain relief under those laws. In addition, the company is required to obtain an opinion from counsel opining on the company’s inability to comply, which opinion must be filed as an exhibit to the filing that includes the pay ratio disclosure.
The de minimis exemption allows companies to exclude all employees located outside of the United States if they account for 5 percent or less of the company’s total employees. If a company has more than 5 percent of its employees located outside the United States, it can choose to exclude all employees of any jurisdiction, so long as the employees in that jurisdiction do not make up more than 5 percent of the company’s total employees. Employees excluded under the data privacy exemption will count toward the 5 percent de minimis exemption. If a company relies on the de minimis exemption, it must identify the excluded jurisdiction and disclose the number of excluded employees.
Identifying the Median Employee and Total Compensation
A company may use any date within three months prior to the last day of the year to determine its employee population for purposes of identifying the median employee. For example, choosing a date before the holidays could avoid the inclusion of seasonal employees. The median employee only must be identified once every three years, unless there has been a change in the employee population or compensation arrangements that the company reasonably believes would significantly change the pay ratio disclosure. If there has been such a change, the company must disclose the nature of the change, identify a new median employee and briefly explain the reasons for the change. Otherwise, the company must disclose that the median employee has not changed and briefly explain why it reasonably believes that no change was necessary. The chosen date (or a change in the date from a prior year) must also be disclosed (and why).
According to the SEC, there is not a required methodology to identify the median employee, except that the median employee must be a real person. Companies may identify the median employee by using the full employee population, through statistical sampling of that population or by using other reasonable methods. In this regard, the median employee may be identified based on annual total compensation or any other compensation measure consistently applied to all employees, such as tax or payroll records. Companies must briefly describe the methodology they use, including any material assumptions, adjustments or estimates used to identify the median employee.
In identifying the median employee, companies may make cost-of-living adjustments to the compensation of employees who live in a jurisdiction than that of the CEO. If the company makes a cost-of-living adjustment to identify the median employee, it must briefly describe the cost-of-living adjustment and then use the same adjustment to calculate the median employee’s annual total compensation. The company must also disclose the median employee’s total compensation and pay ratio without the cost-of-living adjustment.
After identifying the median employee, the company must calculate the median employee’s total compensation using the requirements of Item 402 of Regulation S-K regarding the calculation of executive compensation. This effectively requires that the company prepare a “Summary Compensation Table” for the median employee, including salary, bonus, option and stock awards, incentive plan compensation and pension values, to determine the employee’s total annual compensation for purposes of comparing it to that of the CEO.
Preparing for the Pay Ratio Disclosure
Although companies will not be required to make the pay ratio disclosure until the 2018 proxy season at the earliest, for many companies, it will take a significant amount of time to collect the date and prepare the disclosure. As a result, to the extent they have not done so already, companies should do the following:
- Update the compensation committee (and board) on the final rule so that members (and directors) can become informed and assess the impact the rule and its pay ratio disclosures might have on the company.
- Identify the methodology the company will use for calculating the pay ratio.
- Assess fluctuations in the number and nature of the employee population during the last three months of 2015 and 2016 to determine if there is a specific timing that makes the most sense for the company in identifying the median employee.
- Educate employees who will be responsible for gathering information to calculate the pay ratio disclosure.
- Consider whether existing compensation systems will need to be modified to capture the information needed to calculate the pay ratio.
- If a company has non-U.S. employees, begin reviewing applicable foreign data privacy laws and regulations to ascertain whether there are any conflicts with the pay ratio requirements and, if so, determine the process to follow to satisfy the rule’s foreign data privacy law exemption.
Shareholder Proposal Trends
Before the beginning of each proxy season, a shareholder meeting minimal shareholding requirements may submit a shareholder proposal for inclusion in the company’s proxy materials and vote on it at its forthcoming annual meeting. These shareholder proposals often are contrary to the goals of a company’s executives and its board, and so a company may employ the SEC’s no-action letter process to omit shareholder proposals from its proxy statement based on one or more of 13 grounds for exclusion set out in Rule 14a-8 of the SEC’s proxy rules. If the SEC staff does not concur with a company’s claim for exclusion, then the company must include the proposal in their proxy statement or seek a court order to omit it.
In this regard, shareholder proposals can be roughly grouped into four broad categories: corporate governance and shareholder rights; environmental and social issues; executive compensation; and corporate civic engagement, including political contributions or membership in political, lobbying or charitable organizations. Global political, social and economic developments can affect the popularity of these categories from year to year.
According to published ISS data, approximately 943 shareholder proposals were made for 2015 shareholder meetings, which surpassed the previous year’s 901 proposals. In 2015, the most frequently submitted proposals were corporate governance and shareholder rights proposals (with approximately 352 submitted), largely due to the unprecedented number of proxy access proposals (108 proposals). If not for the dramatic rise in the number of proxy access proposals, proposals on environmental and social issues would have again comprised the largest category of proposals (with approximately 324 submitted). In 2014, the most common proposal topics requested for no-action letter exclusion were political and lobbying activities (126 proposals), independent chair (68 proposals), and climate change (56 proposals).
Most shareholder proposals voted on in 2015 did not receive majority support. Based on the 447 shareholder proposals for which ISS provided voting results for 2015 meetings, proposals averaged support of 33.2 percent of votes cast. Six proposal topics that received high shareholder support, including four that averaged majority support, were:
- Adoption of majority voting in uncontested director elections, averaging 77 percent of votes cast, compared to 57 percent in 2014;
- Board declassification, averaging 73 percent of votes cast, compared to 84 percent in 2014;
- Proxy access, averaging 55 percent of votes cast, compared to 35 percent in 2014;
- Elimination of supermajority vote requirements, averaging 53 percent of votes cast, compared to 69 percent in 2014;
- Shareholder ability to call special meetings, averaging 44 percent of votes cast, compared to 42 percent in 2014; and
- Shareholder ability to act by written consent, averaging 39 percent of votes cast, compared to 38 percent in 2014.
Primarily as a result of the success of proxy access proposals, ISS reported that 16.7 percent of proposals (75 proposals) voted on at 2015 shareholder meetings received support from a majority of votes cast, compared to 14.8 percent of proposals (64 proposals) in 2014.
According to Georgeson, Inc., a preeminent proxy solicitation firm, individual shareholders accounted for a large portion of 2015’s shareholder proposals and submitted nearly half of the proposals that actually went to a vote. As a percentage, however, proposals from individual shareholders declined from 2014 due to public pension funds nearly doubling the number of proposals they submitted in 2015, with the New York City Pension Funds taking the lead in sponsoring 75 proxy access proposals. Seven other proponent groups were reported to have submitted or co-filed at least 20 proposals each, largely focused on environmental, political and compensation matters, as well as corporate governance and shareholder rights.
2016 Proxy Access Proposals
On January 11, 2016, the New York City Pension Funds expanded its “Boardroom Accountability Project” by submitting proxy access proposals at 72 companies for the 2016 proxy season, including 36 companies that had received proxy access proposals in 2015. These companies were targeted again because they had not yet adopted proxy access at a 3 percent ownership threshold. Another 36 companies were newly targeted for 2016, with a focus on the New York City Pension Fund’s largest portfolio companies, coal-intensive utilities and companies selected due to concerns about board diversity and excessive CEO pay. The form of proxy access proposal submitted for the 2016 proxy season does not differ substantively from the template submitted for the 2015 proxy season, except that it no longer specifically seeks shareholder approval of proxy access bylaws.
SEC Rule Proposals Still To Come
During 2015, the SEC introduce a number of proposed new rules pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Below are snapshots highlighting three highly-impactful proposals with some related practical implications for public companies.
On July 1, 2015, almost five years after the enactment of Dodd-Frank, the SEC proposed Rule 10D-1 relating to the “claw back” of incentive-based compensation. The proposed rule directs national securities exchanges and associations to require companies to adopt a “claw back policy” requiring executive officers to pay back incentive-based compensation erroneously awarded. Moreover, proposed Rule 10D-1 requires exchanges to delist any company who does not adopt, disclose, or implement such a policy.
The claw back policy would require companies to recover any incentive-based compensation an executive would otherwise not have received on account of the material error causing the company to restate its financial statements. The new listing standards are proposed with an eye toward increased accountability and greater focus on the quality of financial reporting to benefit investors and market transparency. Proposed Rule 10D-1 defines “incentive-based compensation” as any compensation granted, earned, or vested based wholly or in part upon the attainment of a financial reporting measure (i.e., a measure tied to accounting-related metrics, stock price, or total shareholder return).
Under the proposed rule, the requirement to recover incentive-based compensation would be on a “no fault” basis and would apply to any excess incentive-based compensation received by current or former executive officers in the three fiscal years preceding the date a company is required to prepare an accounting restatement. Moreover, companies would be prohibited from indemnifying or otherwise repaying the officers any amounts recovered.
In conjunction with proposed Rule 10D-1, the SEC also proposed an amendment to Item 601 of Regulation S-K requiring a listed company to file its recovery policy as an exhibit to its periodic reports. A company also would be required to disclose the details of any actions it has taken to recover excess compensation if a restatement requiring recovery was completed in the most recent fiscal year or if there was an outstanding balance of excess compensation from a prior restatement. If the proposed listing standards are made effective, companies will have 60 days to adopt the necessary mandated policies and provide the disclosures.
Pay Versus Performance Under Dodd-Frank
On April 29, 2015, the SEC proposed an addition to Item 402(v) of Regulation S-K pursuant to Section 953(a) of Dodd-Frank, captioned “Pay versus Performance.” According to the SEC, in an effort to provide greater transparency to shareholders so they are better informed when voting for directors and in connection with executive compensation, the proposal would require companies to disclose executive pay and performance for itself and companies in a peer group in a new table format. Companies would be required to show the relationship between senior-level executive pay and the companies’ total share return (TSR) on an annual basis over the previous five years (or three for smaller reporting companies) as compared to a peer group. The main features of this proposal not already required by current regulations include:
- Disclosure of “Actual Pay” based on named executive officers (NEOs) compensation as already disclosed in the proxy statement’s summary compensation table with adjustments included for pensions and equity;
- A division of NEOs into two groups: (1) PEO (i.e., principal executive officer or more commonly referred to as chief executive officer) and (2) non-PEOs (i.e., all other named executive officers other than the PEO);
- A requirement to tag the disclosure in an interactive data format using eXtensible Business Reporting Language or XBRL; and
- A suggested new format for shareholders to compare pay versus performance in a tabular format such as:
Click here to view the table.
The goal is for this new metric to help shareholders assess executive compensation relative to the company’s financial performance. In light of this additional disclosure, the proposal could pressure companies to pro-actively justify their compensation decisions. In any event, the proposal certainly would require companies to devote additional time, effort and resources to calculate the new compensation metrics and effectively explain its performance.
Hedging Disclosure Rule Under Dodd-Frank
As authorized by Section 955 of Dodd Frank, on February 9, 2015, the SEC proposed to implement Item 407(i) of Regulation S-K to enhance corporate disclosure of hedging policies for officers, directors and employees. According to the SEC, in an effort to help investors better understand the alignment of interests of employees and directors with their own, the proposal would require disclosure about whether directors, officers and employees are permitted to hedge or offset any decrease in market value of equity securities granted by the company as compensation or held by such individuals.
In this regard, the proposed policy would extend to companies not currently required to provide such disclosures, including smaller reporting companies, emerging growth companies, business development companies and closed-ended investment companies with shares listed and registered on a national exchange. Additionally, the proposal would expand disclosure to policies applying to non-named executive officers and other employees (even those who cannot affect the company’s share price). The proposal would broaden the hedging activities that must be disclosed to include equity securities of not only the company, but its parent, subsidiary, or any subsidiary of any parent of the company registered under Section 12 of the Exchange Act.
Lastly, the proposed rule would require disclosure of whether employees or board members are permitted to purchase financial instruments, including prepaid variable forward contracts, equity swaps, collars, and exchange funds otherwise designed to hedge or offset any decrease in value of company equity securities. With this proposal, the rule would require a company to disclose prohibited and permitted hedging transactions. Moreover, if the company permits some, but not all, of its employees and board members to engage in hedging transactions, it must disclose the details of who is and is not permitted to do what. Given this broadening of required disclosure, if implemented as proposed in 2016, companies will have to carefully consider their hedging policies, including who they apply to and what types of transaction will be subject to the policy.