The 2013 proxy season brings with it new conflicts of interest and Cybersecurity concerns, revised proxy advisory firm voting policies, Iran sanctions disclosures and possible shareholder activism related to director nominations. Say-on-pay continues to raise issues as companies address the results of these non-binding shareholder votes, and conflict minerals continues to be a significant concern. Moreover, behind these issues always lurks the remaining Dodd-Frank corporate governance and executive compensation rulemaking initiatives that yet await SEC action.
New Disclosure for Conflicts of Interest Involving Compensation Consultants
Public companies have new disclosure requirements related to conflicts of interest involving compensation consultants. In this regard, Dodd-Frank added Section 10C(c)(2) to the Securities Exchange Act of 1934, which requires, among other things, that in any proxy or consent solicitation material for an annual meeting of shareholders (or a special meeting held in lieu of an annual meeting), the issuer must disclose “whether (A) [its] compensation committee retained or obtained the advice of a compensation consultant, and (B) the work of the compensation consultant has raised any conflict of interest and, if so, the nature of the conflict and how the conflict is being addressed.”
Item 407(e)(3)(iii) of Regulation S-K already addresses the first portion of the SEC’s new mandate. This rule has required public companies to disclose in each annual proxy statement the role of compensation consultants in providing advice or recommendations on the amount or form of executive and director compensation. This requirement applies to any compensation consultant, regardless of whether it is engaged by the issuer’s management, board of directors or compensation committee, other than where the compensation consultants give advice that is limited to broad-based plans or non-customized information or data. Where disclosure is required, the issuer must:
- Identify each consultant.
- State whether the consultant was engaged directly by the compensation committee (or persons performing equivalent function) or any other person.
- Describe the nature and scope of the consultant’s assignment.
- Describe the material elements of the instructions or directions that were given to the consultant regarding their duties.
In addition to the foregoing, the issuer is also required to disclose the aggregate fees paid to the consultant for determining or recommending the amount or form of executive compensation to be paid and the aggregate fees for additional services performed by the consultant where the consultant provided both and fees for the additional services exceeded $120,000 during the fiscal year.
In response to its charge under Dodd-Frank, the SEC supplemented the disclosure described above by finalizing new Item 407(e)(3)(iv) of Regulation S-K. The new rule requires that the issuer disclose, with respect to any compensation consultant identified in response to Item 407(e)(3)(iii) whose work has raised any conflict of interest, both the nature of that conflict and how the conflict is being addressed. The instruction to new Item 407(e)(3)(iv) notes that issuers should consider the six factors set forth in Rule 10C-1(b)(4) to the Exchange Act (adopted by the SEC under the Dodd-Frank Act in connection with this new rule) when determining whether a conflict of interest exists with respect to a compensation consultant as follows:
- The provision of other services to the issuer by the person that employs the compensation consultant, legal counsel or other adviser.
- The amount of fees received from the issuer by the person that employs the compensation consultant, legal counsel or other adviser, as a percentage of the total revenue of the person that employs the compensation consultant, legal counsel or other adviser.
- The policies and procedures of the person that employs the compensation consultant, legal counsel or other adviser that are designed to prevent conflicts of interest.
- Any business or personal relationship of the compensation consultant, legal counsel or other adviser with a member of the compensation committee.
- Any stock of the issuer owned by the compensation consultant, legal counsel or other adviser.
- Any business or personal relationship of the compensation consultant, legal counsel, other adviser or the person employing the adviser with an executive officer of the issuer.
The new disclosure requirements set forth in Item 407(e)(3)(iv) will apply to any proxy or consent solicitation material for an annual meeting of shareholders (or a special meeting held in lieu of an annual meeting) at which directors will be elected on or after January 1, 2013.
Practical Considerations. Companies should solicit information from directors and executive officers in annual meeting questionnaires in order to make any necessary disclosure. In addition, Boards and their compensation committees should consider implementing a review of material interests and relationships of current compensation consultants, legal counsel (other than in-house counsel) and other advisers now in advance of the mandate to consider such matters under the Nasdaq and NYSE revised listing standards. In this way, they will become aware of any conflicts, can deliberate about the nature of the conflicts and can determine what actions, including protocols to limit the impact of conflicts, would be in the best interests of the company and its shareholders.
Disclosure Obligations Relating to Cybersecurity Risks—A Year Later
Still not sure if you need to make disclosures relating to Cybersecurity risks and cyber incidents? A year after the Division of Corporation Finance of the Securities and Exchange Commission issued CF Disclosure Guidance: Topic No. 2, the SEC has still yet to issue any applicable rules or regulations. While the SEC has not taken any action, given companies’ increasing dependence on digital technologies to operate their businesses, Congress revisited Cybersecurity issues in 2012. While the proposed Cybersecurity Act of 2012 failed to gain Senate approval, it did place an emphasis on the need for the SEC to take action and provide updated guidance. In September 2012, Senator John D. Rockefeller IV (D, West Va.) went as far as to write a letter to CEOs of Fortune 500 Companies requesting information regarding each company’s Cybersecurity policies and related issues.
The questions that Senator Rockefeller posed in his letter to the CEOs were:
- Has your company adopted a set of best practices to address its own Cybersecurity needs?
- If so, how were these Cybersecurity practices developed?
- Were they developed by the company solely, or were they developed outside the company? If developed outside the company, please list the institution, association, or entity that developed them.
- When were these Cybersecurity practices developed? How frequently have they been updated? Does your company’s board of directors or audit committee keep abreast of developments regarding the development and implementation of these practices?
- Has the federal government played any role, whether advisory or otherwise, in the development of these Cybersecurity practices?
- What are your concerns, if any, with a voluntary program that enables the federal government and the private sector to develop, in coordination, best Cybersecurity practices for companies to adopt as they so choose, as outlined in the Cybersecurity Act of 2012?
- What are your concerns, if any, with the federal government conducting risk assessments, in coordination with the private sector, to best understand where our nation’s cyber vulnerabilities are, as outlined in the Cybersecurity Act of 2012?
- What are your concerns, if any, with the federal government determining, in coordination with the private sector, the country’s most critical cyber infrastructure, as outlined in the Cybersecurity Act of 2012?
These Congressional actions lead many people to believe that mandated additional disclosure requirements may not be far behind, including a Form CS. Until then, though, all companies have for guidance with respect to Cybersecurity and cyber incident disclosure is CF Disclosure Guidance: Topic No. 2. Not intending to be exhaustive, CF Disclosure Guidance: Topic No. 2 focused on the following six key disclosure areas: Risk Factors, Management’s Discussion and Analysis of Financial Condition (MD&A), Description of Business, Legal Proceedings, Financial Statement Disclosures and Disclosure Controls and Procedures. For a detailed summary of these six key disclosure areas, please see 2012 Alert—Disclosure Obligations Relating to Cyber Security Risks.
Practical Considerations. While we wait for additional guidance and disclosure requirements from the SEC, companies should continue to be vigilant in Cybersecurity areas. The current information, which includes CF Disclosure Guidance: Topic No. 2, the SEC’s recent actions and Senator Rockfeller’s letter provide insight to help companies identify and fix potential problem areas and to comply with future disclosure obligations. Remember, in addition to SEC disclosure obligations, your company must comply with any existing Federal and state cyber and cyber incident laws and, if your company operates in a regulated industry, you may have additional legal obligations with respect to Cybersecurity and the cyber incident area.
ISS and Glass Lewis Voting Policy Updates for 2013
The leading proxy advisory firms, Institutional Shareholder Services, Inc. (“ISS”) and Glass Lewis & Co. (“Glass Lewis”), have each recently published updates to their 2013 U.S. proxy voting guidelines. The 2013 updates include revisions to ISS’s and Glass Lewis’s policies on board responsiveness to shareholder proposals, director service on multiple public company boards, ISS’s policies on pay-for-performance, say-on-golden parachute recommendations and hedging and pledging of company stock.
Board Responsiveness. ISS’s current policy has been to recommend a vote against or withhold from the entire board (except new nominees, who are considered on a case-by-case basis) if the board failed to act on a shareholder proposal that received the support of a majority of the shares outstanding in the last year, or a majority of votes cast in the last year and one of the two previous years. ISS made two significant changes to this policy. First, for annual meetings beginning in 2013, board non-responsiveness will no longer trigger a negative recommendation for the entire board. ISS will, however, recommend against individual directors, committee members or the entire board as it deems appropriate. Second, for annual meetings beginning in 2014, ISS will recommend a vote against or withhold from individual directors, committee members or the entire board if the board failed to act on a shareholder proposal that received the support of a majority of the votes cast in the previous year.
ISS also published additional guidance on the sufficiency of a board’s response to a majority-supported shareholder proposal. Generally, responding to a shareholder proposal will mean either full implementation of the proposal or, if the matter requires a vote by shareholders, a management proposal on the next annual ballot to implement the proposal. If the board’s response involves less than full implementation, ISS will consider on a case-by-case basis the response, taking into account the following factors:
- The subject matter of the proposal.
- The level of shareholder support and opposition provided to the resolution in past meetings.
- Disclosed outreach efforts by the board to shareholders in the wake of the vote.
- Actions taken by the board in response to its engagement with shareholders.
- The continuation of the underlying issue as a voting item on the ballot (as either shareholder or management proposals).
- Other factors as appropriate.
ISS updated their FAQ on board responsiveness to provide guidance on how ISS would treat board responses to specific shareholder proposals including proposals requesting board declassification, an independent chairman, majority voting in director elections, expansion of shareholders’ right to call special meetings, provision for shareholder action by written consent and reduction of supermajority voting requirements.
Glass Lewis adopted new guidelines to address its review of board responsiveness to proposals that receive a vote of 25% or more against the board’s recommendation, including withhold or against votes on director elections, votes in favor of shareholder proposals and votes against management proposals. Previously, Glass Lewis reviewed board responsiveness only where 25% or more shareholders voted against management’s say-on-pay proposal. If a vote meets the 25% or more against threshold, Glass Lewis will conduct a review of the board’s response based on publicly available information (including SEC filings, press releases and other publicly available communication). Glass Lewis’s review will focus on:
- Changes in board and committee composition.
- Director meeting attendance.
- Related person transaction disclosure.
- Amendments to the company’s governing documents.
- Changes to company policies or practices.
- Amendments to the company’s compensation practices.
Overboarding. ISS has modified its policy on overboarding to no longer count publicly-traded subsidiaries owned 20% or more by the parent company as one board with the parent company. Instead, each publicly-traded subsidiary will be treated as a separate board. ISS will recommend a vote against a director who sits on more than six public company boards or who is a public company CEO sitting on more than two publicly-traded company boards in addition to their own.
Under Glass Lewis’s 2013 guidelines, when a director serves as an executive officer of a publicly-traded company and also serves on two other public company boards, Glass Lewis will recommend a vote against that director at the two other public companies, not at the company where the individual serves as both a director and executive officer.
Pay for Performance Evaluation. When evaluating pay-for-performance, ISS begins with a preliminary quantitative screening of company pay and performance relative to an ISS-selected pegroup. ISS’s current peer group selection methodology focuses on the subject company’s Global Industry Standard (“GICS”) classification. This focus has caused ISS to overlook competitors of the subject company and include firms that do not have a connection to the subject company for performance and pay comparison purposes. To address this oversight, ISS has revised its methodology to incorporate information from the subject company’s self-selected pay benchmarking peer group in order to prioritize GICS industry groups beyond the subject company’s own GICS classification. Under ISS’s revised methodology, the ISS selected peer group will include 14 to 24 companies and will prioritize peers that are in the subject company’s peer group, have chosen the subject company as a peer, are comparable in size to the subject company or maintain the subject company near the median of the peer group, and will adjust for size differences relating to both revenue and market value.
ISS will also add a “realizable pay” element to its pay-for-performance evaluation of CEO compensation at large capitalization companies. ISS defines realizable pay as the sum of relevant cash and equity-based grants and awards made during the specified performance period being measured, based on equity award values for actual earned awards, or target values for ongoing awards, calculated using the stock price at the end of the performance measurement period. ISS will re-value stock options and stock appreciation rights using a Black- Scholes model utilizing the remaining term and updated assumptions. ISS has recommended that companies include disclosure of ongoing or completed performance-based equity awards in their proxy statement to facilitate ISS’s calculation of realizable pay.
Hedging and Pledging of Company Stock. ISS has modified its policy on voting on director nominees to take a case-by-case approach to determining whether pledging of company stock as collateral for a loan rises to a level of serious concern for shareholders. ISS will evaluate significant pledging or hedging of any amount of company stock as a failure of risk oversight and a governance failure. In determining vote recommendations with regard to the election of directors who currently have pledged company stock, ISS will consider the following factors:
- Presence in the company’s proxy statement of an anti-pledging policy that prohibits future pledging activity.
- Magnitude of aggregate pledged shares in terms of total common shares outstanding or market value or trading volume.
- Disclosure of progress or lack thereof in reducing the magnitude of aggregate pledged shares over time.
- Disclosure in the proxy statement that stock ownership and holding requirements do not include pledged company stock.
- Other relevant factors.
Other Updates. Glass Lewis will evaluate equity compensation plans for potential dilution or costs to common shareholders. Glass Lewis’s 2013 guidelines provide that “plans should not count shares in ways that understate the potential dilution, or cost, to common shareholders. In addition, Glass Lewis added a new section to its guidelines describing its approach to holding the chairmen of director committees primarily responsible for committee actions. Glass Lewis also indicated that while it remains generally opposed to exclusive forum provisions, it may recommend approval of an exclusive forum provision if there are compelling reasons for such a provision that would benefit shareholders, there is evidence of abuse of legal process in non-favored jurisdictions, and the company has a record of good corporate governance.
ISS revised its director attendance policy to recommend a vote against or withhold from individual directors where the directors have attended less than 75% of the board and committee meetings during their period of service. ISS also updated their policy on evaluating social and environmental shareholder proposals, indicating that such proposals will be evaluated on a case-by-case basis.
Practical Considerations. Issuers should continue monitoring ISS and Glass Lewis voting guidelines and consider conforming to such guidelines where practicable. Moreover, in light of ISS’s position on hedging and pledging, and the related pending provision under Dodd-Frank, companies may wish to review and, if appropriate, revise their policies with respect to these matters and consider disclosing their hedging and pledging policies and any other relevant factors in their proxy statements to address shareholder and ISS concerns.
Iran Sanctions Disclosure
The Iran Threat Reduction and Syria Human Rights Act of 2012 (ITRA) added new Section 13(r) to the Securities Exchange Act of 1934, which requires companies filing quarterly and annual reports to disclose the details of certain sanctionable activities related to Iran in which they or their affiliates are or were engaged. The new disclosure requirement becomes effective for filings made after February 6, 2013. Moreover, the disclosure included in a Form 10-K for 2012 must address all activities in 2012, even though ITRA was not passed until later in the year.
In this regard, Section 13(r) requires a reporting company to disclose certain activities in which it, or its affiliates, knowingly is or was engaged in relating to Iran’s energy sector or activities relating to foreign financial institutions that facilitate Iran’s development of weapons of mass destruction, terrorism, money laundering or Islamic Revolutionary Guards Corps activity as detailed in the Iran Sanctions Act of 1996, the Comprehensive Iran Sanctions, Accountability, and Divestment Act of 2012, and specific executive orders.
An issuer that engaged in one of the described activities must disclose a detailed description of each activity, including the nature of the activity, the gross revenues and net profits attributable to the activity and whether the issuer intends to continue the activity. Additionally, an issuer with activities to report under Section 13(r) must also send a separate notice to the SEC. The SEC will pass these notices on to the President and several House and Senate committees for further investigation. An issuer that has not engaged in any reportable activities under Section 13(r), however, does not need to make a statement to that effect in its annual or periodic reports.
Practical Considerations. Issuers should review their operations for all of calendar year 2012 to determine whether any of their activities, or the activities of any of their affiliates worldwide, might be a reportable activity under Section 13(r). Moreover, companies should consider whether to update their compliance policies and procedures to prohibit any non-US subsidiary business dealings involving the Government of Iran. Finally, companies should review and update their disclosure controls and procedures, if necessary, to ensure that any covered activities are identified and disclosed.
Shareholder Proposals and Proxy Access
In October 2012, the staff of the SEC’s Division of Corporation Finance issued Staff Legal Bulletin No. 14G (“Bulletin”). This Bulletin clarifies the Division’s interpretive positions regarding (i) the parties that can provide proof of ownership for verifying whether a beneficial owner is eligible to submit a proposal under Rule 14a-8, (ii) how companies should notify proponents of a failure to provide valid proof of ownership, and (iii) the use of website references in proposals and supporting statements.
The Bulletin was prompted by certain Rule 14a-8 amendments that became effective in late 2011, which permitted shareholders to submit proposals for inclusion in a company’s proxy statement that sought to amend a company’s organizational documents with respect to director nomination procedures. Previously, companies were permitted to exclude from their proxy materials any proposal relating “to a nomination or an election for membership on the company’s board of directors… or a procedure for such nomination or election.” As a result, the 2013 proxy season will be the second season during which shareholders may submit proposals for inclusion in a company’s proxy statement seeking to amend bylaw provisions relating to proxy access for elections in general.
This is particularly noteworthy because, while Rule 14a-8 shareholder proposals are generally precatory (i.e., non-binding), the one exception is amendments to a company’s bylaws. Shareholders therefore have an opportunity again this proxy season to establish proxy access standards on a company-by-company basis through the Rule 14a-8 shareholder proposal process, and companies will need to be vigilant in policing the process.
Verifying Record Ownership. Under Rule 14a-8(b), to be eligible to submit a proposal, a shareholder must prove that it has continuously held at least $2,000 in market value, or 1%, of the company’s securities entitled to be voted on the proposal at the meeting, for at least one year through the date the shareholder submits the proposal. To prove such continuous holding, a shareholder must (i) submit a copy of Schedule 13D, Schedule 13G, Form 3, Form 4 and/or Form 5 as filed with the SEC, (ii) be a registered holder of the company’s securities, meaning that such shareholder’s name appears in the company’s records as a shareholder and can be independently verified by the company, or (iii) submit to the company written proof from the record holder of the securities (usually an agent, such as a broker or bank, acting on behalf of the shareholder).
In Staff Legal Bulletin No. 14F, released in October 2011, the Division maintained that only securities intermediaries that are participants in the Depository Trust Company (DTC) could be viewed as record holders of securities for purposes of verifying record ownership through an agent. The Division has broadened this view to include affiliates of DTC participants, stating that a proof of ownership letter from an affiliate of a DTC participant will meet the requirement because a securities intermediary holding shares through its affiliated DTC participant should be able to verify its customers’ ownership of securities.
Notice Regarding Proof of Ownership Deficiencies. A company may exclude a shareholder proposal for an eligibility defect only after it has sent written notice to the shareholder of such defect within fourteen days of receiving the shareholder’s proposal and the shareholder fails to remedy such defect within fourteen days of receiving written notice. Such written notice must contain adequate detail about what a proponent must do to remedy the applicable defect.
In the Bulletin, the Division expresses particular concern that companies’ notices of defect do not adequately describe defects relating to continuous holding of securities. Proof of share ownership must be shown to cover a continuous year up to and including the day on which the shareholder submits its proposal. Some companies’ notices of defect make no mention of the gap in the period of ownership or other time-related deficiencies. Going forward, the Division will not permit exclusion of a proposal on the basis of failure to adequately prove ownership for one year, unless the company provides written notice that identifies the specific date on which the proposal was submitted, which is the postmark date or the date of electronic transmission, and explains that the proponent must obtain a new proof of ownership letter verifying continuous ownership.
Use of Website References in Proposals and Supporting Statements. The Division has previously explained that a reference to a website in a proposal or in supporting statements is counted as one word for purposes of the 500-word limit imposed by Rule 14a-8(d). Despite such treatment for purposes of word count, references to websites could be subject to exclusion if the information contained on the website is materially false or misleading, irrelevant to the subject matter of the proposal, or otherwise in contravention of the proxy rules, including Rule 14a-9 prohibiting false and misleading statements.
To determine whether a proposal may be excluded for providing a reference to a website, a company should evaluate whether the information on the website only supplements the information contained in the proposal or whether it provides information necessary for shareholders and the company to understand with reasonable certainty what actions or measures the proposal requires that is not otherwise contained in the proposal itself. In the latter case, the proposal would be subject to exclusion as vague and indefinite.
In addition to concerns regarding the content of referenced websites, the Bulletin addresses several timing issues related to such references. First, although a reference to a website may be excluded as irrelevant on the basis that it is not operational at the time of submitting the proposal, such reference may not be excluded if, at the time the proposal is submitted, the proponent provides the company with the materials that are intended for publication on the website and with a representation that the website will become operational at, or prior to, the time the company files its definitive proxy materials.
Second, if the content of a referenced website changes after the proposal is submitted, the Division may permit a company, which would otherwise be prohibited by Rule 14-8(j) from seeking exclusion of the referenced website if the company’s request is made later than 80 calendar days before it files its definitive proxy materials, to proceed with a request for exclusion if the Division concludes that the changes to the referenced website constitute good cause for the company’s untimely request for exclusion.
Practical Considerations. Companies should carefully review and consider any shareholder pro posals that are received in light of the Division’s new guidance. If a proposal is deficient, the company should ensure that any defect notice sent to a shareholder complies with the Division’s position relating to proof of ownership letters (e.g., specifying the dates on which continuous ownership must be shown). In addition, companies should monitor website addresses that are included in shareholder proposals and the disclosures contained thereon for any changes that could warrant a request for exclusion.
New PCAOB Standards on Communications with Audit Committees
The Public Company Accounting Oversight Board (“PCAOB”) adopted a new set of procedures in 2012 to govern the communications between auditors and audit committees: Auditing Standard No. 16—Communications with Audit Committees. According to the PCAOB, this new auditing standard is geared towards enhancing the relevance and quality of the communications between external auditors and audit committees, thereby assisting audit committees in fulfilling their statutory oversight responsibilities to investors in the preparation of financial statements and audits.
A salient distinction under Auditing Standard No. 16 from the existing standard is the requirement that the auditor establish an understanding of the terms of the audit engagement with the audit committee, rather than with management. This is intended to underscore the imperative that the audit committee is responsible for the appointment of the auditor. The standard provides that if the engagement letter is not signed by either the audit committee or its chair, the auditor is required to determine that the audit committee has nevertheless acknowledged and agreed to the terms of the engagement.
Expansion of Existing Requirements. Although Auditing Standard No. 16 retains many of the existing communication requirements in the PCAOB’s interim standards and SEC rules, it enhances these existing requirements by mandating that the auditor communicate the following to the audit committee:
- Provide information regarding the company’s accounting policies, practices and estimates.
- Provide the auditor’s evaluation of the quality of the company’s financial reporting, including conclusions regarding critical accounting estimates and the company’s financial statement presentation.
- Give information related to significant unusual transactions, including the business rationale for such transactions.
- Provide the auditor’s views regarding significant accounting or auditing matters when the auditor is aware that management consulted with other accountants about such matters, and the auditor has identified a concern regarding these matters.
New Requirements. The following are new requirements under Auditing Standard No. 16, with the primary purpose of improving communications about significant aspects of the audit procedure:
- An overview of the overall audit strategy, particularly with respect to the timing of the audit, significant risks the auditor identified, and significant changes to the planned audit strategy or identified risks.
- The basis for the auditor’s determination that he or she can serve as principal auditor, if significant parts of the audit will be performed by other auditors.
- Information about the nature and extent of specialized skill or knowledge needed in the audit; the extent of the planned use of internal auditors, company personnel or other third parties; and other independent public accounting firms, or other persons not employed by the auditor who are involved in the audit.
- Situations in which the auditor identified a concern regarding management’s anticipated application of accounting pronouncements that have been issued but are not yet effective, and might have a significant effect on future financial reporting.
- Difficult or contentious matters for which the auditor consulted outside the engagement team.
- The auditor’s evaluation of going concern.
- Any departure from the auditor’s standard report.
- Other matters arising from the audit that are significant to the oversight of the company’s financial reporting process, including complaints or concerns regarding accounting or auditing matters that have come to the auditor’s attention during the audit.
In addition to the aforementioned requirements, the standard also requires that the auditor inquire of the audit committee as to whether the audit committee is aware of matters relevant to the audit, including, but not limited to, violations or possible violations of laws or regulations. This requirement expands on Auditing Standard No. 12—Identifying and Assessing Risks of Material Misstatement, which requires the auditor to inquire of the audit committee regarding matters relating to the identification and assessment of material misstatements and fraud.
Furthermore, the standard requires that communications by the auditor to the audit committee be made in a timely manner before the audit report is issued. The appropriate timing of the communication is contingent on the circumstances and significance of the matters to be communicated and any follow-up actions that may be necessary.
Auditing Standard No. 16 and its related amendments will be effective for public company audits of fiscal years beginning on or after December 15, 2012. In addition, the SEC determined that the standard and its related amendments will apply to audits of “emerging growth companies” under the Jumpstart Our Business Startups Act of 2012.
Practical Considerations. Audit committees should begin to examine the possibility of expanding their meeting agendas with the auditors in order to accommodate the increased communication requirements under Auditing Standard No. 16. Moreover, audit committees may wish to evaluate the existing processes for receiving and reviewing information on compliance matters, given the heightened communication requirement between external auditors and audit committees under the new standard. With respect to the new requirement for auditors to obtain information from the audit committee about possible violations of laws or regulations, the audit committee may wish to consider what procedures, if any, should be implemented in order to respond to such inquiries and whether the company’s compliance program is robust enough to identify most violations before the auditors’ review. Finally, audit committees and boards of directors should consider if updates to the audit committee charter and other organizational documents are warranted to reflect the new communication requirements.
The 2012 annual meeting season was the second year of mandatory say-on-pay (“SOP”) and issuers generally saw the same results as in 2011. The vast majority of SOP proposals were approved, with approximately 97% of the Russell 3000 receiving the approval of a majority of the votes cast compared to 98% in 2011. Another 3% saw a strong positive vote in 2011 sink to less than 70% in 2012. The favorable results were likely due to improved proxy disclosure, increased off-cycle communications with significant shareholders regarding executive compensation, and elimination of problematic compensation policies deemed objectionable by proxy advisory firms and institutional investors. The biggest proxy advisory firms, ISS and Glass Lewis, continued to wield significant influence in 2012, with nearly all of the issuers that received a negative SOP vote receiving a negative SOP vote recommendation from at least one of these firms.
The year 2012 was also a year for developments in SOP litigation. The first wave of these cases was brought in 2010, 2011 and early 2012 against companies with failed SOP votes. The cases centered on claims that the board breached its fiduciary duties by approving the compensation packages for the executive officers and then failing to claw back compensation when performance did not meet expectations, thus violating the pay-for-performance philosophy most issuers profess to employ. The linchpin of these cases was that the negative SOP vote negated the applicability of the business judgment rule—the legal presumption employed by Delaware and many other state courts, including Michigan, that the board acted in good faith, on an informed basis and in the honest belief that the action taken was in the best interests of the issuer—and that the burden of proof therefore should be shifted to the board to prove that their actions were in the issuer’s best interests. Courts found the legal basis for these cases to be flawed, and all but one of the court decisions to date have been dismissals. The one case that survived a motion to dismiss was settled prior to trial.
Given their lack of success in the first wave of SOP litigation, plaintiff’s lawyers have taken a different tack. Following the course taken in litigation challenging mergers and acquisitions, cases are now being brought before the SOP vote occurs seeking an injunction to delay the annual meeting until alleged disclosure deficiencies are remedied by the issuer. Although disclosure-based claims have succeeded in a few other compensation-related cases and numerous M&A-related cases, courts so far are rejecting requests for an injunction in the SOP context in view of what they say is the absence of irreparable harm (since the vote is merely advisory) or because the “missing” disclosure is rarely, if ever, included. In some cases, the issuer has convinced the plaintiff to drop the suit without a settlement. However, faced with delaying the annual meeting and potential bad publicity, several companies have settled these cases by agreeing to disclose additional details relating to their executive compensation decisions and by paying attorney’s fees in the low to mid-six figures. These settlements will likely encourage the firm involved in bringing nearly all of these lawsuits to continue filing complaints. Given the almost unlimited supply of potential defendants, it seems likely that this second wave of disclosure-related litigation will continue.
Practical Considerations. In view of these developments, public issuers should look at their CD&A discussions with an eye towards demonstrating how their compensation programs link pay with performance, why they chose the performance targets used in the program and how the compensation committee’s decisions on executive compensation promoted the best interests of shareholders. Issuers should also continue to include an executive summary of the CD&A, avoid broad generalizations and boilerplate and use charts or graphs where helpful. More is not necessarily better, however. The focus should be on stating the issuer’s case and complying with the applicable disclosure rules as concisely as possible finding the right balance between including enough detail to adequately “state the case”, and so much detail that shareholders are overwhelmed and plaintiff’s lawyers have a roadmap for litigation. Reviewing precedents of other issuers in the industry and retaining compensation consultants to obtain information on current market practices can be very useful in helping an issuer determine how much detail to include.
Finally, if the 2012 vote was negative or substantially lower than in 2011, the issuer should consider being proactive in reaching out to significant shareholders who voted against the SOP proposal to determine their concerns and to take responsive action where appropriate. Although the SOP vote is not binding, a prudent board will want to modify compensation programs in ways that take shareholder concerns into account as a means of building rapport with shareholders and avoiding negative vote recommendations in director elections by ISS and Glass Lewis in the following year for lack of responsiveness.
While Form 10-Ks filed in 2013 for calendar year 2012 will not have to include “conflict minerals” disclosure, companies will need to start tracking the required information in 2013. Notwithstanding the current court challenge, as it presently stands the SEC will require disclosure of supply chain and sourcing information on the conflict minerals and metals contained in products that companies manufacture or contract to manufacture in each calendar year beginning on January 1, 2013. Most companies will have to disclose this information about 2013 in a Form SD filed no later than May 31, 2014, regardless of their particular fiscal year-end. Moreover, this disclosure obligation applies broadly and includes domestic companies and foreign private issuers, as well as smaller reporting companies.
Unresolved Related Dodd-Frank Rulemaking
Several Dodd-Frank corporate governance and executive compensation disclosure requirements have not yet been implemented through SEC rulemaking and consequently will not be effective for the 2013 proxy season. While none of these matters have a specified deadline for adoption, any of them could well the subject of rulemaking in 2013:
Pay-for-Performance/Internal Pay Equity. The Dodd-Frank Act directs the SEC to promulgate rules requiring a company to include a clear description of any executive compensation in its annual proxy statement, including information that shows the relationship between executive compensation actually paid and the financial performance of the company, taking into account any change in the value of the shares of stock and dividends of the company and any distributions (“pay for performance”). This disclosure may be presented graphically or in narrative form. In addition, the SEC is directed to amend Item 402 of Regulation S-K to require a company to disclose (1) the median of the annual total compensation of all employees of the issuer, except the CEO; (2) the annual total compensation of the CEO; and (3) the ratio between the CEO’s total compensation and the median total compensation for all other company employees (“internal pay equity”).
Clawback Policies. Dodd-Frank also requires the SEC to adopt rules requiring the national securities exchanges to amend their listing standards to require that listed companies adopt a policy providing that, in the event that a company is required to prepare an accounting restatement due to the material noncompliance with any financial reporting requirement under the securities laws, the company will recover from any current or former executive officers who received incentive based compensation (including stock options awarded as compensation) during the 3-year period preceding the date on which the company is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement.
Director and Employee Hedging. Under Dodd-Frank, the SEC is directed to promulgate rules requiring each company to disclose in any proxy or consent solicitation material for an annual meeting of the shareholders whether any employee or director, or any designee of such, is permitted to purchase financial instruments (including prepaid variable forward contracts, equity swaps, collars, and exchange funds) that are designed to hedge or offset any decrease in the market value of equity securities.