SEC Press Release, May 2009 — The Securities and Exchange Commission today voted to propose a comprehensive series of rule amendments to facilitate the rights of shareholders to nominate directors on corporate boards.
SEC Press Release, July 2009 — The Commission proposed a set of new rules intended to improve the disclosure provided to shareholders of public companies regarding…The relationship of a company's overall compensation policies to risk.
New York Times, July 2009 — Wall Street's bonus culture is widely seen as having encouraged the excessive risk-taking that set off the financial crisis.
Bob Dylan, "Subterranean Homesick Blues," March 1965 — You don't need a weatherman to know which way the wind blows.
Normally, reacting to the potential effects of proposed Securities and Exchange Commission (SEC) rules can be premature; while they provide directional guidance, proposed rules are frequently revised in substantive ways prior to ultimate adoption and sometimes they are withdrawn or abandoned. In the case of the SEC's recently announced proposals to enhance company disclosure about the role of risk in compensation policies (SEC Release Nos. 33-9052; 34-60280; IC-28817; Proxy Disclosure And Solicitation Enhancements (the "Risk Release")) and to provide shareholders the ability to nominate director candidates directly in company proxy materials (SEC Release Nos. 33-9046; 34-60089; IC-28765, Facilitating Shareholder Director Nominations (the "Nomination Release")), it is hard to imagine that these will be left to molder. In fact, recent headlines would only seem to intensify the pressure on the SEC to adopt these and other initiatives that will likely make life more complex for public company management and directors.
Risk Release Overview
If the rules proposed in the Risk Release are adopted, public companies will be required to expand the Compensation Discussion and Analysis (CDA) required in their annual meeting proxy statements to include a new section that will provide information about how overall compensation policies create incentives that can affect company risk taking and risk management. The revised CDA would require a discussion, not only of the company's broader compensation policies, but also the actual compensation practices if risks arising from those policies and practices may have a material effect on the company. The SEC expects that in "preparing this disclosure…companies will need to consider the level of risk that employees might be encouraged to take to meet their incentive compensation elements." Apparently, the SEC believes that by being required to describe and disclose its risk assessment deliberation process, company management and the board (and committees thereof) will more fully consider the potential for risk when designing and implementing a compensation system.
It is important to note that the proposed risk discussion would extend to non-executive employees if the potential compensation of those employees could create material risk. Accordingly, disclosure could be required regarding particular business operating units that carry a greater risk profile, have compensation structured differently that other units within a consolidated company, are significantly more profitable than others within a company, in which compensation expense is a significant percentage of revenues, or in which bonus compensation is awarded on a "success basis" (i.e., upon consummation of a task) while the ultimate income and risk of that task extend over a longer period of time.
The proposed rules would also revise in certain technical respects how equity compensation is disclosed in the various proxy statement compensation tables; that is, requiring disclosure in the summary compensation table of the value of the compensation on the date of grant rather than just the annual equity compensation expense recognized by the company in its most recent annual income statement. One can argue that this is mostly "reshuffling" the presentation of data that is already required. Also, additional biographical information on director candidates would be required that goes beyond the typical five-year look back of current disclosure and a discussion of the particular skills and experiences that qualify a candidate to serve will need to be provided. Not surprisingly, one of the matters to be disclosed under the proposed new rules would be information about a director's or nominee's risk assessment skills. Moreover, existing disclosure requirements about certain legal proceedings involving a director or nominee would be increased to a 10-year "look back" period from the current five-year period.
Consistent with this enhanced "risk disclosure" theme, the proposed rules would mandate disclosure regarding a company's leadership structure. This would entail a discussion of why, for example, a company did not separate the CEO and Chairman's roles or adopt a lead independent director structure. A discussion of the board's role in the company's risk management process will also be required. The SEC has also proposed (presumably for identification of potential conflicts of interest) additional mandatory disclosure about the services that compensation consultants provide to the company in addition to pure compensation advisory work. For example, if a compensation consultant, directly or through an affiliate, provides benefits administration, actuarial services or human resources consulting, then the fees earned for these services would have to be disclosed.
While not likely to be quite as controversial as the rules proposed in the Nomination Release discussed below, the proposed new compensation disclosure rules will likely increase pressure on public companies to be more careful about how they describe and, potentially, design their compensation systems. Moreover, the quality or lack of meaningful risk disclosure could well create a new basis for stockholder lawsuits when — viewed with hindsight — corporate performance suffers, and when risks (even risks worth taking on an informed basis) negatively affect financial results. In addition, the proposed new disclosures may influence the structure of executive compensation packages and programs as public companies respond directly to investor perceptions as to the proper role of risk in a particular company's compensation system and stockholder judgments as to best compensation practices.
Nomination Release Overview
The Nomination Release proposes comprehensive new rules mandating direct stockholder access to the proxy materials of domestic reporting companies. In so doing, the SEC observed that its proposal (which, in large measure, would "federalize" an area of corporate governance historically relegated to state corporate legislatures and embodied in corporate organizational instruments) attempts, in the wake of the recent Wall Street financial crisis, to eliminate "unnecessary barriers" to the ability of stockholders to "hold boards accountable through the exercise [by such stockholders] of their fundamental right to nominate and elect…directors."
In short, the SEC's proposed amendments to current Rule 14a-8 and the proposed adoption of new Rule 14a-11, would permit stockholders who own more than one percent (in the case of a "large accelerated" public company), three percent (in the case of an "accelerated" public company) and five percent (in the case of a "non-accelerated" public company), to submit a "short-slate" of their director-nominees for inclusion directly in the company's proxy materials. The nominating stockholder would have to certify that it has owned the requisite percentage of outstanding shares continuously for a period of at least 12 months and that it is not seeking, through such nomination and direct proxy-access, to change or influence control of the company. Moreover, the stockholder could not nominate more than the greater of one director-candidate or 25 percent of the size of the existing board (with certain exceptions in the case of companies with "classified boards").
Proposed Rule 14a-11 would require certain disclosures and representations relating to the nominating stockholder and its nominees, as well as with respect to the nature and extent of relationships, if any, between the nominating stockholder or its nominees, on the one hand, and the company or any of its affiliates, on the other hand. To an extent, these disclosures are not dissimilar to certain of the information required by existing federal proxy rules (in the case of company nominees included in the company's proxy statement) and the provisions of company "advance notice" bylaws (governing shareholder nominations of directors for election at annual meetings outside of the company's proxy materials). Most interestingly (albeit, perhaps functionally problematic), the SEC has proposed a "notice-race" (or "first-in-time") system to address the scenario where more than one insurgent stockholder request for direct proxy-access is received by a company. In such a case, if the company timely and properly receives more stockholder nominations than the company is required to accommodate (by reason of the cap on the number of nominees described above), the nominating stockholder who first provides proper notice "wins" and its nominees would be included in the company's proxy materials. In all cases, subject to the nominee cap, the "runner up" (or "next-in-time") stockholder would have the right to include its nominees in the company's proxy materials to the extent that the first-in-time stockholder did not nominate the maximum cap number permitted by proposed Rule 14a-11. One certainly can envision a range of potential administrative and practical complications arising from such a system.
The SEC's proposed direct proxy-access rules contain procedures for challenging the eligibility of stockholder nominations (generally analogous to the procedures contained in current Rule 14a-8 with respect to stockholder submissions for inclusion in company proxy materials of non-director nomination and election proposals), deadlines for "timely submission" (that may well conflict with the nomination submission deadlines contained in the advance notice bylaws of many companies), limitations on the content and length of stockholder support statements to be included in the company's proxy materials, certain technical and clarifying amendments to current SEC rules exempting certain stockholder communications from the definition of "solicitation," the eligibility of stockholders submitting Rule 14a-11 proposals to remain eligible (as a "passive investor") to report their five percent or more holdings on Schedule 13G in lieu of Schedule 13D, and provisions imposing liability on nominating stockholders who furnish information for inclusion in company proxy materials that contain material misstatements or omissions.
This latest proposed iteration of federally mandated direct proxy access is a culmination of more than a decade of SEC review and rulemaking initiatives on the subject and, therefore, is expected to be the subject of continuing controversy and, very likely, modification, before the rules are adopted in definitive form. Indeed, the current proposal was published over a split 3-2 vote of the SEC's Commissioners.
Apart from the robust debate on whether this area of corporate governance (and boardroom access) is best left to private ordering and should remain within the exclusive jurisdiction of state legislatures (e.g., the "opt-in" direct proxy access system contained in Sections 112 and 113 of the Delaware General Corporation Law which become effective on August 1, 2009), the SEC's current nomination proposal animates a broad range of legal, commercial and practical implications. As in the case of most legislative initiatives that impose fundamental policy change, not all of these implications can be fully appreciated before the proposed rules are finalized. Not atypically and to its credit, the SEC poses in the Nomination Release literally hundreds of specific questions and requests for public comment and recommendations. In view of the fundamental importance of the issue, the results and comment process which, to date, has been rather extensive, will shape the final rules.
To the extent adopted substantially as proposed, the SEC's direct proxy access proposal — combined with its recently adopted "stockholder forum communication" and e-Proxy rules, the elimination of discretionary broker voting in uncontested director elections, the continuing trend of companies adopting majority (or other forms of non-plurality) voting requirements for director elections, and certain recent state judicial decisions that restrict the permissible use of organic "shark repellents" and structural anti-takeover mechanisms — will facilitate for the foreseeable future a continued surge in institutional stockholder activism, dissident proxy campaigns, contests for corporate control, and unsolicited and alternative M&A transaction activity.
The SEC indicates that if the rules proposed by the Risk Release are adopted, they will be effective for the 2010 proxy season. Given their complexity and somewhat unprecedented nature, it is less clear when the rules proposed by the Nomination Release would become effective. In any event, it is clear which way the wind is blowing — for now.