Wall Street Lawyer (Vol. 17, 3)
Say What? Smaller Reporting Companies Subject to Say-on-Pay in 2013; When Do You Need to Start Complying With New NASDAQ and NYSE Compensation Committee Rules? New Form of Due Diligence: Relationships with Compensation Consultants; Netflix’s CEO Facebook Posting Continues to Trigger Debate
Say What? Smaller Reporting Companies Subject to Say-on-Pay in 2013
Smaller reporting companies are subject to say-on-pay and say-on-frequency votes for the first time this year. In January 2011, the U.S. Securities and Exchange Commission (SEC) adopted final rules implementing the say-on-pay and say-on-frequency requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act). Under such rules, public companies are required to conduct shareholder advisory votes: (i) to approve the compensation of executives, as disclosed pursuant to Item 402 of Regulation S-K; and (ii) to determine how often an issuer will conduct a shareholder advisory vote on executive compensation. Pubic companies, other than smaller reporting companies, were required to conduct such votes starting with the 2011 proxy season. Smaller reporting companies did not have to conduct such votes until their first annual or other meeting of shareholders occurring on or after January 21, 2013.
In drafting their proxy statements for this year’s annual meeting, smaller reporting companies should look to strategies utilized by other public companies during the past two proxy seasons to avoid a failed say-on-pay vote. For example, public companies have been using their proxy statements, especially their Compensation Discussion and Analysis (CD&A) section, as an opportunity to explain their executive compensation practices to shareholders. Although smaller reporting companies are not required to include a CD&A in their proxy statements, they may want to include disclosure similar to the CD&A, or, at a minimum, a summary of executive compensation practices in their proxy statements this year to discuss the company’s compensation philosophy and how executive compensation is aligned with performance.
When Do You Need to Start Complying With New NASDAQ and NYSE Compensation Committee Rules?
On January 11, the SEC approved proposed changes to the listing standards of the New York Stock Exchange LLC and NASDAQ Stock Market LLC related to compensation committees. Both exchanges created transition periods to comply with the new rules.
As of July 1, 2013, NASDAQ-and NYSE-listed companies will be required to comply with the new rules relating to the authority of a compensation committee to retain compensation consultants, legal counsel, and other compensation advisers; the authority to fund such advisers; and the responsibility of the committee to consider independence factors before selecting such advisers. The requirement that such authority and responsibilities of the compensation committee be included in the compensation committee’s written charter does not apply until a later date (see below) for NASDAQ-listed companies, and such companies should consider under state corporate law whether to grant such specific responsibilities and authority through a charter, resolution or other board action. In contrast, NYSE-listed companies will have to amend their existing charters as of July 1, 2013 to address these additional rights and responsibilities of the compensation committee related to compensation consultants, legal counsel, and other compensation advisers. To the extent a NASDAQ-listed company does not have a compensation committee by July 1, 2013, these requirements will apply to the independent directors who determine, or recommend for the board’s determination, the compensation of the CEO and other executive officers of the company.
The remaining new rules—for example, compensation committee charter and independence standards for compensation committee members—will not have to be complied with by NASDAQ-listed companies until the earlier of their first annual meeting after January 15, 2014, or October 31, 2014. NYSE-listed companies will have until the earlier of their first annual meeting after January 15, 2014, or October 31, 2014, to comply with the new standards for compensation committee director independence.
New Form of Due Diligence: Relationships with Compensation Consultants
Due to recent SEC rulemaking,1 conflicts of interest with compensation consultants are at the forefront of disclosure issues in 2013 proxy season. The SEC added paragraph (e)(3)(iv) to Item 407 of Regulation S-K concerning issuers’ use of compensation consultants and related conflicts of interest to implement Section 952 of the Dodd- Frank Act. New Item 407(e)(3)(iv) disclosure, which should be addressed in any proxy or information statement for a meeting of shareholders at which directors will be elected occurring on or after January 1, 2013, expands disclosures related to compensation consultants.
Generally, Item 407(e)(3) requires public companies subject to the SEC proxy rules to describe the company’s procedures for the consideration and determination of executive and director compensation. In 2009,2 the SEC amended Item 407(e)(3) to bring to light conflict of interest situations arising when a consultant is paid for both compensation consulting services as well as other services (for example, benefits administration, human resources consulting and actuarial services) because such dual engagement may affect the independence of the advice related to compensation matters. Amendments to Item 407(e)(3) adopted in 2012 are broader in their scope and require3 public companies, in the case of compensation consultants that played any role in determining or recommending the amount or form of executive and director compensation during the company’s last completed fiscal year and whose work has raised any conflict of interest, to disclose the nature of the conflict and how the conflict is being addressed. Instruction to Item 407(e)(3)(iv) states that, among the factors that should be considered in determining whether a conflict of interest exists, companies should review the same factors as the ones that should be evaluated by the compensation committee in connection with its assessment of the independence of a compensation adviser.4
In order to prepare the disclosure related to compensation consultants for this proxy season, companies need to carefully conduct due diligence on their relationships with compensation consultants and solicit conflict information, whether via a formal compensation consultant questionnaire or otherwise, in order to evaluate whether a conflict of interest exists in their relationships with compensation consultants.
If the company had a compensation consultant that played any role in determining or recommending the amount or form of executive and director compensation during the company’s last completed fiscal year, the company needs to clearly understand the parameters of this role. If such role in executive or director compensation was limited to only:
- consulting on any broad-based plan that does not discriminate in favor of executive officers or directors of the company and that is available generally to all salaried employees (for example, 401(k) plan or health insurance plan); or
- providing information that is not customized for a particular company or, if customized, is based on parameters that are not developed by the compensation consultant, and about which the compensation consultant does not provide advice, then activities of such compensation consultant are not covered by the SEC disclosure rules.
If the compensation consultant’s role was broader than just providing the general services described above, then the company should be able to clearly identify (i) the nature and scope of the compensation consultant’s assignment; and (ii) the material elements of the instructions or directions given to the consultants with respect to the performance of their duties. The company should identify all types of services provided by the compensation consultant or its affiliates, including the person that employs the compensation consultant, during the company’s last completed fiscal year in addition to recommendations on the amount or form of executive and director compensation. Such information not only affects the level of disclosure, but also is a factor in the company’s determination of whether the conflict of interest exists in the relationship with the compensation consultant.
The company should also focus on the role played by the compensation committee (or persons performing the equivalent functions) or management in the engagement of the compensation consultant. For example, if the compensation consultant was engaged by the compensation committee, the company should determine whether:
- the decision to engage the compensation consultant or its affiliates for other services was made, or recommended, by management; and
- the compensation committee or the board approved such other services of the compensation consultant or its affiliates.
The amount of fees5 paid to compensation consultants should be very carefully tracked and companies should distinguish fees paid for compensation consulting services and additional services performed by the consultant or its affiliates during the company’s last completed fiscal year. If fees for such additional services did not exceed $120,000, then public companies are not obligated to disclose the aggregate fees paid to the compensation consultant for (i) determining or recommending the amount or form of executive and director compensation; or (ii) any additional services provided by the compensation consultant or its affiliates. However, the amount of fees paid by the company to the person that employs the compensation consultant (irrespective of the amount) as a percentage of the total revenue of such person is one of the factors that should be considered in determining whether a conflict of interest with the compensation consultant exists.
In order to be able to evaluate whether the relationship with a compensation consultant during the company’s last completed fiscal year presented any conflict of interest issues, the company should also go through the following “due diligence” steps:
- request either a copy or a description of the policies and procedures of the person that employs the compensation consultant that are designed to prevent conflicts of interest;
- inquire about any business or personal relationship of the compensation consultant with a member of the compensation committee (or persons performing the equivalent functions) as well as any business or personal relationship of the compensation consultant or the person employing the consultant with an executive officer of the company; and
- obtain information regarding any company stock owned by the compensation consultant (the SEC believes that this inquiry should also include the stock owned by family members of the compensation consultant).
Generally, for the purposes of these conflict of interest determinations, the term “compensation consultant” is viewed broadly and includes members of the consultant’s team working on the company’s engagement.
There are no materiality thresholds included in the foregoing factors related to the conflict of interest determinations, which makes it more difficult for companies to determine which compensation consultant had a conflict of interest. A public company is not required to use only those compensation consultants that are free from any conflict of interests. However, through disclosure rules regulations, the SEC sends a clear message that the consultants’ recommendations regarding executive and director compensation should not be influenced by various conflicts of interest that may exist between the company and the compensation consultant.
Netflix’s CEO Facebook Posting Continues to Trigger Debate
We have previously written about the fact that Netflix and its CEO, Reed Hastings, each received a “Wells Notice” from the SEC Staff over Hastings’ Facebook post in July 2012, in which Mr. Hastings wrote that Netflix’s members had enjoyed over 1 billion hours in June 2012.6 The SEC Staff indicated in the Wells Notice its intent to recommend to the SEC that it institute a cease and desist proceeding and/or bring a civil injunctive action against the company and Mr. Hastings for violations of Regulation FD, § 13(a) of the Securities Exchange Act and Rules 13a-11 and 13a-15.
Mr. Hastings continues to post on Facebook and said in an interview on January 30, referring to his July post, “I’m not going to back down and say it’s inappropriate. I think it’s perfectly fine. Sometimes you’re just the example that triggers the debate.” Mr. Hastings post has indeed triggered the debate of what constitutes “public disclosure” of material information under Regulation FD.
Regulation FD requires a public company to publicly disclose material, nonpublic information (oral or written) that is selectively disclosed to market professionals and security-holders. Under the regulation, the required public disclosure may be made by filing or furnishing a Form 8-K, or by another method or combination of methods that is reasonably designed to effect broad, nonexclusionary distribution of the information to the public.
Despite this broad approach, from the time of the adoption of Regulation FD in 2000 until August 2008, a press release or a Form 8-K was practically the only form of distribution of information under Regulation FD. In August 2008, when the SEC issued its Guidance on the Use of Company Web Sites (2008 Guidance) it officially acknowledged that a company Web site could serve as a broad, non-exclusionary method of distribution of the information to the public under Regulation FD, provided (i) such Web site is a recognized channel of distribution; (ii) posting of information on a company Web site disseminates the information in a manner making it available to the securities marketplace in general; and (iii) there has been a reasonable waiting period for investors and the market to react to the posted information.
The debate started by Mr. Hastings has revealed that there are two unofficial “camps” on this issue: one camp believes that CEOs and other public company executive officers should refrain from posting company information on social media to ensure that Regulation FD and other securities rules and regulations are not violated; and the other camp encourages the SEC to take a clear position on which social media postings would be considered Regulation FD compliant given the role that social media is playing in our society today.
It seems that Prof. Joseph A. Grundfest, of Stanford Law School and former SEC Commissioner, 7 is in the second camp. On January 30, Stanford Law School and The Rock Center for Corporate Governance published his article, Regulation FD in the Age of Facebook and Twitter: Should the SEC Sue Netflix? This article is in the form of an amicus Wells Submission and suggests that the SEC should proceed by rulemaking to address issues raised by the evolution of social media, instead of initiating enforcement proceedings against Netflix and Mr. Hastings. Prof. Grundfest’s article stated that any prosecution on these facts would constitute a “dramatic divergence from precedent” and would violate the SEC’s commitments not to “second guess” good faith attempts to comply with Regulation FD. Prof. Grundfest also believes that while the posting was not “inconsistent with the Commission’s 2008 Guidance regarding the implementation of Regulation FD and the use of company Web sites, that guidance is, in any event, outdated because it fails to account for the evolution of social media.”
Other interesting arguments outlined in Prof. Grundfest’s article include the following:
- Regulation FD is vulnerable as an unconstitutional restraint on truthful speech, particularly as applied on the facts of this case.
- The Staff’s Wells Notice has already had a chilling effect on the use of social media without a contemporaneous Form 8-K filing. The Staff has thus obtained much of the remedy it seeks without subjecting its action to SEC review.
- The proposed enforcement action is a questionable allocation of limited agency resources.
- The SEC’s regulatory solution should emulate many practices that are now common in the social media rather than challenge information dissemination through the social media.
Generally, I give conservative advice to executives to stay away from the social media posts until the SEC comes out with additional rulemaking on this issue. But I have to confess that I became one of Mr. Hastings’ 200,000-plus followers on Facebook to be able to follow firsthand his posts that may lead the SEC to extend permissible, broad nonexclusionary forms of distribution of information under Regulation FD to social media.