The 2018 proxy season brings forth a number of trending topics and new considerations public companies should bear in mind.
In this edition
– Executive Pay – Impact of Tax Cuts on Section 162(m) Amendments to Deduction Limit on Executive Pay
– Pay Ratio Disclosures
– Revised Guidance On Excluding Shareholder Proposals
– ISS and Glass Lewis 2018 Voting Policy Updates
– PCAOB's New Auditor's Reporting Model
– Form 10-K Changes and Other Considerations
Executive Pay – Impact of Tax Cuts on Section 162(m) Amendments to Deduction Limit on Executive Pay
On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (the Act), which includes many dramatic changes to the executive compensation deduction rules of Section 162(m) of the tax code.
Since 1994, Section 162(m) has limited the deductibility of payments to “covered employees” of publicly-held companies to the extent the payments exceed $1 million. Certain forms of “performance-based” compensation were excepted from this limitation. Executive compensation, including stock options, stock appreciation rights and cash and equity performance bonuses were generally excepted from the deduction limitation so long as they satisfied the conditions in Section 162(m).
The Act makes the following changes to Section 162(m) effective for company fiscal years beginning after December 31, 2017:
- Eliminates the “performance-based compensation” and commission exception—all compensation paid to a covered employee more than $1 million is now non-deductible;
- Deduction limitation will apply to the CEO, CFO and the three other most highly compensated officers for the taxable year (the “covered employees”). The amendment includes the CFO for the first time;
- Employees designated as covered employees after January 1, 2017, will remain covered employees for all future years; and
- Expands the coverage of 162(m) to corporations that have publicly traded equity or publicly traded debt, as well as certain foreign private issuers.
Planning for 162(m) Changes
Compensation Plan Design – Companies are no longer tied to the strict performance-based exception rules of 162(m). As a result, companies will be able to design performance goals and objectives with relative freedom and may establish goals more than 90 days into a performance period. Also, companies will be able to adjust payments based on actual performance and use discretion in making awards. Companies will be able to be more subjective when designing compensation packages giving them more flexibility to reward executives on non-financial measures.
Shareholder and Proxy Advisory Firm Considerations – Even though the deductibility of qualified performance-based compensation is no longer available, most companies will still want to continue using performance-based compensation as part of their compensation packages. Shareholders and proxy advisory firms are increasingly concerned that executive payment plans are tied to shareholder value and these views should be considered when designing executive pay packages.
Proxy Season 2018 Guidance
Determine Affected Employees and Conduct Modelling – Companies should determine their covered employees (including the CFO). Companies may also model the costs of compensating covered employees taking into account the federal corporate tax reduction, increase in covered employees, elimination of the performance-based compensation exception and transition rule contracts.
Review Existing Compensation Plans – Existing compensation plans may provide for flexibility to grant performance awards that are not intended to qualify as performance-based compensation. Also, the Section 162(a) provisions in existing cash and equity compensation plans may be eliminated.
Transition Rule Review – Companies should review all of their performance-based compensation arrangements in place at November 2, 2017, to determine if they are covered by the transition rule. Any performance-based payments made to covered employees under those arrangements will continue to be deductible, so long as no material changes are made to these arrangements.
Proxy Disclosure – Companies should review any current Section 162(m) proxy disclosure and consider appropriate modification taking into account any changes that the company makes or intends to make to its executive compensation program due to the amendments to Section 162(m).
Pay Ratio Disclosures
Despite hopes to the contrary, the 2018 proxy season will find most public companies including a required pay ratio disclosure for the first time. Under Item 402(u) of Regulation S-K, public reporting companies, other than smaller reporting companies, emerging-growth companies or foreign private issuers, must disclose in their upcoming proxy statements or Form 10-Ks: (1) the median annual total compensation of all employees, excluding the CEO; (2) the annual total compensation of the CEO; and (3) the ratio of these two totals. The ratio can be disclosed either as a factor—the pay ratio is 150:1—or as a multiple of the median employee’s compensation—the CEO’s compensation is 150 times that of the median employee’s compensation. The pay ratio rule was mandated in 2010 by the Dodd-Frank Act, with the SEC subsequently promulgating rules putting it into effect for fiscal years starting January 1, 2017.
Fortunately, what began as a potential disclosure liability quagmire, was greatly relieved recently by the SEC itself in an interpretive release that highlighted the rule’s flexibility to use reasonable estimates or assumptions in identifying the median employee. This ability to use estimates, assumptions and statistical sampling initially raised some concern about potential liability due to the imprecision of the results. In its interpretive release, however, the SEC indicated that the use of reasonable estimates, assumptions or methodologies in an issuer’s pay ratio calculations and disclosures would not provide the basis for an SEC enforcement action, unless the disclosure was made or reaffirmed without a reasonable basis or other than in good faith. In this regard, most companies are expected to follow the SEC staff’s guidance that the pay ratio may be disclosed as a reasonable “estimate.”
Companies should have already begun the process of assessing their employee population and payroll systems in order to determine a consistently applied compensation measure to identify the median employee. In this regard, the SEC said that companies may use their internal payroll or tax records that provide a reasonable accounting of median compensation as a pay measurement methodology even if they do not factor in all compensation, such as equity awards. Once the median employee is identified, the company must recalculate that employee’s compensation in the same way that the CEO’s annual compensation is calculated for the summary compensation table under Item 402(c)(2)(x) of Regulation S-K.
2018 Proxy Season Guidance
Companies with late annual meetings will have the benefit of seeing pay ratio disclosures by those with early annual meetings, as well as the investing public’s general reaction to the various levels of pay ratios disclosed. In either case, companies should be prepared with an employee communication plan as employees discover where they rank in relation to the median employee. While the media may focus more on the disclosed pay ratios among companies, the greater concern seems to be impact on employee relations.
The SEC’s non-enforcement position has relieved some of the pressure in determining the methodology to be used to identify the median employee and to calculate his or her annual total compensation. Companies should document this process, including the rationale for selecting the various methodologies, assumptions and estimates. Documentation describing the effort made to comply with the pay ratio rules will establish a company’s good faith compliance and facilitate compliance in future years.
Finally, companies should consider potentially modifying their overall compensation analysis and discussion (CD&A) to put the ratio in context. The pay ratio disclosure, however, is not required to be included in the CD&A, nor in its own separately sub-captioned section. It seems that many companies will be including the pay ratio disclosure following their director compensation discussion, and in as few words as necessary.
Revised Guidance on Excluding Shareholder Proposals
On November 1, 2017, the SEC staff issued Staff Legal Bulletin No. 14I, which provides guidance regarding no-action requests to exclude shareholder proposals under Rule 14a-8(i)(7) (the “ordinary business” exception) and Rule 14a-8(i)(5) (the “economic relevance” exception) from a company’s proxy materials. The guidance is part of a continuing effort by the SEC staff to clarify issues arising under Rule 14a-8 of the Exchange Act.
Ordinary Business Exception
Under Rule 14a-8(i)(7), a company may exclude shareholder proposals that concern matters relating to the company’s “ordinary business” operations from its proxy materials. In its analysis of whether a company can properly exclude such a proposal, the staff considers: (i) the proposal’s subject matter; and (ii) the degree to which the proposal “micromanages” the company. The staff will not, however, permit exclusion of a shareholder proposal under the ordinary business exception if the proposal transcends the company’s day-to-day business matters by raising a policy issue so significant that it would be appropriate for a shareholder vote. According to the staff, these determinations raise difficult judgment calls, which the company’s board is generally in the best position to make.
Accordingly, the guidance shifts responsibility from the SEC staff to the board to analyze significant policy issues under the ordinary business exception in the first instance. No-action requests made in reliance on Rule 14a-8(i)(7) will now be required to include a discussion of the board’s analysis of the particular policy issue raised and its significance to the company, and this discussion should detail the specific processes that the board used to ensure its conclusions were “well-informed and well-reasoned.” Of course, the guidance provides no insight into the level of board processes and analysis or how in-depth the description in the no-action relief request must be to be considered sufficient from the staff's perspective.
Economic Relevance Exception
The economic relevance exception, Rule 14a-8(i)(5), permits a company to exclude a shareholder proposal relating to company operations that account for less than 5 percent of a company’s total assets, net assets and gross sales, and is not otherwise significantly related to the company’s business. Companies rarely rely on this exception, as historically the SEC staff has been reluctant to agree that a proposal is not “otherwise significantly related to a company’s business” even when the topic does not meet the 5 percent threshold when the issue was of broad social or ethical concern. In the guidance, the staff acknowledges that its historical application of the economic relevance exception unduly limited the exclusion’s availability because it did not fully consider whether the proposal “deals with a matter that is not significantly related to the issuer’s business” and is therefore excludable.
Going forward, the staff will focus on a proposal’s significance to the company’s business regardless of whether it raises broad issues of social or ethical significance. The staff’s analysis will now be dependent on the particular circumstances of the company to which the proposal is submitted. Similar to its view on the ordinary business exception, however, the staff now will look to the company's board to provide its analysis as to whether a particular proposal is “otherwise significantly related to the company's business” as part of a company’s no-action request. The company's discussion should detail the specific processes used to ensure that the board’s conclusions are “well-informed and well-reasoned.” It remains to be seen how this exception will evolve and how the staff will analyze no-action requests under the revised guidance.
"Images" Under Rule 14a-8
Rule 14a-8(d) is one of the procedural bases for exclusion of a shareholder proposal in Rule 14a-8. It provides that a “proposal, including any accompanying supporting statement, may not exceed 500 words.”
According to the SEC staff, questions have arisen concerning the application of Rule 14a-8(d) to proposals that include graphs and/or images. In two recent no-action decisions (General Electric Co. (Feb. 3, 2017, recon. granted Feb. 23, 2017); General Electric Co. (Feb. 23, 2016)), the staff expressed the view that the use of “500 words” and absence of express reference to graphics or images in Rule 14a-8(d) do not prohibit the inclusion of graphs and/or images in proposals. Just as companies include graphics that are not expressly permitted under the disclosure rules, the staff is of the view that Rule 14a-8(d) does not preclude shareholders from using graphics to convey information about their proposals.
While the staff recognized the potential for abuse in this area, it found that these potential abuses can be addressed through other provisions of Rule 14a-8. For example, exclusion of graphs and/or images would be appropriate under Rule 14a-8(i)(3) where they:
- make the proposal materially false or misleading;
- render the proposal so inherently vague or indefinite that neither the stockholders voting on the proposal, nor the company in implementing it, would be able to determine with any reasonable certainty exactly what actions or measures the proposal requires;
- directly or indirectly impugn character, integrity or personal reputation, or directly or indirectly make charges concerning improper, illegal, or immoral conduct or association, without factual foundation; or
- are irrelevant to a consideration of the subject matter of the proposal, such that there is a strong likelihood that a reasonable shareholder would be uncertain as to the matter on which he or she is being asked to vote.
Moreover, according to the staff, “exclusion would also be appropriate under Rule 14a-8(d) if the total number of words in a proposal, including words in the graphics, exceeds 500.”
"Proposals by Proxy" Under Rule 14a-8
While Rule 14a-8 does not address shareholders’ ability to submit proposals through a representative, shareholders frequently elect to do so, a practice commonly referred to as “proposal by proxy.” The SEC staff has been, and continues to be, of the view that a shareholder’s submission by proxy is consistent with Rule 14a-8.
In this regard, there may be questions about whether the eligibility requirements of Rule 14a-8(b) have been satisfied. There have also been concerns raised that shareholders may not know that proposals are being submitted on their behalf. In light of these challenges and concerns, and to help the staff and companies better evaluate whether the eligibility requirements of Rule 14a-8(b) have been satisfied, going forward, the staff will look to whether the shareholders who submit a proposal by proxy provide documentation describing the shareholder’s delegation of authority to the proxy. In general, the staff expects this documentation to:
- identify the shareholder-proponent and the person or entity selected as proxy;
- identify the company to which the proposal is directed;
- identify the annual or special meeting for which the proposal is submitted;
- identify the specific proposal to be submitted (e.g., proposal to lower the threshold for calling a special meeting from 25 percent to 10 percent); and
- be signed and dated by the shareholder.
The staff believes that this documentation will alleviate concerns about proposals by proxy, and will also help companies and the staff better evaluate whether the eligibility requirements of Rule 14a-8(b) have been satisfied. Where this information is not provided, however, there may be a basis to exclude the proposal under Rule 14a-8(b).
ISS and Glass Lewis 2018 Voting Policy Updates
Both Institutional Shareholder Services (ISS) and Glass, Lewis & Co., Inc. (Glass Lewis), published updates to their proxy voting policies applicable to shareholder meetings held on or after February 1, 2018, (ISS) or January 1, 2018, (Glass Lewis). Below we highlight certain areas of focus in these updated proxy voting guidelines for companies to consider as they draft their proxy statements and prepare for their annual meetings.
Executive Compensation Matters
Pay Ratio – Both ISS and Glass Lewis indicated that the pay ratio will not impact their vote recommendations in 2018. They will, however, display pay ratio data in their research reports and proxy papers.
Say-On-Pay – ISS expanded its guidance on board’s responsiveness if a company’s prior say-on-pay vote received less than 70 percent of the votes cast. In addition to its current policy of considering a board’s response to investor concerns, ISS will now look for a more detailed disclosure regarding (i) the timing and frequency of the company’s engagements with major institutional investors; (ii) whether independent directors participated in such engagement in forming its vote recommendation; and (iii) the specific concerns voiced by dissenting shareholders, as well as the specific and meaningful actions taken by the company to address such concerns.
Non-Employee Director ("NED") Pay – ISS will generally recommend against board committee members who are responsible for setting or approving NED compensation if there is a recurring pattern of awarding “excessive… compensation without disclosing a compelling rationale or other mitigating factors” in two or more consecutive years from this point forward. While this will not impact voting recommendations in 2018, negative recommendations will be triggered in subsequent years if a pattern of excessive NED pay is identified. Although ISS doesn’t define excessive, it suggests that NED will be evaluated on a basis relative to peers and the broader market.
Gender Diversity – Board diversity remains a strong focus among institutional investors. ISS reports that companies with no female directors will receive a notation to that effect in its proxy research, but it will not make adverse vote recommendations due to a lack of gender diversity. Similarly, Glass Lewis will not make voting recommendations solely on a lack of gender diversity, but it may be noted in the company’s research report. Beginning in 2019, however, Glass Lewis will generally recommend against the nominating committee chair of a board with no female members.
Climate Change Proposals – ISS policy changes in this regard are intended to better align ISS’ policy with the recommendation of the Task Force on Climate-Related Financial Disclosures (TCFD), including transparency around the board and management’s role in assessing, measuring and managing climate-related risks and opportunities. ISS generally supports proposals seeking disclosure of risks related to climate change, including financial, physical and regulatory risks. Although generally supportive of the TCFD disclosure recommendations, Glass Lewis will review proposals requesting TCFD-style disclosures on a case-by-case basis. Moreover, Glass Lewis generally will recommend in favor of shareholder proposals requesting that companies in certain extractive or energy-intensive industries that have increased exposure to climate change-related risks provide information concerning climate-change scenario analyses and related considerations.
Board Independence – ISS will recommend voting against or withholding from non-independent directors if: (i) independent directors comprise 50 percent or less of the board; (ii) the non-independent director serves on the audit, compensation or nominating committee; (iii) the company lacks an audit, compensation or nominating committee; or (iv) the company lacks a formal nominating committee, even if the board attests that the independent directors fulfill the functions of such a committee.
Board Accountability – ISS will now issue an adverse vote recommendation for directors of companies that either opt into or fail to opt out of state laws requiring classified boards. This change signals ISS’ willingness to penalize companies that incorporate in states with laws that ISS views as unfriendly to shareholders. ISS also clarified that its policy on voting against or withholding votes from members of the governance committee will apply if a company’s governing documents contain undue restrictions on shareholders ability to amend the bylaws.
Shareholder Proposals on Gender Pay Gap – ISS expects to see more shareholder proposals on gender pay gap in the coming years. As such, ISS adopted a new policy to address shareholder proposals requesting that a company report whether there is a gender pay gap at the company, as well as on measures being taken to mitigate any existing gender pay gaps. Under the new policy, ISS will consider proposals related to gender pay gaps on a case-by-case basis, taking into account the following four factors:
- the company’s existing policies and disclosures on diversity and inclusion;
- the company’s compensation practices (and whether they are fair and equitable);
- whether the company has been the subject of any controversies, litigation or regulatory actions related to gender pay gap issues; and
- a comparison of the company’s disclosures regarding gender pay gap policies or initiatives to the disclosures of its peers.
The updated guidelines reflect the growing interest of institutional shareholders in gender diversity issues and are intended to provide more clarity on how ISS will evaluate these proposals versus the ISS policies on shareholder proposals relating to diversity and equality of opportunity generally.
Other Policy Changes
Pledging of Stock by Executives and Directors – ISS clarified its position on pledging of stock by executives or directors indicating that it will recommend a vote against the members of the committee that oversees risks related to pledging where ISS finds “excessing” pledging. ISS said that it will consider: (i) the presence of an anti-pledging policy, disclosed in the proxy statement, that prohibits future pledging; (ii) the magnitude of shares pledged, in terms of total shares outstanding, market value and trading volume; (iii) the disclosure of progress or lack thereof in reducing the magnitude of pledged shares over time; (iv) disclosure in the proxy statement that shares subject to stock ownership and holding requirements do not include pledged company stock; and (v) any other relevant factors.
Equity Plan Amendments – In its updated FAQs, ISS indicated that it will evaluate equity plan amendment proposals on a case-by-case basis. In this regard, ISS stated that its recommendation will generally be based on the Equity Plan Scorecard (EPSC) result if any of the following apply: (i) the proposal includes a material request for additional shares; (ii) the proposal represents the first time shareholders have had an opportunity to opine on the plan; (iii) the amendments include an extension of the plan’s term; or (iv) the amendments include the addition of full value awards as an award type when the current plan authorizes only option/SAR grants. If none of these scenarios apply, ISS will make a recommendation based on an analysis of whether the overall impact of the amendments is beneficial or contrary to the shareholders’ interests, regardless of EPSC score. In these cases, the EPSC score will be disclosed for informational purposes.
Poison Pills – ISS will recommend against all board nominees if a company has a poison pill with a term greater than one-year that has not been approved by shareholders. Unlike in the past, a company’s commitment to put a long-term pill to a vote the following year will no longer be considered a mitigating factor to a negative voting recommendation. More importantly, boards with 10-year pills that are have been grandfathered from 2009 under ISS’s policy will no longer be exempt and will receive negative recommendations. Adoption of short-term pills (one-year or less term), will continue to be assessed on a case-by-case basis, but ISS will focus more on the rationale for their adoption than on the company’s governance and track record.
PCAOB's New Auditor Reporting Model
In October 2017, the SEC approved a new PCAOB auditing standard, AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, intended to make public company auditor’s reports more informative to investors and the public. The new auditor report standard includes certain formatting and disclosure changes that are effective for audits of fiscal years ending on or after December 15, 2017, while the more significant changes will not be applicable for the upcoming proxy season.
Immediate changes for all issuers for fiscal years ending on or after December 15, 2017, include provisions requiring statements in the auditor’s report disclosing the auditors’ tenure and independence, and form standardizations, including new section titles to guide readers. For a company with a long-standing auditor, management may want to consider adding a discussion in the proxy statement to explain how the company benefits from the long-standing auditor relationship and the reasons that the company believes a long tenure does not impede the auditor’s independence.
Beginning with fiscal years ending on or after June 15, 2019, for large accelerated filers and December 15, 2020, for all other issuers, the new standard will require auditors to include new disclosures in their audit reports regarding “critical audit matters” or CAMs. As defined in the PCAOB standard and related amendments, CAMs is defined as any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that:
- relates to accounts or disclosures that are material to the financial statements; and
- involved especially challenging, subjective, or complex auditor judgment.
This marks the first major change to the standard form auditor’s report in 70 years, according to PCAOB Chairman James Doty. For any CAMs, the auditor must include disclosure in its auditor's report that identifies the CAM, describes the principal considerations that led the auditor to determine that the matter is a CAM, describes how the CAM was addressed in the audit, and refers to the relevant financial statement accounts or disclosures. The new auditor’s report will provide investors with more meaningful information about the audit, including significant estimates and judgments, significant unusual transactions and other areas of risk at a company.
Form 10-K Changes and Other Considerations
The SEC implemented a few form changes over the past year that companies should keep in mind in preparing Form 10-K, including new checkboxes and hyperlinked exhibits. These changes were followed by new proposed rule amendments in October 2017 by the SEC to modernize and simplify the disclosure requirements for public companies. The changes do not apply to certain filings, such as Forms 6-K and certain forms required to be filed by Canadian issuers pursuant to the multijurisdictional disclosure system.
Hyperlink Exhibits – On March 1, 2017, the SEC adopted rule and form amendments that were intended to make it easier for investors and other EDGAR users to find and access exhibits in registration statements and periodic reports that were originally provided in earlier filings The rule amendments became effective on September 1, 2017, and require most companies to include a hyperlink to each exhibit listed in the exhibit index of its registration statements and its current and periodic reports subject to the exhibit requirements under Item 601 of Regulation S-K, including Form 10-K.
The hyperlink requirement covers both exhibits that are filed as part of a registration statement or periodic report and exhibits that are incorporated by reference to prior filings. As a result, companies will have to identify the URLs for the exhibits that were previously filed by each (in some cases decades ago), and which are incorporated by reference into its current filings. The new rules, however, do not require companies to hyperlink to an exhibit that was not filed electronically, or to refile exhibits that have previously been filed in paper.
Exhibit Index – At the same time, the SEC also revised Item 601(a)(2) to require that the exhibit index be placed before the required signatures in the registration statement or periodic report. In this regard, the SEC staff has informally indicated that companies can combine the exhibit list (e.g., Item 15 of Form 10- K; Item 16 of Form S-1) with the exhibit index and place the exhibit index, with hyperlinks, before the signature pages of the registration statement or report. In this way, a separate exhibit index page (after the signature pages) is no longer required.
HTML Format – These changes also require companies to file any registration statement or periodic report subject to the hyperlinking requirement in HTML format (Hypertext Markup Language) because the American Standard Code for Information Interchange (“ASCII”) format cannot support functional hyperlinks. Any schedules or forms that are not subject to the hyperlinking requirement, such as proxy statements, may continue to be filed in ASCII. Non-accelerated filers and smaller reporting companies that submit filings in ASCII will not need to comply with these requirements until September 1, 2018.
Although the SEC initially proposed to eliminate the option to use ASCII altogether, after consideration of public comments, the final amendments permit companies to continue to use ASCII for any schedules or forms that are not subject to the new hyperlink requirement.
Cover Page Changes – The SEC also made minor changes to the cover page for registration statements and current and periodic reports, including Form 10-K. A company must now include two new check boxes to indicate whether, at the time of filing, the company is an “emerging growth company” (EGC) and, if it is an EGC, whether it elects not to use the extended transition period for compliance with new financial accounting standards.