Including a look ahead to other Dodd-Frank Act proxy or executive compensation related new rules
On August 25, 2010, the SEC adopted new proxy rules that are expected to be effective for most public companies for the 2011 proxy season. The new rules facilitate shareholder access to director nominations by requiring public companies subject to the new rules to include in their proxy materials director nominees proposed by certain shareholders. Although the SEC has limited the shareholders who may use these new rules to those that meet long-term, significant ownership thresholds (generally 3 percent, with a three-year holding period), this new direct access to the use of a company’s proxy materials is material because it greatly reduces the costs and procedural challenges involved in proposing a director nominee and, therefore, makes it more likely that a shareholder meeting the threshold requirements, or a group of shareholders owning smaller amounts banding together, will nominate its own director candidates. The new rules also amend certain existing proxy rules to provide that public companies may not exclude from their proxy materials shareholder proposals that seek to establish even less restrictive proxy access procedures, which could reduce the requirements for access.
Although the SEC had previously proposed the proxy access rules in 2009, the SEC was no doubt spurred into finally adopting these rules by the passage on July 21, 2010 of the Dodd-Frank Wall Street Reform and Consumer Protection Act’s enabling legislation. In addition to the new proxy access rules, public companies should also be focusing on the various other proxy and executive compensation related matters that have been mandated by the Dodd-Frank Act. A brief summary of these matters, some of which will also be effective for the 2011 proxy season, are described below.
To Whom Do the New Proxy Access Rules Apply?
The new proxy access rules apply to all companies that are subject to the SEC proxy rules, including investment companies and controlled companies, but excluding “debt-only” companies. The new proxy access rules do not apply to foreign private issuers, but do apply to other foreign issuers that are subject to US proxy rules unless applicable foreign law prohibits shareholders from nominating directors.
When Do the New Rules Apply?
The exact effective date of the new proxy access rules has not yet been determined, as it depends on when the rules are published in the Federal Register (i.e., 60 days after their publication). Companies whose first anniversary of their 2010 proxy materials occurs within 120 days of the new rules’ effective date are required to comply with the new rules. For example, if you assume a Federal Publication date of September 12, 2010, all companies that mailed their 2010 proxy materials on or after March 11, 2010 would be required to comply with the new rules. New Rule 14a-11 provides smaller reporting companies (generally, companies that have a public float of less than $75 million) a three-year phase-in period.
The SEC has stated that it will evaluate during that period whether to make changes to the rules or accommodations for smaller reporting companies. However, this three-year phase-in period for smaller reporting companies does not apply to the Rule 14a-8 amendments described below. Therefore, during the three-year-phase-in period, a smaller reporting company could still become subject to proxy access through shareholder approval of a binding proxy access bylaw amendment submitted under Rule 14a-8(i)(8).
New Proxy Access Rules Summarized
New Rule 14a-11
A summary of some of the key points of the new proxy access rules include:
- The nominating shareholder or group must have both investment and voting power over 3% of the company¡¦s voting securities that can vote on director elections. Shares that a nominating shareholder has sold in a short sale or borrowed do not count towards the 3%. Shares loaned to others count so long as the shareholder or group can and does recall the shares for the vote. This provision helps, among others, large pension funds or other holders who lend shares as a means of generating revenue.
- The nominating shareholder or group must have held the required percentage of voting securities for at least three years at the time of providing notice to the company of its intent to nominate directors, must continue to hold those securities through the date of the shareholder meeting, and must disclose its intentions about whether it plans to keep those securities after the meeting. If a nominating shareholder or group fails to continue to hold the requisite amount of voting securities as required by the rule, a company may exclude the nominee or nominees submitted by the nominating shareholder or group.
- A company will not be required to include more than one shareholder nominee, or a number of nominees that represents up to 25% of the company¡¦s board of directors, whichever is greater (rounded down to the nearest whole number). In the case of companies with staggered boards, the 25% calculation is based on the total number of board seats (not the number of board seats up for election in any particular year). Where there are multiple eligible shareholders, the nominating shareholder or group with the highest percentage of the company¡¦s voting power is given precedence over other shareholders or groups.
- A nominating shareholder or group will not be eligible to use Rule 14a-11 if it has an agreement with the company regarding the nomination of the nominee. This prevents a nominating shareholder or group from acting in concert with the company or its management to block the utilization of the rule by another nominating shareholder or group.
- The nominating shareholder or group must certify that it lacks a change in control intent and does not intend to gain more board seats than the number of nominees a company could be required to include in its proxy materials under Rule 14a-11.
- The nominees of exchange listed public companies must meet the objective independent director standards of such exchange and must not violate applicable laws or regulations. The nominee will not be required to meet other director qualification standards included in the company¡¦s organizational documents or committee charters. The shareholder or group will, however, be required to disclose whether, to its knowledge, the nominee satisfies those standards.
- There is no limitation on the extent of relationships between the nominating shareholder and the nominee. Therefore, a shareholder or group could nominate himself or a member of the group, respectively.
- The nominating shareholder or group would be required to file a Schedule 14N notice with the SEC and provide a copy to the company.
- The Schedule 14N must be provided during the period from 150 days to 120 days prior to the first anniversary of the mailing date of the company¡¦s prior year proxy materials.
- In addition to the disclosures noted above (e.g., concerning a shareholder¡¦s ownership of and intent to hold company securities, lack of change in control intent or intent to gain a larger number of seats, and knowledge as to the nominee¡¦s compliance with the company¡¦s director qualification standards), other disclosures required to be included in Schedule 14N include:
- security ownership amounts held by the nominating shareholder or group and holding period of such securities;
- information about the nominating shareholder or group and nominees that is based upon the information required to be provided to shareholders in a proxy contest;
- information about any relationships between the nominating shareholder or group, the director nominee and the company or any affiliate of the company, including any agreement, pending or threatened litigation or other material relationship; and
- if the shareholder desires, a statement of support for the nominee that is no longer than 500 words.
- If the company questions a nominating shareholder¡¦s or group¡¦s eligibility pursuant to Rule 14a-11, the company must notify the nominating shareholder or group and provide the nominating shareholder or group a chance to respond. Thereafter, if the company continues to question a nominating shareholder¡¦s or group¡¦s eligibility, no later than 80 days before the company files its proxy statement the company must provide notification of its intent to exclude the nominee from its proxy materials. Similar to the existing Rule 14a-8 process, there will be a no-action process through which companies can seek the informal views of the SEC staff with respect to the eligibility of a nominating shareholder or group to propose a director candidate that must be included in a company¡¦s proxy materials pursuant to Rule 14a- 11.
- Companies will not be liable for information provided by the nominating shareholder or group and included in the proxy statement unless they specifically incorporate that information. Companies should take this into consideration in crafting incorporation by reference disclosures.
Amendments to Rule 14a-8
- The SEC also amended certain provisions of Rule 14a-8 that govern when a shareholder proposal can be excluded from a company proxy statement. Amended Rule 14a-8 will require inclusion of shareholder proposals that would amend or solicit an amendment to a company’s governing documents that relate to the director nomination process, so long as the proposals do not conflict with applicable law, including Rule 14a- 11. Prior to these changes, the SEC interpreted Rule 14a-8 as permitting public companies to exclude proposals relating to elections. As a result of these amendments, the shareholder proposals that will be required to be included in a company’s proxy materials may go beyond Rule 14a-11 but may not limit the operation of that rule (e.g., a shareholder could request to include a proposal in the company’s proxy statement that would lower the eligibility thresholds for director nomination submissions but could not request the inclusion of a proposal that would increase such thresholds).
- The SEC did not amend the eligibility provisions for Rule 14a-8; therefore a shareholder owning significantly less shares than those required for a Rule 14a-11 nomination can request inclusion of a Rule 14a-8 proposal. Shareholders need only have continuously held for at least one year $2,000 in market value (or 1%, whichever is less) of the company's securities entitled to be voted on the proposal to be eligible to submit a Rule 14a-8 proposal.
A Look Ahead: Other Dodd-Frank Proxy or Executive Compensation Related Rules
The new proxy access rules are just the first in a series of expected SEC rules and/or interpretations that will affect proxy statements and executive compensation matters as a result of the enactment of the Dodd-Frank Act. A brief summary of some other Dodd-Frank Act mandated matters are described below.
- Say-on-Pay: Generally all public companies (holding shareholders meetings after January 21, 2011) will be required to include a non-binding “say-on-pay” proposal concerning named executive officer compensation in their 2011 annual meeting proxy statements and a proposal to determine how frequently (at least once every three years) such “say-on-pay” proposals must be included thereafter. Public companies will also be required to resubmit the frequency on say-on-pay proposal to their stockholders at least once every six years. While these required proposals are non-binding, boards that do not adhere to the shareholders’ vote on these matters may experience investor relations issues and may see an increase in votes being withheld from or cast against their directors, particularly members of their board’s compensation committee.
- Say-on-Golden Parachutes: With respect to shareholders meetings to approve a merger or other business combination transaction occurring after January 21, 2011, the Dodd-Frank Act requires that the shareholders be given an opportunity to also cast a separate, non-binding vote on any compensation arrangements of the named executive officers that are based on or otherwise relate to such transaction. If the change-of-control compensation arrangements have been previously approved pursuant to a say-on-pay vote, no separate vote is required at the time of transaction.
- Compensation Committee Independence: Although public companies listed on a national securities exchange are already required to have a compensation committee comprised of all independent directors (subject to certain exceptions), the Dodd-Frank Act mandates that the SEC issue its own compensation committee independence rules that cover most public companies by no later than July 16, 2011. The Dodd Frank Act specifically provides an exception from this requirement for controlled companies, limited partnerships, companies in bankruptcy proceedings, registered open-ended investment companies and, provided that they disclose why they do not have an independent compensation committee, foreign private issuers. These new rules may impose additional independence requirements from those that already apply to listed public companies. The Dodd-Frank Act also provides that the compensation committee must have the sole authority to engage compensation consultants, legal counsel and other experts, must consider certain yet to be determined independence factors in making such selections and must be provided by the public company with the funding to engage these advisors.
- Pay Versus Performance Disclosure: The Dodd-Frank Act mandates that the SEC issue new rules that would require public companies to disclose the relationship between executive compensation actually paid and financial performance of a company. The Dodd-Frank Act leaves the specifics of such rules to the SEC’s discretion, with the exception that the Act does note that such disclosures should take “into account any change in the value of the shares of stock and dividends of the issuer and any distributions.” The Dodd-Frank Act also notes that such disclosure may include a graphic representation of the information required to be disclosed.
- Executive Compensation Clawbacks: The Dodd-Frank Act mandates that the SEC issue rules requiring the national securities exchanges to prohibit the listing of any securities of a public company that does not have an executive compensation clawback policy. The Dodd-Frank Act requires that such policies include a mechanism for the public company’s recovery (i.e., clawback) of any incentive compensation received by any current or former executive officer during the 3-year period preceding an accounting restatement “due to the material noncompliance of the issuer with any financial reporting requirement” to the extent that such officer would not have been entitled to such incentive compensation had the incentive compensation been calculated based on the restated financials as opposed to the erroneous data. The Dodd-Frank Act also mandates that the SEC issue rules requiring disclosure of these executive compensation clawback policies. The Dodd-Frank Act mandated executive compensation clawback requirements are much broader than those that had been implemented by the Sarbanes-Oxley Act. For example, the Dodd-Frank Act requirements apply to all current and former executive officers (not just the Company’s CEO and CFO), have a 3-year look-back period (not just a 1-year look-back period), and do not require any misconduct on the executive officer’s part. The Dodd-Frank Act does not state when these rules must be effective.
- All Employees to CEO Compensation Ratio: The Dodd-Frank Act mandates that the SEC issue new disclosure rules that require public companies to disclose: (i) the median total all employee annual compensation (not including the CEO); (ii) the total annual CEO compensation, and (iii) the ratio of (i) to (ii). The Dodd-Frank Act does not state by when the SEC must promulgate these disclosure requirements or when they will be effective.
- Hedging Disclosure: The Dodd-Frank Act mandates that the SEC issue new disclosure rules that require public companies to disclose whether any employee or director 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 granted to the employee or director as compensation or otherwise held by the employee or director. The Dodd-Frank Act does not state when the SEC must promulgate these disclosure requirements by or when they will be effective.
- Broker Discretionary Voting on Executive Compensation: Public companies listed on a national securities exchange will no longer be allowed to have broker discretionary voting on any executive compensation matters. The Dodd-Frank Act mandates that the national securities exchanges implement rules to prohibit broker discretionary voting in these matters. The New York Stock Exchange has already issued a notification to its members that it intends to amend its rules (Rule 452) to prohibit its members from voting on executive compensation matters, such as say-on-pay proposals, unless brokers have received instructions from the beneficial owner of the shares. Since broker discretionary voting generally follows management recommendations, this change is likely to make it harder for management to secure the necessary votes and therefore likely increases the influence of proxy advisory firms and institutional stockholders in shareholder votes on these matters.
What To Do Now
The following are some suggestions for what public companies subject to these rules should be doing now in order to prepare for their application:
- Determine whether you have any shareholders who meet, or may try to form a group to meet, the 3%/threeyear holding period rule thresholds. In that regard, public companies should be aware that smaller shareholders seeking to form a nominating group will likely file a notice on Schedule 14N before communicating with other shareholders about forming such a group, as such a filing exempts such communications from the proxy rules for such solicitations. Public companies should be monitoring these filings.
- Consider discussing with eligible shareholders their satisfaction with your company’s corporate governance matters (including, executive compensation policies, particularly in light of the recent Dodd-Frank Act requirement regarding advisory “say on pay” proposals and other Dodd-Frank Act mandated executive compensation matters described above). These conversations could be easily added to your company’s existing investor relations discussions with these shareholders.
- Use these shareholder investor relations discussions to resolve possible disagreements with respect to your company’s corporate governance matters (including the Dodd-Frank Act mandated executive compensation matters described above) before you receive a 14a-11 or 14a-8 director nomination or shareholder proposal.
- Be mindful that discussions with shareholders concerning specific board nominees need to be handled with care. Generally such discussions should be avoided. A company that reaches an agreement to include a shareholder nominee on its board of directors can count that nominee towards the 25% limit provided the company (i) reached that agreement with the shareholder or group after the filing of a nomination by such shareholders or group on Schedule 14N and (ii) did not have any discussions with the shareholder about such nomination before the filing. As a result of the foregoing requirement, in circumstances where a shareholder nomination is likely, a company may want to consider not having such discussions with any shareholder or group until after the filing of a Schedule 14N containing a nomination proposal. In the event such discussions cannot be avoided, a company that determines to nominate a director proposed by such a shareholder should negotiate a settlement agreement providing that such nomination will be revoked if the shareholder subsequently uses Rule 14a-11 to nominate additional directors.
- Review your advance notice bylaws to determine whether any amendments should be made to conform your bylaws to the proxy access rule requirements, including its notice provisions and information requirements.
- To the extent such confidentiality policies are not already in place, consider revising your confidentiality policies applicable to directors to specifically address the maintenance of all board room discussions, not just material nonpublic information (i.e., inside information matters), confidential, and to address a clear chain of command as to who is entitled to make public statements on behalf of your company. This may help partially alleviate the inevitable tension in the board room and associated effect on board communications that will arise if a Rule 14a-11 candidate that is opposed by the current board is elected. A director nominated by a specific shareholder or group of shareholders is bound by the same fiduciary obligations as other directors. Consider enhanced director educational programs.
- Review your corporate governance and committee charters and related bylaws to determine whether any changes should be made to the shareholder nominations procedural and qualification standards set forth therein. Examples of possible amendments could include mandatory retirement ages and requirements that at least a certain percentage of your board have related industry experience or other desirable experience. It is important to note however, that as discussed above, while the Rule 14a-11 candidate must meet the objective independent director standards of any stock exchange on which the company’s shares are listed and their nomination or board membership must not violate applicable laws or regulations, the nominee will not be required to meet any subjective independence tests or other director qualification standards included in the company’s governing documents. Therefore, the amendment of such corporate governance guidelines, charters and bylaws alone will not preclude the nomination of such candidates. However, if the director qualification tests have a compelling or persuasive rationale, a company could potentially use such director qualification tests to bolster the disclosure in its proxy statement in support of its rationale for why the company’s shareholders should vote against a Rule 14a-11 candidate.
- In light of the anticipated new Dodd-Frank Act mandated executive compensation clawback policies, public companies may want to consider proactively adopting such policies now or amending existing policies to more closely follow the anticipated rules.
- In light of the anticipated new Dodd-Frank Act mandated hedging disclosure rules, public companies may also wish to review their insider trading policies and implement prohibitions against such hedging transactions to the extent not already prohibited.
- Director questionnaires will need to be updated to capture new independence requirements and other information.