On July 10, 2009, the Securities and Exchange Commission (“SEC”) published the text of proposed amendments, previously approved at an open meeting of the Commissioners on July 1, 2009, relating to enhanced compensation and corporate governance disclosure, more rapid reporting of shareholder voting results and various technical amendments to the proxy rules, including a change that could result in more “short slate” director nominations.1 If adopted, the proposed amendments will be effective for the 2010 proxy season and would:
- require a discussion of a company’s overall compensation policies and practices as they relate to the company’s risk management practices and/or risk-taking incentives;
- require disclosure of the amount of fees paid to a compensation consultant and the nature of the services provided, if a compensation consultant played any role in determining or recommending the amount or form of executive or director compensation and also provided additional services;
- revise the method of calculating the value of equity compensation in the Summary Compensation Table and Director Compensation Table to equal the aggregate grant date fair value under FAS 123R rather than the value recognized each year for accounting purposes;
- require enhanced disclosures about the particular experience, qualifications, attributes or skills that qualify each person to serve as a director or nominee of the board or a committee;
- require disclosure about a company’s leadership structure and why the company believes it to be the best structure for it at the time of the filing;
- require disclosure about the board’s role in the company’s risk management process;
- require disclosure of voting results on Form 8-K including preliminary voting results, in case of contested elections, within four business days of the shareholder vote; and
- make changes to the proxy solicitation rules, including making it possible for a person soliciting proxies for a “short slate” to seek authority to vote the proxy for nominees contained in another shareholder’s proxy statement.
The amendments are applicable to proxy and information statements, annual reports and registration statements under the Securities Exchange Act of 1934 (the “Exchange Act”), and registration statements under the Securities Act of 1933 (the “Securities Act”), as well as the Investment Company Act of 1940.
In addition to these specific proposed amendments, the SEC is soliciting comments on its rules and regulations with an aim at improving proxy disclosure in general. One of the more interesting areas on which the SEC is soliciting comment is whether it should (i) eliminate the ability of companies to omit performance targets based on the potential competitive harm from their disclosure, or (ii) require disclosure of performance targets on an after-the-fact basis (i.e., after the performance related to the award is measured), such as three or more fiscal years later, whether or not the disclosure may result in competitive harm.
I. Compensation Disclosure
Risk Disclosure in CD&A
Description of Proposed Amendment. Under proposed Item 402(b)(2) of Regulation S-K, companies will be required to include in their Compensation Discussion and Analysis (“CD&A”) a discussion of the company’s overall compensation policies and practices as they relate to the company’s risk management practices and/or risk-taking incentives. Unlike the rest of the CD&A, this discussion is required to include information on compensation practices for employees generally and not just for “named executive officers.”2 The discussion is only required if the relevant compensation policies and practices “may have a material effect” on the company. The SEC notes that disclosure may be triggered by compensation policies and practices:
- at a business unit of the company that carries a significant portion of the company’s risk profile;
- at a business unit with compensation structured significantly differently than other units within the company;
- at business units that are significantly more profitable than others within the company;
- at business units where the compensation expense is a significant percentage of the unit’s revenues; or
- that vary significantly from the overall risk and reward structure of the company, such as when bonuses are awarded upon accomplishment of a task, while the income and risk to the company from the task extend over a significantly longer period of time.
Comments. The proposed rule will require companies to conduct a new risk assessment to determine whether their compensation policies and practices encourage employees to take risks in order to achieve their incentive compensation. The SEC takes the view that such a risk analysis, if material, is already required with respect to named executive officers. Therefore, companies will need to engage in a determination of whether the compensation of some or all other employees encourages excessive risk-taking that may be material to the company. This assessment will be highly fact specific and will often not be straightforward. It may be difficult to indentify and describe which compensation structures may expose the company to material risks. Consider, for example:
- financial institutions that incentivize employees to sell financial products to consumers while at the same time requiring compliance with eligibility criteria to limit default risk;
- oil and gas, and energy generation companies, that incentivize a small group of employees to engage in hedging transactions to minimize the impact of commodity price fluctuation on their results of operations; or
- drug development companies that incentivize key employees to meet clinical trial milestones for key products upon which the company is dependent.
Note that even if a company’s compensation policies are designed to discourage excessive risk-taking, disclosure and discussion would still be required if the compensation that it actually pays encourages such risk-taking that may be material to a company. In addition, the “may be material” standard is lower than just a straight requirement that the impact be material to the company.
Description of Proposed Amendment. If a compensation consultant or its affiliates played any role in determining or recommending the amount or form of executive or director compensation and also provided additional services, the proposed amendments to Item 407(e)(3)(iii) of Regulation S-K would require a company to disclose:
- the nature and extent of all additional services provided to the company or its affiliates during the last fiscal year by the compensation consultant and any affiliates of the consultant;
- the aggregate fees paid for all additional services, and the aggregate fees paid for work related to determining or recommending the amount or form of executive and director compensation;
- whether the decision to engage the compensation consultant or its affiliates for non-executive compensation services was made, recommended, subject to screening or reviewed by management; and
- whether the board of directors or the compensation committee has approved all of these services in addition to executive compensation services.3
These disclosures would not be required if the compensation consultant’s only role in recommending the amount or form of executive or director compensation is in connection with consulting on broad-based plans that do not discriminate in favor of executive officers or directors of the company, such as 401(k) plans or health insurance plans.
The proposed amendments require disclosure of services during the prior year; however, the SEC is seeking comment on whether disclosure should be required for any currently contemplated services in order to provide information when the compensation consultant provides services in one year and in the next year receives fees for other services. This disclosure would require that the company estimate the fees for the currently contemplated services.
Comments. The proposed rules are focused almost exclusively on potential conflicts of interest faced by the compensation consultant when providing additional services, such as benefits administration, human resources consulting and actuarial services, with fees often exceeding those earned for executive compensation advice. It is interesting to contrast this proposed disclosure with that required with respect to the fees paid to a company’s auditors. In that case, aggregate fees paid are required to be disclosed even if non-audit services are not provided.
Changes to Summary Compensation and Director Compensation Tables
Description of Proposed Amendment. Under the proposed amendment to Item 402(c)(2) of Regulation S-K, companies would be required to disclose in the Summary Compensation Table and Director Compensation Table the aggregate grant date fair value of stock or options awards under Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 123 (revised 2004) Share-Based Payment (FAS 123R). This would replace the current requirement of disclosing the annual value recognized each year under FAS 123R for financial statement purposes rather than the aggregate value on the date of grant. This returns the required disclosure to the position in August 2006 when the SEC overhauled its compensation disclosure requirements and reverses an “interim final rule” adopted in December 2006, which was widely criticized by companies and investors.
The current rules require disclosure of the grant date fair value of individual equity awards both in the Grants of Plan-Based Awards Table and in footnote disclosure to the Director Compensation Table. If this amendment is adopted, the SEC will rescind these requirements to avoid duplicative disclosure. The SEC is also proposing an amendment to Instruction 2 to the salary and bonus columns of the Summary Compensation Table to provide that companies will not be required to report in those columns the amount of salary or bonus forgone at a named executive officer’s election, and that non-cash awards received instead are reportable in the column applicable to the form of award elected.
The SEC is also considering whether to require companies to recompute the disclosure included in the Summary Compensation Table for previous years. Revised historic disclosure would be required for named executive officers in the 2009 fiscal year. However, inclusion of different named executive officers would not be required for previous years if the calculation results in a different outcome for those years.
Comments. The proposed amendment will generally be welcomed by companies and investors. The full grant fair value better reflects compensation decisions taken during the prior fiscal year than the amount of equity compensation recognized during a particular fiscal year. The SEC points out that the existing rules can result in negative compensation being recorded for financial statement purposes which serves to reduce total compensation and is confusing to investors.
Nevertheless, the proposed amendment may cause significant year-to-year variability in the list of named executive officers for which compensation disclosure is required. The CD&A includes information on a company’s named executive officers based on total compensation paid in the prior fiscal year. The proposal alters the calculation of total compensation and may change the identities of the three most highly compensated executive officers. For example, under the proposed rules, a single large grant to be earned for services to be performed over multiple years would be treated as compensation in the fiscal year it was granted, even though the executive may earn a consistent level of compensation over the award’s term. Nevertheless, this still seems preferable to the current situation where a significant change in a company’s stock price changes the amount recognized in a particular year under FAS 123R. In addition, because presentation of aggregate grant date fair value would include the incremental fair value of options repriced during the fiscal year, the effect of option repricings on total compensation would be clearer.
Smaller reporting companies should be aware that, if adopted, the proposal would require them to disclose the grant date fair value of awards. Currently, the rules do not require smaller reporting companies to provide a Grants of Plan-Based Awards Table where this information appears for other reporting companies.
II. Corporate Governance
Enhanced Director and Nominee Disclosure
Description of Proposed Amendment. The proposed amendments to Item 401 of Regulation S-K would require disclosure of the particular experience, qualifications, attributes or skills that qualify a person to serve as a director of the company or as a member of any committee, in light of the company’s business and structure. This requirement would apply to incumbent directors, to nominees for director who are selected by a company’s nominating committee and to any nominees put forward by other proponents. These disclosures would appear in proxy and information statements, annual reports on Form 10-K and registration statements on Form 10 under the Exchange Act, as well as in registration statements under the Securities Act.4
In addition, the proposed amendments would expand the disclosure of directorships under Item 401, which at present only requires disclosure of current directorships, to include any directorships held by each director and nominee at public companies at any time during the prior five years. The proposed rules would also lengthen the period for which disclosure of legal proceedings is required from five to ten years. The SEC is seeking comment on whether disclosure regarding a broader range of legal proceedings than is currently required would be helpful to investors.
The SEC has not yet determined if the disclosures relating to committee membership will be required for all board committees or just key committees, such as the audit, compensation and nominating/governance committees, and how frequently these disclosures will be required. In light of the amendments’ expanded disclosures, the SEC may not retain Item 407(c)(2)(v) which currently requires disclosure of any specific minimum qualifications that a nominating committee believes must be met by someone nominated by the committee for a position on the board and also a description of any specific qualities or skills that the nominating committee believes are necessary for one or more of the company’s directors to possess. The SEC is seeking comment on these issues, including whether diversity in the boardroom is a significant issue that requires additional or different disclosure.
Comments. A requirement to discuss the experience, qualifications, attributes or skills that qualify a director or nominee to serve on the board might result in meaningless or boilerplate disclosure when applied on an individual basis. For example, if the CFO of a public company is nominated as a director of another company, one would expect that investors could assess the relevance of that experience. It may be more beneficial for the company to provide disclosure as to whether and how each individual director candidate meets the standards disclosed under Item 407(c)(2)(v).
Since the amended disclosure requirements would apply to existing directors of a company, they may result in potentially embarrassing disclosures related to legal proceedings that occurred more than five years ago and that were not picked up under the current disclosure requirements. If the amendments are adopted, companies should consider notifying their directors of the change and asking them to contact the company’s legal department if any additional disclosure would be required. Irrespective of the five- (or proposed ten-) year look-back, we recommend that directors and nominees be required to disclose to the company any legal proceedings that could be considered material to their ability to serve as a director irrespective of time period. For example, fraud committed before the current (or proposed) look-back period may be material under any circumstance.
Description of Proposed Amendment. The proposed amendment to Item 407 of Regulation S-K would require disclosure in a company’s proxy statement or information statement of a company’s leadership structure and why the company believes it to be the best structure for it at the time of the filing. This disclosure must include discussion of:
- whether and why the company has chosen to combine or separate the principal executive officer and board chair positions; and
- for companies where those roles are combined, whether ¦¦and why the company has a lead independent director, as well as the specific role the lead independent director plays in the leadership of the company.5
Comments. Companies that do not combine the CEO and Chairperson roles will likely find it difficult to include meaningful disclosure about their leadership structure beyond, perhaps, discussing the size of the board. For those that combine the CEO and Chairperson roles, there has been an increasing spotlight on this practice for the last few years. In 2009, RiskMetrics reported that 22 companies with combined CEO and Chairperson roles were subject to shareholder proposals to institute an independent Chairperson. Senator Chuck Schumer’s proposed Shareholder Bill of Rights Act of 2009 would mandate the separation of the CEO and Chairperson roles.
Risk Management Process
Description of Proposed Amendment. The proposed amendment to Item 407 of Regulation S-K would also require additional disclosure in proxy and information statements about the board’s role in the company’s risk management process. This disclosure would include a discussion of whether risk management is overseen by the board or by a committee of the board, such as the audit committee, and whether reports by individuals responsible for risk management are made to the board as a whole or only to such committee.6
Comments. Rule 303A.07(c)(iii)(D) of the NYSE Listed Company Manual requires that the audit committee of an NYSE listed company have a charter that addresses the committees “purpose,” which includes “policies with respect to risk assessment and risk management.”7 Senator Chuck Schumer’s proposed Shareholder Bill of Rights Act of 2009 would require the SEC to promulgate rules requiring the establishment of a risk committee comprised entirely of independent directors. The boards or audit committees of many companies routinely receive reports regarding the overall risk facing the company and steps that are advised to reduce or mitigate them. Nevertheless, the proposed SEC disclosure requirement is somewhat open-ended and many companies, particularly those that believe they face risks that are inseparable from their general business strategy (e.g., how to deal with competition), may struggle with providing meaningful disclosure.
III. Shareholder Meetings and Proxy Solicitations
Current Reporting of Voting Results
The SEC is proposing to require current disclosure of shareholder voting results by transferring the applicable reporting requirements from Forms 10-Q and 10-K to Form 8-K. The SEC believes that if a matter is important enough to submit to a shareholder vote, it is likely important enough to require current reporting of the results of such vote on Form 8-K. Under the proposals, a new Item 5.07 would be added to Form 8-K requiring a company to disclose the results of a shareholder vote within four business days after the end of the meeting at which the vote was held. If the matter voted upon at the meeting relates to a contested election of directors and the voting results are not definitively determined at the end of the meeting, companies would be required to disclose on Form 8-K the preliminary voting results within four business days after the preliminary voting results are determined, and file an amended report on Form 8-K within four business days after the final voting results are certified. The SEC is seeking comment as to whether a failure to file a Form 8-K with respect to proposed new Item 5.07 should result in a loss of Form S-3 eligibility.
Clarification that Notice of Revocation is an Exempt Solicitation under Rule 14a-2(b)
Exchange Act Rule 14a-2(b) exempts solicitations by non-affiliated shareholders and other non-management parties, provided those parties do not seek to act as a proxy for another security holder and do not seek a form of revocation, abstention, consent or authorization.8 The SEC is proposing to amend Rule 14a-2(b)(1) to clarify that an unmarked copy of management’s proxy card that is requested to be returned directly to management is not a “form of revocation” under this rule even though, if submitted by a shareholder who already voted, it could serve to revoke the prior vote. This clarification is consistent with the SEC Staff’s informal advice on this topic and reverses a decision of the US Court of Appeals for the Second Circuit that held that a duplicate of management’s proxy card, when included in a mailing opposing a proposed merger, was a form of revocation and therefore subject to the disclosure filing and other requirements under the proxy rules.9
Clarification that Having a Substantial Interest does not Require a Person to be a Securityholder in connection with an Exempt Solicitation under Rule 14a-2(b)
The exemption provided under Rule 14a-2(b) is not available to “[a]ny person who, because of a substantial interest in the subject matter of the solicitation, is likely to receive a benefit from a successful solicitation that would not be shared pro rata by all other holders of the same class of securities, other than a benefit arising from the person’s employment with the registrant.” The SEC is proposing to clarify that having a “substantial interest” does not depend on being a securityholder, as might currently be understood by the rule. The SEC gives the example that a soliciting person that wishes to acquire a target company would have a substantial interest without owning any shares in the company whose shareholders are being solicited.
Expansion of the Short Slate Rounding Exception under Rule 14a-4(d)(4)
Recent proxy seasons have seen significant growth in the solicitation of proxies to elect one or more directors who, if elected, would constitute a minority of the board (referred to as a “short slate”). Rule 14a-d(4) permits a person soliciting proxies for a short slate to round out its short slate by seeking authority to vote for persons named in the company’s proxy statement.
The SEC is proposing to amend Rule 14a-d(4) to permit a person soliciting proxies for a short slate to seek authority to vote for persons named in the proxy statement of another soliciting person or the company. In order to take advantage of the proposed change, a soliciting party would need to represent that it has not agreed and will not agree to act, directly or indirectly, as a group or otherwise engage in activities that would cause a group with the meaning of Section 13(d)(3) of the Exchange Act to be formed with the other non-management soliciting party. The soliciting party must also represent that it is not a “participant” in the solicitation by the other non-management soliciting party within the meaning of the proxy solicitation rules.
If adopted, this amendment will likely lead to the increased use of short slates, particularly side-by-side short slates, and could provide shareholders with significantly greater influence in the composition of boards, which may lead to more changes of control as incumbent directors face more opposition.
Reasonable Specified Conditions Must be Objectively Determinable under Rule 14a-4(e)
Exchange Act Rule 14a-4(e) currently requires that a proxy statement or form of proxy provide that the shares represented by the proxy be voted “subject to reasonable specified conditions.” The SEC is proposing an amendment to clarify that these conditions must be objectively determinable in order to enable a shareholder to make an informed decision in regard to granting proxy authority and confirm that any later withholding of shares from voting is consistent with the authority granted. The SEC gives the example that a proxy could not be subject to the proxy holder concluding in its sole discretion that it would be inadvisable to vote the shares. Conversely, a proxy could be subject to a condition that a third party files a Schedule TO for a tender offer for over half of the issuer’s shares.
Specified Participant Information under Rule 14a-12 Must be Provided No Later than the First Soliciting Communication
Exchange Act Rule 14a-12 permits a solicitation to be made before furnishing security holders with a proxy statement meeting the requirements of Exchange Act Rule 14a-3(a) if, among other requirements, each written communication that is part of the solicitation contains specified participant information or a legend advising securityholders where they can obtain that information. The SEC is proposing an amendment to confirm that the information referred to in the legend must be filed under cover of Schedule 14A as part of a proxy statement or other soliciting materials no later than the time the first soliciting communication is made.
IV. Shareholder Approval of Executive Compensation for TARP Recipients
In addition to the aforementioned proposals, the SEC recently released proposed amendments to implement the requirement under Section 111(e) of the Emergency Economic Stabilization Act of 2008 (the “EESA”) for an advisory vote on executive compensation at companies that received funds under the Troubled Asset Relief Program (“TARP”).10
Under proposed Rule 14a-20, reporting companies that are TARP recipients would be required to provide for such a separate shareholder vote in proxies solicited during the period in which any obligation arising from financial assistance provided under the TARP remains outstanding. Proposed Rule 14a-20 would clarify that the separate shareholder vote would only be required in connection with a proxy solicited for an annual meeting (or a special meeting in lieu of the annual meeting) for which proxies will be solicited for the election of directors.
Under a corresponding amendment to Item 20 of Schedule 14A, TARP recipients would be required to disclose in their proxy statement that they are providing a separate shareholder vote on executive compensation pursuant to the requirements of the EESA, and to briefly explain the general effect of the vote, such as whether the vote is non-binding.
It remains to be seen whether an advisory vote on executive pay will be required for all public companies and not just those that received TARP funds. SEC Chairperson Mary Shapiro has indicated support for such a measure and it has been the subject of proposed legislation, most recently in Senator Chuck Schumer’s proposed Shareholder Bill of Rights Act of 2009. To date, however, only companies receiving TARP funds are required to hold such a vote.