2014 ANNUAL MEETING SEASON

Dear clients and friends,

We present to you our traditional year-end issue of Snell & Wilmer’s Corporate Communicator to help you prepare for the upcoming annual report and proxy season. This issue highlights SEC reporting and corporate governance considerations that will be important this annual meeting season as well as in the upcoming year. In this issue, we include our customary articles on recent SEC, NYSE/NASDAQ and other corporate law developments. ISS, Glass Lewis and other proxy advisory firms continue to have increasing influence on public companies’ corporate governance policies, executive pay and the related disclosures about these matters, and this issue discusses the latest policy updates that will take effect in the 2014 proxy season. Finally, we are including a short article about the pending United States Supreme Court case Halliburton Co. v. Erica P. John Fund, Inc. Depending on how the Court rules, this case could have a profound impact on securities class action and similar litigation.

Jeff Beck’s Quarterly Tidbit of Interest:

Quote from Mary Jo White, Chair of the United States Securities and Exchange Commission (October 9, 2013):

“The underpinning for this strategy was outlined in an article, which many of you will have read or heard of, titled, ‘Broken Windows.’ The theory is that when a window is broken and someone fixes it – it is a sign that disorder will not be tolerated. But, when a broken window is not fixed, it is a signal that no one cares, and so breaking more windows costs nothing. The same theory can be applied to our securities markets – minor violations that are overlooked or ignored can feed bigger ones, and, perhaps more importantly, can foster a culture where laws are increasingly treated as toothless guidelines. And so, I believe it is important to pursue even the smallest infractions.”

During 2014, members of our Business & Finance group will continue to publish the Corporate Communicator, host business presentations, participate in seminars that address key issues of concern to our clients and sponsor conferences and other key events. First on the calendar is our Sixth Annual Public Company Proxy Season Update, which will be held at Skysong on January 9, 2014. Finally, we are pleased to present our 2013 Tombstone, which highlights selected deals that Snell & Wilmer’s Business & Finance group helped our clients close during the year. As always, we appreciate your relationship with Snell & Wilmer and we look forward to helping you make 2014 a successful year.

Very truly yours,
Snell & Wilmer
Business & Finance Group

SEC UPDATE

PROXY SEASON PREVIEW

Say-on-Pay and Equity Compensation Plans

Although say-on-pay votes are only advisory in the United States, they will likely continue to be a focus for many companies in the upcoming 2014 proxy season. Since the inception of this requirement, shareholders in most cases have approved executive compensation proposals. In 2013, the percentage of Russell 3000 companies that had say-on-pay votes pass with over 90% shareholder approval was 77%, while the percentage of companies that had say-on-pay votes pass with over 70% shareholder approval was 91%. On the other hand, the percentage of companies whose say-on-pay votes failed to garner a majority of votes was a mere 2.5%.

Another important trend of note is that companies that failed to obtain shareholder approval of executive compensation proposals in 2012 performed much better in 2013 – those companies received 39% more support in 2013 than in 2012. This was likely due in part to companies conducting more outreach to shareholders, including providing more extensive disclosures in 2013 proxy statements and making changes to their executive compensation programs. This change may also be due in part to a general trend of improvement in shareholder returns in 2013, suggesting that to some extent say-on-pay votes are, in effect, say-on-performance votes.

Companies should expect that say-on-pay will continue to be a focus and will impact the design of compensation plans in 2014. Shareholder return will also continue to affect say-on-pay votes, and there may be growing pressure for performance-based equity grants.

Companies should also be aware that there have been various waves of litigation surrounding say-on-pay proposals and equity compensation plans. Shareholders of some companies filed lawsuits against companies and their boards of directors for breach of fiduciary duty after say-on-pay proposals failed to receive approval from a majority of shareholders. There have also been lawsuits alleging that proxy statements provided insufficient disclosure regarding compensation and typically seeking to enjoin shareholder votes unless the company provided additional disclosure regarding compensation. Another wave of litigation involved allegations of waste of corporate assets or breach of fiduciary duty arising out of Internal Revenue Code Section 162(m), which puts limits on the deduction that certain highly paid officers of public companies can take on their non-performance-based compensation.

Shareholders may continue to file these and other similar types of lawsuits in 2014, and although these lawsuits have been mostly unsuccessful, the potential cost and distraction of litigation to a company and its board suggests that companies should be cognizant of the trends and carefully draft any disclosures concerning say-on-pay, equity plans and Section 162(m). 

Shareholder Proposals

Shareholders have become increasingly active in filing shareholder proposals for inclusion in proxy statements.  The number of shareholder proposals at Russell 3000 companies increased by approximately 6% in 2013, and requests for no-action relief also increased in 2013. However, the SEC was less likely to allow companies to exclude shareholder proposals from their proxy statements, while the percentage of proposals withdrawn by shareholders increased. Most significantly for companies, shareholders were less likely to approve shareholder proposals by a majority vote. Other significant trends of note are that the source of shareholder proposals has shifted from labor unions to hedge funds (e.g., Carl Icahn) and religious groups, board declassification continues to be a focus of shareholder proposals and board diversity has become the subject of an increasing number of shareholder proposals. 

Some of the main issues that are likely to come up in shareholder proposals in the 2014 season include those involving shareholders’ rights, corporate governance and social issues. Shareholders’ rights proposals may address issues such as board declassification, majority voting in the election of directors, proxy access, the ability of shareholders to call special meetings or act by written consent and the elimination of supermajority provisions to amend company bylaws. Corporate governance issues will likely include board diversity, board leadership and director tenure, while social and environmental issues may include human rights, environmental sustainability and political spending.

CONFLICT MINERALS—ARE YOU READY FOR THE NEW SEC DISCLOSURE REQUIREMENT?

Companies should be aware that they may be required to file a new Form SD on May 31, 2014, and annually thereafter, disclosing their use of conflict minerals that originated in the Democratic Republic of Congo or any of its adjoining countries (the “covered countries”). The final rule was promulgated by the SEC on August 22, 2012 pursuant to the Dodd-Frank Act and requires that a company that manufactures or contracts to manufacture a product containing conflict minerals that are “necessary to the functionality or production” of that product must disclose such use. Although there is currently an appeal pending in National Association of Manufacturers, Chamber of Commerce of the United States of America, and Business Roundtable v. Securities and Exchange Commission in the U.S. Court of Appeals for the District of Columbia Circuit following the district court’s decision to uphold the SEC’s conflict minerals rule, companies should continue to prepare for the new filing requirement.

DODD-FRANK ACT RULEMAKING UPDATE

The SEC continues its efforts to adopt the rules mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, and in 2013 approved the final NYSE and NASDAQ rules regarding compensation committee and compensation advisor independence, which are discussed elsewhere in this Corporate Communicator, and adopted rules to disqualify felons and other “bad actors” from offering or selling securities in certain exempt offerings. Many rules, however, remain to be adopted by the SEC. 

The following is a brief summary of certain other rules prescribed by the Dodd-Frank Act that have either been proposed or are expected to be proposed soon.  

Proposed Pay Ratio Disclosure Rule

On September 18, 2013, the SEC proposed to amend Item 402 of Regulation S-K (Executive Compensation) to require disclosure of the ratio of the compensation of a reporting company’s principal executive officer to the median compensation of all employees of such company, excluding the principal executive officer. As proposed, reporting companies would be required to include this pay ratio disclosure in their annual reports on Form 10-K, registration statements, and proxy and information statements. However, the pay ratio disclosure would not be required to be made by emerging growth companies, smaller reporting companies, foreign private issuers, and companies that file reports and registration statements under the U.S.–Canadian Multijurisdictional Disclosure System. This proposed rule is not expected to impact the 2014 proxy season because, as proposed, companies would only be required to comply with the proposed rule for fiscal years commencing on or after the effective date of the rule.

Compensation Clawback Policy Rule

Section 954 of the Dodd-Frank Act requires the SEC to direct national securities exchanges to adopt rules that prohibit such exchanges from listing companies that do not develop, implement and disclose compensation “clawback” policies. The compensation “clawback” policies will have to provide for the recovery of compensation that any current or former executive officer of the company was erroneously awarded in the event the company is required to restate its financial statements due to “material noncompliance” with any financial reporting requirement under the securities laws. 

In the event of such a restatement, the policy must provide for the company’s recovery from such executive officer of any incentive based compensation (including stock options awarded as compensation) “in excess of what would have been paid to the executive officer under the accounting restatement” during the three-year period preceding the date on which the company is required to prepare the accounting restatement.

While listed companies will not be able to implement these compensation “clawback” policies until the rule is finalized by the SEC, in the meantime, it may be prudent to consider adding a provision in any new incentive compensation plans or other agreements providing incentive compensation to executive officers that permits the company to recover from its executive officers any incentive compensation required to be recovered pursuant to the provisions of the Dodd-Frank Act and any rules promulgated thereunder. 

SEC DISCLOSURE REMINDERS—TRENDS AND LITIGATION

Trend Disclosures

Regulation S-K Item 303 requires public companies to identify and describe in the MD&A section known trends or uncertainties that have had or that the registrant reasonable expects will have a material favorable or unfavorable impact on revenues, results of operations or liquidity. It is important to remember the SEC’s trend disclosure rules are just that—they are rules or, said another way, there is a disclosure duty. Also, disclosure is required whether the impact on revenues, results of operations or liquidity is favorable or unfavorable. 

Determining whether disclosure about a known trend or uncertainty is required is a two-step process. The first step is determining whether the known trend, commitment, event or uncertainty is likely to come to fruition. If it is not reasonably likely to occur, no disclosure is required. If management cannot make that determination, the second step of the process requires management to evaluate consequences of the known trend, commitment, event or uncertainty, on the assumption that it will come to fruition. Disclosure is then required unless management determines that a material effect on the company’s revenue, results of operations or liquidity is not reasonably likely to occur.

Common uncertainties that should be considered include, among others, reduction in product prices, market share loss, manufacturing defects or difficulties, increases in the cost of raw materials, supplier limitations or similar supply chain problems, decline in product quality, adverse regulatory developments, decrease in, or prohibitive increase in cost of, insurance coverage and loss/nonrenewal of a material contract. The SEC also expects that in addition to identifying a known trend or uncertainty itself, companies should disclose the facts and circumstances surrounding a known trend or uncertainty, including, if determinable, quantification of material effects. 

Inadequate disclosures about known trends and uncertainties can lead not only to SEC scrutiny, but securities litigation exposure for failure to disclose. Prominent securities litigation cases and SEC comment letters suggest there is often a thin line, or tension, between specific disclosures about known trends or uncertainties and generalized forward-looking risk factor statements. We recommend companies be thoughtful in preparing their MD&A disclosures to include appropriate and meaningful discussion about known trends and uncertainties because in some cases a generalized, or non-specific, forward-looking risk factor may not, particularly in hindsight, be sufficient disclosure. 

Loss Contingencies

As we have written about in prior editions, during 2011 the SEC began a campaign to push companies to enhance their disclosure of loss contingencies. The existing disclosure standards are set forth in ASC 450 (formally known as FAS 5). Although the FASB’s proposed amendments in 2008 to its long-standing loss contingency reporting standards died on the vine (after significant and vigorous objections from the legal community) and the SEC’s intense focus on loss contingency disclosures has subsided somewhat in the last couple of years, companies should be aware that loss contingencies remain a focus of the SEC Staff in their reviews of periodic filings and registration statements. The focus of the SEC remains on those loss contingencies where it is “reasonably possible” that a loss will be realized (vs. those deemed probable or remote). The SEC Staff has indicated that they will continue to ask questions where a large settlement or award is reported and prior disclosures failed to mention the contingency or consistently disclosed the contingency but indicated that it is was not possible to determine the amount or range of the loss. 

PROXY ADVISORY FIRMS UPDATE

This year, our proxy advisory firm update focuses on ISS, which issued policy updates on November 21, 2013 that will take effect for annual meetings held on or after February 1, 2014. In connection with announcing its updated voting guidelines for the 2014 proxy season, ISS also announced changes in its policy development process, which will now include a new “benchmark consultation period” ending on February 14, 2014. More information about that process, as well as the results of ISS’ 2013 policy survey (which ISS considered in formulating its updates for 2014), is provided below. Here is a brief summary of “what’s new” for 2014:

Governance Issue

Old Policy

New Policy

Key Changes

Board Responsiveness (to Shareholder Proposals)

Notes About 2013 Survey:

• In 2013, 84 shareholder proposals received support from a majority of the shares outstanding or of a majority of the votes cast. Of those, 73 proposals have been partially or fully implemented.

• “Comply or explain” – 40% of institutional investors indicated the board should be free to exercise its discretion and disclose the rationale for its actions (92% of issuers took this position in the survey); 36% indicated the board should take specific action to address the proposal.

Vote against or withhold from individual directors, committee members or the entire board as appropriate if the board fails to act (i.e., full implementation of proposal or management proposal in next proxy statement) on a shareholder proposal that received the support of (i) a majority of the shares outstanding the previous year or (ii) a majority of the shares cast in the last year and one of the previous two years.

Vote case-by-case on individual directors, committee members or the entire board as appropriate if the board fails to act on a shareholder proposal that received the support of a majority of the shares cast in the previous year.

Factors to be considered:

• Disclosed shareholder outreach efforts in wake of vote;

• Rationale provided in proxy statement for level of implementation;

• Subject matter of proposal;

• Level of support and opposition for resolution in past meetings;

• Actions taken by board in response; level of engagement with shareholders;

• Continuation of underlying issue as a voting item on ballot; and

• Other appropriate factors.

• Implemented majority of votes cast in previous year only as policy threshold.

• Clarified that board’s rationale is a factor in the case-by-case analysis of less than full implementation.

• Emphasizes fact-specific, case-by-case nature of analysis.

Executive Compensation (Pay-for-Performance)

ISS annually conducts a pay-for-performance analysis to identify strong or satisfactory alignment between pay and performance over a sustained period. For companies in the Russell 3000 index, the analysis considers:

• Peer group alignment, including (i) degree of alignment between company’s Total Shareholder Return (TSR) rank (40%) and CEO’s total pay rank (60%) within specified peer group, over one- and three-year periods and (ii) multiple of the CEO’s total pay relative to the peer group median; and

• Absolute alignment of trends in CEO pay and company TSR over the prior five years.

Additional qualitative factors may be examined if the above analysis demonstrates significant unsatisfactory long-term pay-for-performance alignment.

ISS annually conducts a pay-for-performance analysis to identify strong or satisfactory alignment between pay and performance over a sustained period. For companies in the Russell 3000 index, the analysis considers:

• Peer group alignment, including (i) degree of alignment between company’s annualized TSR rank and CEO’s annualized total pay rank with specified peer group, each over a three-year period and (ii) multiple of the CEO’s total pay relative to the peer group median; and

• Absolute alignment of trends in CEO pay and company TSR over the prior five years.

Additional qualitative factors may be examined if the above analysis demonstrates significant unsatisfactory long-term pay-for-performance alignment.

• Changed calculation of first peer group alignment measure to annualized “relative degree of alignment” for three-year measurement period.

• Previous standard, which also included a one-year measurement period, resulted in over-emphasizing most recent year (since it was included in both measurement periods).

• Annualized calculation based on three-year measurement period also reduces the extent to which results may be skewed by the timing of equity awards.

Social/Environmental Issues (Lobby)

Vote case-by-case on proposals requesting information on a company’s lobbying (including direct, indirect and grassroots) activities, policies or procedures, considering:

• Company’s current disclosure of relevant policies and oversight mechanisms;

• Recent significant controversies, fines or litigation regarding the company’s lobbying-related activities; and

• Impact that the public policy issues in question may have on the company’s business operations, if specific public policy issues are addressed.

Vote case-by-case on proposals requesting information on a company’s lobbying (including direct, indirect and grassroots) activities, policies or procedures, considering:

• Company’s current disclosure of relevant lobbying policies, and management and board oversight;

• Company’s disclosure regarding trade associations or other groups that it supports, or is a member of, that engage in lobbying activities; and

• Recent significant controversies, fines or litigation regarding the company’s lobbying-related activities.

• Updates intended to clarify ISS policies and “better communicate” the factors that ISS considers in evaluating these types of proposals.

• Specifically addresses executive and board oversight with respect to lobbying activity.

• Specifically addresses trade association activity.

Human Rights Risk Assessment

None.

Vote case-by-case on proposals requesting that a company conduct an assessment of the human rights risks in its operations or in its supply chain, or report on its human rights risk assessment process, considering:

• Degree to which existing relevant policies and practices are disclosed, including information on the implementation of these policies and any related oversight mechanisms;

• Company’s industry and whether the company or its suppliers operate in countries or areas where there is a history of human rights concerns;

• Recent, significant controversies, fines or litigation regarding human rights involving the company or its suppliers, and whether the company has taken remedial steps; and

• Whether the proposal is unduly burdensome or overly prescriptive.

• During 2013 proxy season, new shareholder proposals were filed relating to a company’s assessment of its risks related to human rights issues.

ISS adopted the new policy to provide guidance on these resolutions in the future, since existing policy does not address shareholder proposals on human rights beyond policy disclosure or adoption, which require the consideration of different factors.

OTHER NOTES ABOUT 2013 ISS SURVEY RESULTS

ISS conducted its annual survey from July 31, 2013 to September 13, 2013, seeking input from institutional investors as well as corporate issuers to inform its 2014 policy formulation process. In addition to the results described above under “Board Responsiveness,” the following results were notable:

  • In survey questions focusing on the U.K. and other markets with established corporate governance codes regarding director tenure, 74% of institutional investors indicated that long director tenure is problematic, either because it can diminish a director’s independence over time or interfere with a board’s ability to refresh its membership (or both). On the other hand, 84% of issuers indicated that a director’s tenure should not be presumed to indicate anything problematic.
  • In evaluating equity compensation plans using a holistic approach, 75% of institutional investors indicated that performance conditions on awards is a “very significant” factor (64% and 57% indicated that the cost of the plan and other plan features, respectively, are also “very significant”). Plan cost and other plan features are “somewhat significant” from the perspective of 54% and 61% of issuers, respectively.

NEW “BENCHMARK CONSULTATION PERIOD”

As part of its effort to shift from a seasonal to a continual policy formulation process, ISS announced on November 21, 2013 that it was opening a new “benchmark consultation period” and inviting comments on several policy topics. For U.S. issuers, the following topics will remain open for comments until February 14, 2014:

Policy Topic

Current ISS Policy

Potential Policy Directions

Director Tenure

U.S. proxy voting policy does not consider director tenure in its classification of directors or as a key factor in determining vote recommendations on director elections.

• Consider a mix of director tenures on board as a key factor when determining a vote recommendation on members of the nominating committee (e.g., if average tenure and/or individual director’s tenure exceeds a specified level).

• Classify directors with lengthy tenures as non-independent and apply existing board-related voting polices as they relate to director independence.

• Maintain status quo.

Director Independence

Currently, ISS classifies directors into three categories:

• Inside directors;

• Affiliated outside directors (takes into account previous employment, material transactions and family relationships); and

• Independent outsiders.

• ISS is considering a more facts and circumstances, case-by-case approach to analyzing director independence for 2015 and beyond.

• Areas of focus are former CEOs, family relationships and professional relationships.

Independent Chair Shareholder Proposals

Generally recommend a vote for independent chair shareholder proposals unless the company maintains a counterbalancing governance structure (e.g., robust lead director position and no governance or performance concerns such as TSR relative to peer group).

• Generally vote for all independent chair shareholder proposals as a matter of best practice but consider company-specific circumstances (e.g., size, length of time as public company, CEO transition) on a case-by-case basis.

• Always vote for all independent chair shareholder proposals.

• Maintain status quo.

Auditor Ratification

Vote for proposals to ratify auditors unless any of the following apply:

• An auditor has a financial interest in or association with the company (and is therefore not independent);

• There is reason to believe that the independent auditor has rendered an opinion that is neither accurate nor reflective of the company’s financial position;

• Poor accounting practices are identified that rise to a serious level of concern, such as fraud; or

• Fees for non-audit services (“other fees”) are excessive.

• Update policy to consider auditor tenure as a factor in determining the vote recommendation on proposals to ratify auditors.

• Maintain status quo.

To the extent that ISS adopts policy changes in any or all of the areas subject to the “benchmark consultation period,” the new policies would not take effect until the 2015 proxy season (at the earliest).

NYSE/NASDAQ UPDATE

SEC APPROVES FINAL RULES ON COMPENSATION COMMITTEE LISTING STANDARDS

On January 11, 2013, the SEC approved the NYSE and NASDAQ listing standards implementing Exchange Act Rule 10C-1, which directs the exchanges to prohibit the listing of an equity security of a company that does not comply with the SEC’s rules regarding the independence of compensation committees and their advisers. Notably, however, there was concern that the NASDAQ’s bright-line rule prohibiting members of a compensation committee from receiving certain types of compensation would potentially burden NASDAQ companies seeking to recruit eligible directors. Specifically, NASDAQ received feedback from listed companies and others that the bright-line rule created a burden on issuers because in some industries, such as in energy and banking, directors do de minimus amounts of business with the issuer and these directors would automatically become ineligible under the final rule. As a result, on November 26, 2013, NASDAQ proposed a series of immediately effective amendments to its rules, bringing them more in line with the final NYSE rules. The final rules, as amended, are discussed below.

Final Listing Standards

Rule 10C-1

Rule 10C-1 outlines certain factors (set forth in the chart below) that compensation committees must take into account when considering the independence of its members and of its compensation advisers (which includes compensation consultants, legal counsel or other advisers, but excludes in-house legal counsel).

Factors Relating to Independence of Compensation Committee Members:

Factors Relating to Independence of Compensation Advisers:

• A director’s source of compensation, including any consulting, advisory or compensatory fee paid by the company; and

• Whether a director is affiliated with the company, a subsidiary of the company, or an affiliate of a subsidiary of the company.

• Whether the employer of the compensation adviser provides other services to the registrant;

• The amount of fees received from the registrant by the employer firm of the compensation adviser as a percentage of such firm’s total revenue;

• The policies and procedures of the compensation adviser’s employer that are designed to prevent conflicts of interest;

• Any business or personal relationship of the compensation adviser with a member of the compensation committee;

• Whether the compensation adviser owns any stock of the registrant; and

• Any business or personal relationship between the executive officers of the registrant and the compensation adviser or the employer of the compensation adviser.

Under Rule 10C-1, the compensation committee is also required to be directly responsible for the appointment, compensation and oversight of compensation advisers. Additionally, each company must provide its compensation committee with appropriate funding for the payment of “reasonable compensation” to compensation advisers.

NYSE and NASDAQ Final Rules

Most of the provisions of NASDAQ and NYSE rules require compliance by the earlier of (i) the registrant’s first annual meeting after January 14, 2014 or (ii) October 31, 2014. 

Compensation Adviser Independence Determinations

Both NASDAQ and NYSE companies are required to determine whether compensation advisers are independent from the management of the company using the six factors set forth in Rule 10C-1 (discussed above). Notably, Rule 10C-1 and the new exchange rules do not require a compensation committee to follow the recommendations of compensation advisers or otherwise impact the responsibility of a compensation committee to exercise its own independent judgment in the exercise of its duties. 

Comparative Summary of the Final Rules
Listed companies should carefully review the new rules as they consider how to approach the 2014 proxy season and how to address the issues set forth above. The following chart sets forth a comparative summary of the final compensation committee member and advisers independence standards for NASDAQ and NYSE.

Compensation Committee Independence[1]

NASDAQ

NYSE

The board is required to consider all factors specifically relevant to determining whether a director has a relationship to the listed company that is material to that director’s ability to be independent from management in connection with the duties of a compensation committee member, including, but not limited to, the two factors enumerated in Rule 10C-1 (as set forth above).

Compensation: The commentary provides that the board should consider whether the director receives any compensation that would impair the director’s ability to make independent judgments about the listed company’s executive compensation.

Affiliates: The commentary provides that stock ownership, even of a controlling interest, does not automatically preclude independence. The commentary also provides that the board should consider whether the relationship places the director under direct or indirect control of the listed company or its senior management, or creates a direct relationship between the director and members of senior management, in each case of a nature that would impair the director’s ability to make independent judgments about the listed company’s executive compensation.

NASDAQ’s rules also provide a limited exception from the independence standards in “exceptional and limited circumstances” where a director’s membership on the compensation committee is in the best interests of the company and its stockholders. However, a director appointed under such circumstances cannot serve on the compensation committee for more than two years.

The board is required to consider all factors specifically relevant to determining whether a director has a relationship to the listed company that is material to that director’s ability to be independent from management in connection with the duties of a compensation committee member, including, but not limited to, the two factors enumerated in Rule 10C-1 (as set forth above).

Compensation: The commentary provides that the board should consider whether the director receives any compensation that would impair the director’s ability to make independent judgments about the listed company’s executive compensation.

Affiliates: The commentary provides that stock ownership, even a significant amount, does not automatically preclude independence. The commentary also provides that the board should consider whether the relationship places the director under direct or indirect control of the listed company or its senior management, or creates a direct relationship between the director and members of senior management, in each case of a nature that would impair the director’s ability to make independent judgments about the listed company’s executive compensation.

Compensation Adviser Independence

NASDAQ

NYSE

The compensation committee must consider the six factors set forth in Rule 10C-1 before selecting, or receiving advice from, compensation advisers. In contrast to the NYSE rule, the NASDAQ rule does not require the compensation committee to consider any other factors.

As discussed above, Rule 303A.05(c) tracks the language of Rule 10C-1 almost verbatim in requiring that compensation committees consider the same six factors as those set forth in Rule 10C-1 when selecting compensation advisers. However, in contrast to the NASDAQ rule, the NYSE’s rule frames the six factors as a non-exhaustive list, providing that compensation committees must consider “all factors relevant” to that person’s independence from management.

Cure Periods

NASDAQ

NYSE

If a compensation committee fails to comply due to a vacancy or a compensation committee member ceases to meet the independence standards for reasons outside his reasonable control, he would be permitted to remain a member of the compensation committee until the earlier of (i) the next annual meeting or (ii) one year from date when the member ceased to be independent. However, if a company’s annual meeting is within 180 days of the event that caused noncompliance, the company will instead have 180 days to cure the noncompliance.

If a compensation committee member ceases to meet the independence standards for reasons outside his reasonable control, he would be permitted to remain a member of the compensation committee until the earlier of (i) the next annual meeting or (ii) one year from date when the member ceased to be independent. 

The rule limits the cure provision to situations where a majority of the compensation committee remains independent.

Smaller Reporting Companies

NASDAQ

NYSE

Generally exempted, except for the following:

  1. The company must have, and certify to having, a compensation committee of at least two members, each of whom must be an independent director;
  2. The company may rely on the “limited and exceptional circumstances” exception (discussed above) to the independence standards;
  3. The company may rely on the cure period; and
  4. The company must certify to having adopted a formal written charter or board resolutions that specifies the same authority and responsibilities, except for those set forth in Rule 10C-1 relating to compensation advisers.

Smaller reporting companies exempted from the following:

  1. Rule 303A.02(a)(ii) relating to the additional compensation committee member independence standards; and
  2. Rule 303A.05(c)(iv) relating to the independence considerations for compensation advisers.

SEC APPROVES NYSE ONE-YEAR INTERNAL AUDIT TRANSITION PERIOD FOR NEW LISTINGS

On August 22, 2013, the SEC approved an amendment to NYSE Rule 303A.00 providing any company listing as part of an IPO (or first-time registration of common stock under the Securities Exchange Act of 1934), or as part of a carve-out or spin-off transaction with a one-year period for compliance with the internal audit function requirement.

The NYSE requires that listed companies must have an internal audit function to provide management and the audit committee with ongoing assessments of the company’s risk management process and system of internal control. The rule allows this function to be outsourced to a third-party other than its independent auditor. The NYSE rule also provides that any company listing with the NYSE upon transferring from another national securities exchange that does not have an internal audit requirement has one-year from the date of listing with the NYSE to comply with 303A.07(c). Although NASDAQ proposed an internal audit function rule, it withdrew its proposal on May 7, 2013 after receiving negative feedback about the burden it would impose upon the many emerging public companies that list with the NASDAQ.[2]

SUPREME COURT TO RECONSIDER THEORY UNDERLYING MODERN SECURITIES CLASS ACTIONS

Last month, the Supreme Court agreed to reconsider the “fraud-on-the-market” presumption, an underpinning of class-action securities litigation for the last 25 years. The Court’s decision to grant certiorari in Halliburton Co. et al v. Erica P. John Fund, Inc., could significantly alter the landscape of private securities litigation in the United States.

The fraud-on-the-market theory, which has its roots in the Supreme Court’s 1988 decision in Basic v. Levinson, allows investors who claim to have lost money as a result of misstatements regarding a Company to recover damages without having to show that they actually relied on the misstatements in making their investment decision. Basic provided that plaintiffs could be presumed to have relied on distorted information and placed the burden on the defendant to prove that the plaintiffs did not in fact rely on that information. The Court’s decision in Basic was rooted in the then novel efficient-market hypothesis, which theorized that a public company’s stock’s price reflects all publicly available information regarding the company. The efficient-market hypothesis has come under increased scrutiny of late, with many investors and scholars citing the financial crisis that began in 2007 and related asset bubbles as an indication of how investor irrationality distorts market “efficiency.”

Basic was a four-to-two decision, with three Justices recusing themselves. Of the current nine Justices, the only two who were on the Court at the time of the Basic decision, Justices Kennedy and Scalia, were among the group who recused themselves. In a case decided last term, Amgen v. Connecticut Retirement Plans and Trust Funds, 133 S. Ct. 1184 (2013), Justices Scalia, Kennedy, Thomas and Alito indicated it might be appropriate to revisit the fraud-on-the-market theory because of increasing skepticism of the efficient-market hypothesis. In Amgen, the Court held that plaintiffs need not establish the materiality of alleged misrepresentations or omission at the class certification stage of a class action securities lawsuit.

The fraud-on-the-market theory is a powerful tool for the plaintiffs bar, as it enables certification of large classes in actions brought under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. If the Court overturns its holding in Basic, plaintiffs lawyers will likely face greater challenges when seeking to obtain class certification in securities fraud litigation. The magnitude of that increased burden, however, is currently the subject of much debate among commentators. Many believe that plaintiffs lawyers will turn to greater reliance on pursuing claims under Section 11 of the Securities Act, which statute does not require a showing of reliance but which instead holds issuers, officers, underwriters and experts virtually strictly liable for making a material misstatement or omission in a registration statement. While Section 11 claims do not require scienter or even negligence, they do require plaintiffs to trace the shares purchased back to the shares issued in the offering in regards to which the suit is filed, a key factor that will likely foreclose the possibility of a suit by many plaintiffs who could have otherwise maintained an action under Rule 10b-5. Other commentators predict plaintiffs’ attorneys also may revise the way they allege claims under Section 10. This is because the fraud-on-the-market theory’s presumption of reliance only applies to claims based upon misstatements. Based on other Supreme Court jurisprudence, a different presumption applies when the investor’s claim is based on allegedly omitted material information. In Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128 (1972), the Supreme Court similarly adopted a presumption of reliance, but not one that depended on a fraud-on-the-market theory. Since the line between alleged misstatements and omissions can be murky, plaintiffs could plead future 10b-5 claims based on alleged material omissions and not on material misstatements.

Oral arguments in the Haliburton case are scheduled for March, with the decision expected by mid-summer.

[1] Directors must also satisfy the exchanges’ existing director independence standards.

[2] However, the NASDAQ stated that it “remains committed to the underlying goal of the proposal, to help ensure that listed companies have appropriate processes in place to assess risks and the system of internal controls, and intends to file a revised proposal.” See Exchange Act Release 69792 (June 18, 2013).

Topics:  Annual Meeting, Annual Reports, Chief Compliance Officers, Compliance, Conflict Mineral Rules, Corporate Counsel, Corporate Governance, Dodd-Frank, Executive Compensation, Nasdaq, NYSE, Pay Ratio, Proxy Season, Regulation S-K, SEC, Shareholders, Year-End Planning

Published In: Business Organization Updates, Civil Procedure Updates, General Business Updates, Securities Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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