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.

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

by Anthony J. Ippolito, Jeff Beck and Lulu Chiu

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

by Jeffrey A. Scudder

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:

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:

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

by Joseph M. Miller

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).

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.

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

by Joel P. Hoxie and Joshua Schneiderman

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).