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).
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
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.
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.