Corporate Communicator - Winter 2015

by Snell & Wilmer
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2015 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. 

During 2015, members of our Corporate & Securities 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 Seventh Annual Public Company Proxy Season Update, which will be held in our Phoenix office on January 8, 2015. Finally, we are pleased to present our 2014 Tombstone, which highlights selected deals that Snell & Wilmer’s Corporate & Securities 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 2015 a successful year.

Very truly yours,
Snell & Wilmer
Corporate & Securities Group

SEC UPDATE

Dodd-Frank—A Few Items Remain

The SEC still has not adopted all the rules mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act and little progress was made during 2014. Following is a short discussion of key items remaining to be adopted. 

SAVE THE DATE

Seventh Annual Public Company Proxy Season Update, which will be held in our Phoenix office on January 8, 2015. 

Pay Disparity Ratio

As we reported last year, in September 2013, the SEC proposed to amend Item 402 of Regulation S-K (Executive Compensation) to require companies to disclose the ratio of the compensation of the principal executive officer compared 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 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, and foreign private issuers, among others. 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. Consequently, this rule should not impact the 2015 proxy season as the latest SEC agenda indicates the final rules may not even be adopted until October 2015. 

Many companies have started taking steps in anticipation of final adoption of the rule, including running mock calculations. Many companies are learning that while the rule appears simple on its face, they are discovering a variety of complexities and sensitive disclosure challenges. Remember, each company must find the “median” compensated employee. International operations, part-time employees, different payroll systems and exchange rate fluctuations create challenges in compiling and evaluating data. Designing a statistical sampling methodology is important and consistency will be an important theme — that is, once you pick a method, you should plan to stick with it year to year. Careful consideration needs to be given to how you calculate compensation for purposes of determining the median compensated employee in the first instance. For example, is just using W-2 wage information sufficient, or should health and similar benefits be considered? How do you handle foreign workers where compensation may be calculated differently, or on a different payroll system (potentially using a different fiscal year)? 

For a large international company, it is entirely possible that the median employee will be a factory worker in Malaysia one year and the next year it will be a customer service representative in Kansas. Once you determine the median compensated employee, you still need to calculate “total” compensation for that median compensated employee (based on the NEO Summary Compensation Table standards). Obviously, this calculation may be different, and potentially more variable, than the compensation calculation used to determine the median compensated employee (especially where statistical sampling methods are utilized). Consequently, this could result in a median compensation that varies significantly from year to year, such that it noticeably changes the pay ratio year to year. 

Companies should also consider how investors, activists, the media and proxy advisors might use the pay ratio to compare a company year to year, as well as against other peer companies. Finally, concerns have arisen of how practically to handle employee discontent when they learn they are paid at or below median. 

Compensation Clawback Policy

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 clawback 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.

Until the SEC proposes and adopts its rules to implement the Dodd-Frank mandate, many questions and implementation issues remain. For example,

  • How to document, implement and enforce the clawback policy, e.g., possible tools include corporate governance principles, code of ethics/conduct, incentive plans and/or award agreements, severance/change of control agreements, employment agreements, charter documents, etc. 
  • Administrative procedures; i.e., is the board, a board committee or one or more officers charged with enforcement? 
  • Calculation of the amount(s) to clawback may be complex, subjective or subject to dispute, probably more so with respect to equity awards than cash awards.
  • The clawback may be more difficult to enforce against terminated employees.
  • How to handle conflicting provisions in pre-existing employment agreements and similar legal hurdles and challenges. 
  • Dodd-Frank requires that the issuer recover the excess incentive-based compensation during the three-year period preceding the date on which the issuer is required to prepare an accounting restatement what would have been paid under the restatement. It is not entirely clear how you determine what period the clawback should cover. For example, assume that in the middle of year 5 an accounting restatement is made to the income statement for years 1 and 2—when is the three year recovery period? Years 1 to 3 or years 2.5 to 5.5? 
  • What if restatement would result in higher incentive compensation for one or more of the periods? Should the employee be entitled to the increased incentive compensation that would have been paid under the restatement?  

Pay For Performance

Dodd-Frank requires companies to disclose the relationship between executive compensation actually paid and the company’s financial performance. The SEC has not yet even proposed rules to implement this requirement and many questions remain. For example, it is not entirely clear how the SEC will interpret the meaning of compensation “actually paid” and whether companies will need to apply different standards than are applied to calculation of the compensation disclosed in the Summary Compensation Table (which does not in many cases reflect compensation “actually paid”). Also, Dodd-Frank is silent as to the performance measurement period, e.g., one year, two years, three years, five years, etc.

Hedging and Pledging Disclosures

Dodd-Frank requires companies to disclose whether any employee or member of the board of directors of the company is permitted to purchase financial instruments that are designed to hedge or offset any decrease in the market value of the company’s equity securities. The SEC still has not proposed rules to implement this requirement, although we do not expect this to be a particularly challenging or complex rule to implement as many proxy advisors and institutional investors have already “guided” many companies towards providing this type of disclosure. 

Conflict Minerals—Some Uncertainty Remains

In early June 2014, more than 1,300 public companies filed their first Form SDs in response to the SEC’s controversial conflict minerals rules mandated by Dodd-Frank. Of note, the total number of filings is significantly less than the SEC anticipated (approximately one-fifth). At this point, it is not clear whether this difference resulted from poor estimation by the SEC, aggressive interpretation by companies that they were not subject to the rules, or simple contempt for the filing requirement. We suspect few, if any, companies simply ignored the rules and believe the difference resulted from some combination of the first two factors. 

Complicating the current landscape is the decision of the United States Court of Appeals for the District of Columbia Circuit in National Association of Manufacturers, et al. v. SEC.[1] To summarize, the Court upheld most of the SEC’s conflict minerals rules but struck down on First Amendment grounds the provision that requires companies to describe their products manufactured as “not found to be ‘DRC conflict free.’” The Court stated that “conflict free” is a metaphor that “conveys moral responsibility for the Congo war” and would compel a company to “confess blood on its hands.” As a result of the Court’s decision, the SEC issued an order partially staying the effective date for compliance with the provision of the conflict minerals rules that requires a company to identify its products as “DRC conflict undeterminable” or “not found to be ‘DRC conflict free.’” The SEC made clear, however, that it still expects companies to disclose, for products that fall within the scope of the rules, the country of origin of the minerals and the efforts to determine the mine or location of origin of the minerals. 

In November, the D.C. Circuit Court of Appeals granted a petition from the SEC and Amnesty International for a panel rehearing of the NAM First Amendment issue. In short, the Court will consider the impact of its recent ruling in the American Meat Institute v. U.S. Dept. of Agricultural case on its prior NAM decision.[2] The First Amendment issues to be considered by the Court are technical and beyond the scope of this article but, in summary, they relate to what level of scrutiny the Court will apply to the required disclosures and whether the designation “not DRC conflict free” is “purely factual and uncontroversial” information. 

Many leading commentators believe the rules are here to stay. Nevertheless, the rules remain controversial and we note that the conflict minerals rules were adopted by a split (3-2) Commission along party lines. Moreover, the Commission was similarly split 3-2 in refusing to stay the entire conflict minerals rules pending further proceedings relating to the Court’s NAM decision.[3] And, with the Senate and House of Representatives now under Republican control, it is at least plausible that further legislative action could alter, or repeal, the rules. For now, however, the conflict minerals rules remain mostly in effect and, absent further developments, the second conflict minerals report will be due by June 1, 2015. 

A comprehensive analysis of the first filings is beyond the scope of this article. As a general matter, the first year filings reflect tremendous variation in approaches to preparing the Form SD and, if applicable, the conflict minerals report. To date, we are not aware of the SEC commenting on any individual filings. But, companies should be cognizant that human rights activists have criticized the initial filings as inadequate. At a minimum, companies should consider reviewing peer company filings as best practices are certain to develop as companies move into year two of the new reporting regime.

SEC Comment Letter Trends

The SEC continues with its mandatory reviews of public company periodic reports filed under the Securities Exchange Act of 1934. Since Sarbanes-Oxley was adopted in 2002, the SEC is required to review each issuer’s periodic reports at least once every three years. Although areas of coverage and emphasis vary company-to-company and industry-to-industry, common hot topics include benchmarking and performance target disclosures relating to executive compensation; material trends and uncertainties in MD&A; loss contingencies; non-GAAP financial measures; segment reporting; and the ability and intention to repatriate funds held outside the United States, and the consequences resulting therefrom. Companies should consider that the SEC has access to all public disclosures made by the company, including press releases, investor presentations and social media, and the SEC can, and will, review these disclosures for consistency. 

SEC’s Disclosure Effectiveness Initiative

Recently, the SEC launched its disclosure effectiveness project. This initiative was born out of the Jumpstart Our Business Startups Act, which required the SEC to report to Congress on improving its disclosure requirements. In this report to Congress, the SEC recommended that it conduct a broad-based review of Regulation S-K and Regulation S-X. Although the project is in its early stages, the SEC recently issued a call for public comments and interested parties are already responding. 

The SEC’s stated goal is to comprehensively review the requirements and make recommendations on how to update them to facilitate timely, material disclosure by companies and investor access to that information. The SEC has stated that the review will initially focus on the business and financial disclosures required in periodic and current reports, e.g., Forms 10-K, 10-Q and 8-K. Subsequent phases of the project will include compensation and governance information included in proxy statements.

For example, Keith Higgins, Director of the Division of Corporation Finance, recently suggested that the SEC is “cognizant” that repetitive information is presented in filings as a result of overlapping disclosure requirements contained in Regulation S-K and GAAP.[4] Mr. Higgins cited overlapping disclosures about legal proceedings, off-balance sheet arrangements, derivative instruments and share repurchases as examples of where the SEC and FASB require similar information be provided. In an April 2014 speech, Mr. Higgins similarly identified the common situation where accounting policies are often discussed in the financial statement footnotes and then again verbatim in the MD&A disclosures (covering critical accounting estimates).[5] Mr. Higgins stated: “if there were ever a place in a report that cried out for a cross reference — and there are likely plenty of them — this is near the top of the list.”[6]

We are optimistic that the SEC’s project will ultimately lead to improved disclosure requirements that benefit all stakeholders, including investors and companies that prepare the disclosures. 

____________________
Notes

[1] D.C. Cir. 2014. [back]

[2] D.C. Cir. 2014 (en banc). [back]

[3] The objecting Commissioners argued that the rules should have been stayed entirely because a report lacking a conclusion about whether the issuer’s conflict minerals were, or were not, DRC conflict free renders the rule pointless. [back]

[4] Keith F. Higgins, Director, Division of Corporation Finance, Shaping Company Disclosure: Remarks before the George A. Leet Business Law Conference, Oct. 3, 2014. [back]

[5] Keith F. Higgins, Director, Division of Corporation Finance, Disclosure Effectiveness: Remarks Before the American Bar Association Business Law Section Spring Meeting, April 11, 2014. [back]

[6] See footnote 4. [back]

PROXY AND CORPORATE GOVERNANCE CONSIDERATIONS

Proxy Season Trends

During the 2014 proxy season, the number of shareholder proposals at Russell 3000 companies remained steady, with a slight uptick in the number of proposals going to vote (67 percent in 2014, up from 65 percent in 2013) and a slight decline in the number of proposals being omitted under the SEC’s no-action process. Of the 226 no-action requests not withdrawn, the SEC granted relief to exclude in approximately 70 percent.

At the same time, public companies’ ability to negotiate with shareholders appeared to prove largely successful in 2014, as the number of proposals withdrawn increased to 12 percent in 2014 from 10 percent in 2013 and 6 percent in 2012. This trend is in line with the 12 percent drop in the number of no-action requests that the SEC received in 2014, which suggests that companies have increasingly been pursuing shareholder engagement with success.

Board Declassification, Voting, Tenure

In 2014, the most common shareholder proposals related to governance, social and political issues, which will likely continue to be recurring themes in the 2015 season.

Common shareholder proposals involving governance matters in 2014 included board declassification, majority voting for director elections, and elimination of supermajority voting provisions. For at least the first part of 2014, these types of proposals received high average favorable votes: proposals for board declassification averaged 81 percent in favor, majority (as opposed to plurality) voting for directors averaged 57 percent in favor, and elimination of supermajority vote requirements averaged 66 percent in favor.

Fewer of these types of governance-related shareholder proposals were directed at large-cap companies, most likely reflecting the fact that many large-cap companies have already instituted policies that address common shareholder concerns in the governance arena. However, there has been an increase in these types of shareholder proposals being submitted to mid- and small-cap companies.

New trends see companies receiving shareholder proposals related to the separation of CEO and chairman positions, director tenure, and board diversity – trends that many expect will continue in 2015. For example, although shareholder proposals to separate the positions of CEO and chairman failed to receive majority vote in most cases, they still received a respectable level of support, averaging 31 percent of votes in favor in the first half of 2014. Board diversity is another growing target of shareholder proposals. In ISS’s annual global voting policy survey, nearly 60 percent of institutional investors said they consider diversity when evaluating boards of directors. Companies have commonly responded to shareholder diversity proposals by including a diversity policy in their nominating committee charter. However, companies should be aware that shareholders may begin to request progress reports on diversity efforts, rather than merely reciting respect for diversity.

Another growing shareholder concern relates to board tenure. Some investors believe that directors with long tenure have diminished independence. The rising prevalence of this concern is reflected in ISS’s inclusion of board tenure as a new governance factor in its QuickScore calculation, as well as State Street Global Advisor’s adoption of a director tenure policy that will scrutinize director nominations if it feels that a company needs “board refreshment.” Companies may wish to consider including more information regarding a director’s background, experience, and contributions to the company to mitigate potential concerns about a director’s independence and thoughtfully consider how they nominate directors who have long tenure. 

Say-on-Pay and Compensation Proposals

The high approval rate by shareholders of companies’ say-on-pay proposals continued in 2014, the fourth year of the rule’s existence. Among the Russell 3000 companies holding say-on-pay votes between January 1 and September 5, 2014, shareholders voted in favor of such proposals at a rate of 91 percent on average, with only 2.4 percent of the proposals failing overall. This steady passage rate suggests that companies have continued to be successful in engaging with their shareholders to convey their strategies and actions and anticipating and responding to shareholder concerns.

Companies should be aware that there has been some litigation related to say-on-pay votes and the related compensation disclosures, sometimes involving claims of breach of fiduciary duty and insufficient compensation disclosures, for example. Though these suits have been largely unsuccessful, there have been occasional successes for plaintiffs, and companies should take steps to ensure the completeness of compensation disclosures, as well as be prepared for the possibility of compensation-related suits.

Proxy Access and Shareholder Participation

The 2014 proxy season saw a resurgence of shareholder focus on proxy access since the SEC’s proxy access rules were vacated in 2011. This is due largely to some pension funds’ dissatisfaction and frustration with the SEC’s failure to act in the three years since and with some companies’ disregard of shareholders’ votes on director nominees (i.e., despite majority votes by shareholders against an individual director nominee, many boards have declined to accept resignations). The New York Comptroller, acting on behalf of New York City Pension Funds, has begun a “Boardroom Accountability Project” in response to these concerns, sending 75 U.S. companies “3 percent/3-year proxy access proposals” that would allow shareholders who own at least 3 percent of a company for 3 or more years to list director candidates on the company’s ballot.[1] Other pension funds may be considering following suit.

When proxy access shareholder proposals to allow shareholders to nominate directors have made it onto the ballot, such as in the case of Oracle Corporation, they can achieve a high percentage of shareholder support, even despite management’s recommendation against the proposal. 

Another significant development in the proxy access arena this year was Whole Foods’ no-action request to the SEC in response to a 3 percent/3-year proxy access proposal submitted by a shareholder. Whole Foods sought in its no-action request to exclude the shareholder proposal on the grounds that it already has a 9 percent/5-year proxy access proposal on the proxy ballot. The proponent of the shareholder proposal had rebutted that the company’s proxy access threshold was too high to ever be triggered because Whole Foods’ largest shareholder owns only 5.4 percent. On December 1, 2014, the SEC granted Whole Foods’ no-action request in reliance on rule 14a-8(i)(9) regarding counterproposals. One question that the SEC’s decision raises is whether this opens the door for the SEC to essentially let companies adopt extreme threshold proxy access counterproposals (that may never be triggered) in response to a shareholder proposal with lower thresholds more likely to be triggered. It is anticipated that shareholders will not be satisfied with this turn of events, and Whole Foods shareholders might vote against the Company’s counterproposal, thereby putting pressure on Whole Foods to offer a lower threshold in the 2016 proxy season. The SEC’s decision could have far-reaching consequences on future proxy access shareholder proposals.

Social Policy Proposals

Shareholder proposals related to political contributions, lobbying and environmental activities were popular in 2014 and will likely continue to be popular in 2015. Proposals regarding corporate political spending were the most frequently submitted proposals, while proposals regarding environmental protection, human rights, and cybersecurity are emerging as hot topics. Political spending and lobbying activities have increasingly become a focus of shareholder proposals, a major shift from a few years ago when such issues were nearly nonexistent. In fact, shareholder proposals related to political spending and lobbying submitted to companies numbered 86 in 2014, with five receiving more than 40 percent of votes cast, compared to only one receiving more than 40 percent in 2013.

Shareholder Communication and Proxy Presentation

The overall decline in shareholder proposals suggests that a two-pronged strategy for dealing with shareholder proposals – negotiating with the proposing shareholder while simultaneously pursuing no-action relief from the SEC – has proved to be an effective strategy. Other strategies include communicating with shareholders during the off season, along with increasing readability of proxy materials. Many companies have begun to incorporate more visual aids into their proxy materials, including graphics and charts often in color, and executive summaries, particularly in the compensation discussion and analysis section to highlight key items such as executive compensation policies and the rationales behind such policies.

Voting Standards – Counting Nonvotes and Abstentions

Another hot topic during the 2014 proxy season, that will likely continue to be a hot topic in the coming season, was voting standards.

The issue of voting standards, particularly how to treat broker nonvotes and abstentions, received considerable attention this past proxy season. One company that found itself in the spotlight for its methodology for counting votes was Cheniere Energy. Cheniere had to postpone its 2014 annual meeting after several shareholders filed a lawsuit claiming that the company improperly awarded stock to employees under the company’s previous compensation plan because the company failed to garner a majority of shareholder votes to approve the previous plan due to the company’s exclusion of abstentions when counting votes. The shareholders claimed that Delaware law required that abstentions be counted as “no” votes and that under this standard, the plan did not receive sufficient votes for approval. Cheniere responded that it had disclosed that abstentions would not be counted and that its methodology was appropriate under NYSE rules. As of the time of writing of this article, Cheniere reached a settlement agreement to end the litigation that would place restrictions on executive compensation. Thus, the Delaware courts did not resolve the underlying issue.

In another well-publicized situation involving shareholder vote counting, shareholders of Nabors Industries approved a non-binding shareholder proposal submitted by the California Public Employees’ Retirement System (CalPERS) to exclude broker nonvotes when tallying votes. CalPERS introduced the measure after shareholder proposals submitted during the prior proxy season failed to garner majority votes when the company’s voting methodology included broker nonvotes. If the broker nonvotes had been excluded, the votes received in favor would have totaled a majority. According to CalPERS research report published September 17, 2013, only 36 companies in the Russell 1000 had voting methodologies that included nonvotes when tallying votes on shareholder proposals. Following the Nabors vote, CalPERS stated that it would seek to amend the company’s bylaws to eliminate the practice of counting nonvotes.

Much of the confusion surrounding voting standards and counting likely stems from the differing standards under Delaware law for counting nonvotes as opposed to abstentions, and from the differing standards used by companies for counting abstentions depending on what formulation of voting standard a company determines is proper and applicable, as well as NYSE’s treatment of abstentions. Under Delaware law, the generally accepted default rule is that a nonvote is excluded from the voting calculation. As to abstentions, if applying a “majority of shares present and entitled to vote” voting standard under Delaware law, most companies count abstentions as present and entitled to vote and count them as a “no” vote. If applying a “majority of votes” cast standard under Delaware law instead, most companies do not consider abstentions as votes cast and, accordingly, do not count them as “no” votes. In contrast, under NYSE rules, which impose the “majority of votes cast” standard, abstentions are generally treated as votes cast that should be counted as “no” votes.

In light of the focus on voting standards and vote counting methodologies, companies may wish to pay particular attention to which voting standard they apply and which methodology they use for counting votes, and once determined, companies should be careful to clearly and accurately disclose the standards for each matter to be voted on. This requires careful analysis of the various sources of authority that govern how votes should be counted, including state law, a company’s charter and bylaws, and any stock exchange requirements.

Proxy Advisory Firms Update

Institutional Shareholder Services, Inc. (ISS) recently issued its annual policy updates, which are effective for annual meetings held on or after February 1, 2015, and Glass, Lewis & Co., LLC (Glass Lewis) also issued its updated guidelines for the 2015 proxy season.

ISS Updates

This year’s policy update reflects a general concern of ISS of an increase in what it views as shareholder-unfriendly trends, including unilateral bylaw/charter amendments, combined chairman/CEO positions, and the adoption of exclusive venue and fee-shifting provisions. The updates also reflect attention to other “hot-button” social issues, including political campaign contributions and greenhouse gas emissions. The table below provides a summary of these policy updates, including the rationale provided by ISS for such changes and a summary of key changes to the prior policy.

Rationale

New Policy

Key Changes

Unilateral Bylaw/Charter Amendments

There has been a substantial increase in the number of shareholder unfriendly bylaw/charter amendments made by boards without shareholder ratification, many of which are adopted in connection with an IPO.

 

Generally vote against or withhold from directors individually, committee members, or the entire board (except new nominees, who should be considered case-by-case) if the board amends the company’s bylaws or charter without shareholder approval in a manner that materially diminishes shareholders’ rights or that could adversely impact shareholders.

Factors to consider:

  • The board’s rationale for adopting the bylaw/charter amendment without shareholder ratification;
  • Disclosure by the company of any significant engagement with shareholders regarding the amendment;
  • The level of impairment of shareholders’ rights caused by the board’s unilateral amendment;
  • The board’s track record with regard to unilateral board action on bylaw/charter amendments or other entrenchment provisions;
  • The company’s ownership structure;
  • The company’s existing governance provisions;
  • Whether the amendment was made prior to or in connection with the company’s IPO;
  • The timing of the board’s amendment to the bylaws/charter in connection with a significant business development; and
  • Other factors, as deemed appropriate.

Instead of examining unilateral bylaw/charter amendments under the “Governance Failures” policy (which is still effective), ISS adopted a stand-alone policy for unilateral bylaw/charter amendments.

Independent Chair (Separate Chair/CEO)

Under the proposed revisions, any single factor that may have previously resulted in a “For” or “Against” recommendation may be mitigated by other positive or negative aspects.

 

Generally vote for shareholder proposals requiring that the chairman’s position be held by an independent director, taking into consideration the following:

  • The scope of the proposal;
  • The company’s current board leadership structure;
  • The company’s governance structure and practices;
  • Company performance; and
  • Any other relevant factors that may be applicable.

Regarding the scope of the proposal, consider whether the proposal is precatory or binding and whether the proposal is seeking an immediate change in the chairman role or the policy can be implemented at the next CEO transition.

Under the review of the company’s board leadership structure, ISS may support the proposal under the following scenarios absent a compelling rationale: the presence of an executive or non-independent chair in addition to the CEO; a recent recombination of the role of CEO and chair; and/or departure from a structure with an independent chair.

When considering the governance structure, ISS will consider the overall independence of the board, the independence of key committees, the establishment of governance guidelines, board tenure and its relationship to CEO tenure, and any other factors that may be relevant.

The review of the company’s governance practices may include, but is not limited to poor compensation practices, material failures of governance and risk oversight, related-party transactions or other issues putting director independence at risk, corporate or management scandals, and actions by management or the board with potential or realized negative impact on shareholders.

ISS’s performance assessment will generally consider one-, three, and five-year TSR compared to the company’s peers and the market as a whole. While poor performance will weigh in favor of the adoption of an independent chair policy, strong performance over the long-term will be considered a mitigating factor when determining whether the proposed leadership change warrants support.

Updated the policy by adding new governance, board leadership, and performance factors to the analytical framework and to look at all of the factors in a holistic manner.

Litigation Rights (Including Exclusive Venue and Fee-Shifting Bylaw Provisions)

Companies have begun adopting bylaw provisions limiting shareholders’ litigation rights, starting with limiting the venue for shareholder lawsuits to the jurisdiction of incorporation.

Bylaw provisions impacting shareholders’ ability to bring suit against the company may include exclusive venue provisions, which provide that the state of incorporation shall be the sole venue for certain types of litigation, and fee-shifting provisions that require a shareholder who sues a company unsuccessfully to pay all litigation expenses of the defendant corporation.

Vote case-by-case on bylaws which impact shareholders’ litigation rights, taking into account factors such as:

  • The company’s stated rationale for adopting such a provision;
  • Disclosure of past harm from shareholder lawsuits in which plaintiffs were unsuccessful or shareholder lawsuits outside the jurisdiction of incorporation;
  • The breadth of application of the bylaw, including the types of lawsuits to which it would apply and the definition of key terms; and
  • Governance features such as shareholders’ ability to repeal the provision at a later date (including the vote standard applied when shareholders attempt to amend the bylaws) and their ability to hold directors accountable through annual director elections and a majority vote standard in uncontested elections.

Generally vote against bylaws that mandate fee-shifting whenever plaintiffs are not completely successful on the merits (i.e., in cases where the plaintiffs are partially successful).

Unilateral adoption by the board of bylaw provisions which affect shareholders’ litigation rights will be evaluated under ISS’s policy on Unilateral Bylaw/Charter Amendments.

Expanded the policy to cover other types of bylaw provisions which have a material impact on shareholders’ litigation rights, such as mandated fee-shifting or arbitration.

Equity-Based and Other Incentive Plans

In light of market recovery, investors may be more critical of equity transfers to management without shareholder-friendly plan features and grant practices.

Vote case-by-case on equity-based compensation plans depending on a combination of certain plan features and equity grant practices, where positive factors may counterbalance negative factors, and vice versa, as evaluated in three pillars:

Plan Cost: The total estimated cost of the company’s equity plans relative to industry/market cap peers, measured by the company’s estimated shareholder value transfer (SVT) in relation to peers and considering both:

  • SVT based on new shares requested plus shares remaining for future grants, plus outstanding unvested/unexercised grants; and
  • SVT based only on new shares requested plus shares remaining for future grants.

Plan Features:

  • Automatic single-triggered award vesting upon a change in control (CIC);
  • Discretionary vesting authority;
  • Liberal share recycling on various award types; and
  • Minimum vesting period for grants made under the plan.

Grant Practices:

  • The company’s three year burn rate relative to its industry/market cap peers;
  • Vesting requirements in most recent CEO equity grants (three year look-back);
  • The estimated duration of the plan based on the sum of shares remaining available and the new shares requested, divided by the average annual shares granted in the prior three years;
  • The proportion of the CEO’s most recent equity grants/awards subject to performance conditions;
  • Whether the company maintains a clawback policy; and
  • Whether the company has established post exercise/vesting share-holding requirements.

Generally vote against the plan proposal if the combination of above factors indicates that the plan is not, overall, in shareholders’ interests, or if any of the following apply:

  • Awards may vest in connection with a liberal change-of-control definition;
  • The plan would permit repricing or cash buyout of underwater options without shareholder approval (either by expressly permitting it – for NYSE and Nasdaq listed companies – or by not prohibiting it when the company has a history of repricing – for non-listed companies);
  • The plan is a vehicle for problematic pay practices or a pay-for-performance disconnect; or
  • Any other plan features are determined to have a significant negative impact on shareholder interests.

Adopted a “scorecard” model (Equity Plan Scorecard — “EPSC”) that considers a range of positive and negative factors, rather than a series of “pass” or “fail” tests, to evaluate equity incentive plan proposals.

 

Political Contributions

ISS wanted to provide greater clarity regarding the types of oversight mechanisms (i.e., management and board oversight) that it reviews and considers.

Generally vote for proposals requesting greater disclosure of a company’s political contributions and trade association spending policies and activities, considering:

  • The company’s policies, and management and board oversight related to its direct political contributions and payments to trade associations or other groups that may be used for political purposes;
  • The company’s disclosure regarding its support of, and participation in, trade associations or other groups that may make political contributions; and
  • Recent significant controversies, fines, or litigation related to the company’s political contributions or political activities.

Refined and clarified the current policy in various respects.

Greenhouse Gas Emissions

During the 2014 proxy season, the most prevalent resolutions on climate change were those that asked companies to adopt goals to reduce their greenhouse gas (GHG) emissions.

Vote case-by-case on proposals that call for the adoption of GHG reduction goals from products and operations, taking into account:

  • Whether the company provides disclosure of year-over-year GHG emissions performance data;
  • Whether company disclosure lags behind industry peers;
  • The company’s actual GHG emissions performance;
  • The company’s current GHG emission policies, oversight mechanisms, and related initiatives; and
  • Whether the company has been the subject of recent, significant violations, fines, litigation, or controversy related to GHG emissions.

Updated and expanded the current policy.

Glass Lewis Updates

Similar to the ISS policy updates, the Glass Lewis policy updates reflect similar concern over bylaw/charter provisions that are viewed as shareholder unfriendly, not only in the context of unilateral adoption, but also in the context of IPOs and shareholder proposals. The updated guidelines also address conflicts of interest, executive compensation and stock repurchase programs. Below is a summary of the guideline updates.

Governance Committee Performance

Glass Lewis may recommend that shareholders vote against the chair of the governance committee, or the entire committee, if the board amends its bylaws in a manner that reduces, removes or impairs the exercise of important shareholders rights, without shareholder approval, such as (i) eliminating the ability of shareholders to call a special meeting or to act by written consent, (ii) increasing the ownership threshold required for shareholders to call a special meeting, (iii) increasing the voting requirements for charter or bylaw amendments, (iv) adopting provisions that require arbitration of shareholder claims or fee-shifting bylaws, (v) adopting a classified board, and (vi) eliminating the ability of shareholders to remove a director without cause.

Board Responsiveness to Majority-Approved Shareholder Proposals

Glass Lewis will generally recommend that shareholders vote against all members of the governance committee if the board does not adequately respond to a shareholder proposal that received majority-support during their tenure. In determining whether the board has adequately responded to the proposal, Glass Lewis will examine the quality of the right enacted or proffered by the board for “any conditions that may unreasonably interfere with the shareholders’ ability to exercise the right (e.g., overly prescriptive procedural requirements for calling a special meeting).”

Vote Recommendations Following IPO

Glass Lewis has increased its scrutiny of anti-takeover or other shareholder-unfriendly bylaw/charter provisions adopted prior to an IPO and will recommend that shareholders vote against the all members of the board who served when the anti-takeover provisions were adopted if the provisions are not put up for shareholder vote following the IPO. Further, Glass Lewis will recommend voting against the governance committee chair if an IPO company adopts an exclusive forum provision, or the entire governance committee if it adopts a fee-shifting provision or other provisions limiting shareholder litigation rights, if those provisions are not put up for shareholder vote after the IPO. 

Advisory Vote on Executive Compensation (Say-on-Pay)

One-Off Awards. While shareholders should generally be wary of awards granted outside of the standard incentive schemes and that such compensation programs should generally be redesigned, Glass Lewis will recognize that in certain circumstances these awards may be appropriate provided the company provides a thorough description of the awards, including a “cogent and convincing explanation” of their necessity and why existing awards do not provide sufficient motivation. Further, such awards should be tied to future service and performance whenever possible. In addition, companies should also describe if and how the regular compensation arrangements will be affected by these supplemental awards. In reviewing a company’s use of supplemental awards, Glass Lewis will review the terms and size of the grants in the context of the company’s overall incentive strategy and granting practices, as well as the current operating environment.

Qualitative Factors. Glass Lewis revised how it describes what happens if a company receives a failing grade from its pay-for-performance model, which grades companies from “A” to “F”. Glass Lewis now indicates that other qualitative factors, such as (i) an effective overall incentive structure, (ii) the relevance of selected performance metrics, (iii) significant forthcoming enhancements or (iv) reasonable long-term payout levels, may cause Glass Lewis to recommend in favor of a proposal, even when there is a pay-for-performance disconnect.

Employee Stock Purchase Plans

Glass Lewis will examine employee stock purchase plans (ESPPs) using a quantitative model to estimate the cost of the plan by measuring the expected discount, purchase period, expected purchase activity (if previous activity has been disclosed) and whether the plan has a “lookback” feature. It then compares this cost to ESPPs at similar companies. Except for the most extreme cases, Glass Lewis will generally support these plans given the regulatory purchase limit of $25,000 per employee per year.

Notes

[1] A list of the targeted companies is published on the Boardroom Accountability Project and the Office of the New York City Comptroller Scott M. Stringer. [back]

ENFORCEMENT AND LITIGATION DEVELOPMENTS

SEC Forges Ahead With “Broken Windows” Enforcement Strategy

It’s been a little over a year since Mary Jo White, the Chairwoman of the Securities and Exchange Commission, announced the SEC’s new “broken windows” theory of enforcement. The concept, a prominent theory associated with law enforcement, calls for authorities to enforce even minor legal infractions to foster a culture of compliance with the law. “We are looking for the ‘broken windows’ in our markets,” Ms. White explained, “and not overlooking the small violations to avoid breeding an environment of indifference to our rules.”

To that end, in October 2014, the SEC announced that in its 2014 fiscal year, which ended in September, the SEC filed a record 755 enforcement actions relating to a broad array of legal infractions. All told, the SEC obtained orders totaling $4.2 billion in disgorgement and penalties. These figures compare to 686 enforcement actions and orders totaling $3.4 billion in disgorgement and penalties in fiscal year 2013, and 734 enforcement actions and orders totaling $3.1 billion in disgorgement and penalties in fiscal year 2012.

“Aggressive enforcement against wrongdoers who harm investors and threaten our financial markets remains a top priority, and we brought and will continue to bring creative and important enforcement actions across a broad range of the securities markets,” said Ms. White in regards to the 2014 figures. Key to the SEC’s ability to pursue a greater number of infractions is its enhanced use of data and quantitative analysis, which has expanded the agency’s ability to detect misconduct. (see SEC’s First Sweep Investigation of Beneficial Ownership Reporting for one such example of the SEC’s use of data and quantitative analysis to pursue enforcement actions in regards to filings under Section 13(d) and Section 16(a) of the Securities Exchange Act).

The SEC, however, is not united in its support of the “broken windows” theory. In October 2014, Michael S. Piwowar, an SEC commissioner, criticized the tactic. “If every rule is a priority, then no rule is a priority,” he said. “[R]ather than enabling vital and important economic activity, we will have unnecessarily shackled it — and our country will be far worse off from the absence of such activity.” Mr. Piwowar argued that the SEC’s “broken windows” approach is flawed because regulation should be aimed at achieving resilient markets, not merely regulatory compliance.

Despite the internal tension at the SEC over the “broken windows” strategy, it appears to be here to stay for the time being. “Time and again this past year, the Division’s staff applied its tremendous energy and talent, uncovered misconduct, and held accountable those who were responsible for wrongdoing,” said Andrew J. Ceresney, Director of the SEC’s Division of Enforcement, in a statement issued by the SEC in October. “I am proud of our excellent record of success and look forward to another year filled with high-impact enforcement actions.”

SEC’s First Sweep Investigation of Beneficial Ownership Reporting

In September of 2014, the SEC initiated a series of enforcement actions relating to Section 13(d) and Section 16(a) of the Securities Exchange Act. SEC enforcement actions specifically targeting 13(d) and 16(a) reporting are relatively rare. This sweep may signal an increased enforcement focus on the SEC beneficial ownership rules, and it is likely the product of the SEC’s “broken-window” enforcement theory and its new use of quantitative data analysis to identify suspicious behavior.

The SEC charged a total of 34 companies, executive officers, directors and significant shareholders of public companies. The defendants included 13 individual officers and directors, five individual 5 percent owners, six public companies, nine prominent asset managers and one money-center bank. The defendants were charged with making late filings, or in some cases, not filing at all. Notable is that some filings were only a few days late. This group of defendants agreed to pay penalties ranging from $26,000 to $150,000, for a total of $2.6 million in penalties.

In several cases relating to Section 16(a) filings, public companies were charged for failing to make timely filings on behalf of insiders or failing to report insiders’ filing deficiencies. In one of the cases, the SEC argued that the reporting deficiency rendered the company’s proxy statement materially misleading, and subject to antifraud charges. As noted by Michele Wein Layne, Director of the SEC’s Los Angeles Regional Office, in regards to the case, “It’s not merely a technical lapse when executives fail to report their transactions in company stock, because investors are consequently denied important and timely information about how an insider is potentially viewing the company’s future prospects.” Since many companies file Section 16 reports on behalf of their officers or directors, this recent round of cases serves as a reminder that companies must have disclosure controls to identify and timely report beneficial ownership information in accordance with the regulations.

The SEC used sophisticated computer algorithms and quantitative data sources to identify the violations. Until recently, the SEC did not have analytical tools that would allow it to conduct broad searches across large quantities of data in its EDGAR database. Today, the agency is expending more efforts to develop its tools that allow the agency to sort through the large quantities of data on EDGAR. Companies should expect to see more enforcement cases based on quantitative analysis in the future.

SEC Slow to Act on Dodd-Frank Mandated Clawbacks While Continuing To Recoup Funds Under More Limited Sarbanes-Oxley Rules; Glass Lewis Issues Clawback Guidance Ahead of SEC Rulemaking

As has been widely reported, the SEC remains woefully behind in meeting the rulemaking deadlines mandated by Dodd-Frank, and the requirement to implement executive compensation clawback rules appears to remain towards the bottom of the pack. The Dodd-Frank executive compensation clawback provisions came into renewed focus in late 2014 when Glass Lewis, not waiting for the SEC to implement the clawback provisions mandated by Dodd-Frank, issued its own guidance on recoupment of executive compensation. At the same time, the SEC continued to pursue clawbacks under the more limited existing rules under Sarbanes-Oxley.

Beating the SEC to the punch, in its 2015 Proxy Paper Guidelines issued on November 6, 2014, Glass Lewis encouraged reporting companies to not wait for the SEC to propose and implement clawback rules, stating, “We believe it is prudent for boards to adopt detailed and stringent bonus recoupment policies to prevent executives from retaining performance-based awards that were not truly earned.” Glass Lewis went on to say that such “policies should be triggered in the event of a restatement of financial results or similar revision of performance indicators upon which bonuses were based.” In addition, Glass Lewis stated that recoupment policies “should be subject to only limited discretion to ensure the integrity of such policies.”

Clawback provisions are currently in effect under Section 304 of the Sarbanes-Oxley Act, however, the Sarbanes-Oxley provisions are more limited than the Dodd-Frank mandated provisions in several important ways: (i) the Sarbanes-Oxley provisions only apply to the CEO and CFO as opposed to all current and former executive officers; (ii) Sarbanes-Oxley only has a 12-month look-back period as opposed to the three-year look-back required by Dodd-Frank; and (iii) the Sarbanes-Oxley provisions are only triggered by misconduct on the part of the executive or other employees, whereas Dodd-Frank provides for compensation forfeiture based upon a financial restatement due to false data.

Despite the SEC’s sluggishness to implement the Dodd-Frank recoupment provisions, the SEC has continued to aggressively pursue clawbacks under Sarbanes-Oxley. As of late September, the SEC reported that it had secured clawbacks from 52 individuals at 32 companies. Most recently, the SEC recovered $2.5 million from Babak “Bobby” Yazdani, former CEO Of Saba Software Inc., who reached a settlement with the SEC relating to an alleged scheme involving falsified time-sheets. According to the results of an SEC investigation, Saba executives orchestrated a scheme in which managers based in the U.S. directed consultants in India to either falsely record time that they had not yet worked, or purposely fail to record hours worked during certain pay periods to conceal budget overruns from management and finance divisions. The scheme enabled Saba to obtain its quarterly revenue and margin targets by improperly accelerating and misstating large portions of its professional services and license revenues.

Court Holds that MD&A Disclosure Rules Do Not Trigger Rule 10b-5 Disclosure Obligations

In a ruling that resulted in reporting companies breathing a sigh of relief, the Ninth Circuit Court of Appeals held in In re: NVIDIA Corporation Securities Litigation that the SEC’s rules requiring reporting companies to include a discussion and analysis of their financial condition and results of operations (MD&A) does not create a duty to disclose under Section 10(b) of the Securities and Exchange Act of 1934 and Rule 10b-5.

In reaching its decision, the Court noted that neither Section 10(b) nor Rule 10b-5 create an affirmative obligation to disclose any and all material information. As historically laid out in Basic Inc. v. Levinson, “[s]ilence, absent a duty to disclose, is not misleading under Rule 10b-5.” Management’s duty to disclose in its MD&A, the Court noted, is broader than the duty to disclose under Basic. While under the MD&A rules management is not required to disclose known trends and uncertainties that it determines are not reasonably likely to occur, if management is unable to reach such determination, it must disclose its evaluation of the consequences of the known trends and uncertainties. In contrast, under the Basic standard, the disclosure obligation for Rule 10b-5 purposes hinges “upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.” Comparing these requirements, the Court concluded, “because the materiality standards for Rule 10b-5 and [MD&A] differ significantly, the demonstration of a violation of the disclosure requirements of [MD&A] does not lead inevitably to the conclusion that such disclosure would be required under Rule 10b-5.”

In reaching its decision, the Court thwarted attempts by plaintiffs’ firms to use issuers’ MD&A in periodic reports as a basis for Rule 10b-5 claims. The Court effectively left intact a long line of cases, including Basic, which, for Rule 10b-5 purposes, only requires disclosure when necessary to make statements made, in light of the circumstances under which they were made, not misleading.

*Gregory Ge graduated from the University of Notre Dame Law School in 2014 and is not currently licensed to practice law.

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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JD Supra Privacy Policy

Updated: May 25, 2018:

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