In anticipation of the upcoming annual report and proxy season, we are highlighting new requirements and trends that may impact public companies in 2017.
Non-GAAP Financial Measures
Reevaluate Non-GAAP Disclosures in Light of Updated C&DIs and Other SEC Actions. As the reporting season gets underway, reviewing non-GAAP disclosure practices should remain a top priority in light of the new and updated Non-GAAP Financial Measures Compliance & Disclosure Interpretations (C&DIs) released by the Securities and Exchange Commission (SEC) in May 2016.
The SEC’s Division of Corporation Finance has issued hundreds of comment letters dealing with non-GAAP disclosures since the new and updated C&DIs were released. The SEC’s Division of Enforcement has also reportedly been focused on non-GAAP disclosures, including those made prior to the release of the new C&DIs. In anticipation of their upcoming Q4 earnings releases and annual reports on Form 10-K, companies should ensure that their non-GAAP disclosures comply with the new and updated guidance. Companies that have already reviewed their non-GAAP disclosure practices in connection with earlier periods might take this opportunity to review their annual guidance disclosures, to the extent guidance includes non-GAAP measures. Question 102.10 from the updated C&DIs indicates that the SEC staff expects forward-looking non-GAAP measures to be accompanied by a quantitative reconciliation or specific disclosure that the company is excluding the reconciliation under the “unreasonable efforts” exception in Regulation S-K Item 10(e)(1)(i)(B), along with identification of the information that is unavailable and its probable significance. See our prior update for additional details on the new and updated C&DIs.
Review Use of Non-GAAP Financial Measures in Proxy Statements. Many proxy statements include non-GAAP financial measures to describe annual financial highlights or explain the relationship between pay and performance. The limited exemption from Regulation G and Item 10(e) of Regulation S-K for proxy statement disclosure of non-GAAP financial measures used for executive compensation target levels does not apply to other disclosures of non-GAAP measures. Companies should ensure that any disclosures of non-GAAP financial measures in proxy statements are drafted with applicable SEC guidance in mind.
Proxy Statement and Annual Meeting Matters
Note that Say-on-Frequency Vote Will Be Required for Most Companies. It has been six years since the initial applicability of the say-on-pay rule (Exchange Act Rule 14a-21). This means that calendar year and many other companies will have to include in their 2017 proxy statement the advisory say-on-frequency vote that must be held every six years. The say-on-frequency vote will be required even if a company already conducts the say-on-pay vote annually and intends to continue doing so. In addition, companies will need to report not only the results of the say-on-frequency vote but also the board’s decision on how frequently to hold the say-on-pay vote in the future in light of that vote, either in the Form 8-K that is filed to report the results of the annual shareholder meeting or in an amendment thereto.
Consider Board Refreshment and Diversity. Board refreshment and diversity continue as hot topics in governance circles in 2016. The California Public Employees’ Retirement System (CalPERS) revised its Global Governance Principles in 2016 to encourage companies to review the independence of board members serving 12 years or more and provide “a detailed annual explanation of why the director can continue to be classified as independent.” Institutional Shareholder Services (ISS) recently announced its updated and rebranded “QualityScore” (formerly “QuickScore”) scoring model, including a new director tenure factor in its corporate governance analysis that grants additional credit for nonexecutive directors with less than six years of tenure, for up to one third of directors.
Boards might consider highlighting board refreshment and diversity in the annual board evaluation process by soliciting input on specific skills the board should be looking for and suggestions for diverse candidates for new or open board seats. Companies should also consider increasing disclosure regarding board tenure and diversity and the board self-evaluation process in the proxy statement.
Review Audit Committee Disclosure Practices. Increased focus from the SEC and institutional investors on audit committee disclosure in recent years has led many public companies to voluntarily increase disclosure in this area. These voluntary disclosures often touch on topics related to the committee’s selection, retention and oversight of the independent auditor, such as the committee’s involvement in negotiating the auditor’s fees, consideration of the significance of non-audit services when assessing independence, consideration of auditor tenure, and factors considered in assessing the auditor’s quality and qualifications. On July 1, 2015, the SEC issued a concept release seeking public comment on audit committee disclosure requirements, and during the past few proxy seasons, the United Brotherhood of Carpenters Pension Fund reached out to over 70 public companies to request additional disclosures on audit committee oversight. The concern being addressed is that the current required audit committee disclosures do not provide sufficient consolidated information on how the audit committee oversees the company’s independent auditor and financial reporting process. A company might consider enhancing its audit committee-related disclosures to preempt concerns that its institutional investors’ may have about the lack of transparency about the audit committee’s role.
Check Proxy Cards and Voting Disclosures. The SEC released a proxy card C&DI on March 22, 2016, which served as a reminder that proxy cards must “clearly and impartially” identify each item to be voted on by shareholders and provided specific examples on what this guidance means for shareholder proposals. The SEC’s October proposal on universal proxy card rules also highlighted the SEC’s previously expressed concerns about poorly drafted proxy statement and proxy card descriptions of the voting standard for director elections. The SEC specified in the proposed rules that companies with a majority vote standard generally would be required to include options to vote “against” the nominee and to “abstain” from voting, but not an option to “withhold” against a director. Companies with a plurality voting standard, including plurality voting with a director resignation policy, would need to disclose the treatment and effect of a “withhold” vote in the election.
Matters Potentially Impacting D&O Questionnaires
NASDAQ Golden Leash Disclosure. New Nasdaq Listing Rule 5250(b)(3) requires listed companies to publicly disclose (in a proxy, information statement or annual report, or on the company’s website) the material terms of certain compensation or other payments provided by third parties to directors or director nominees. Because Item 402 of Regulation S-K generally requires disclosure of director compensation paid by any person (including third parties), standard questions about director compensation in D&O questionnaires may already address third party director compensation arrangements. However, because the new Nasdaq disclosure requirement does not perfectly overlap with Item 402 requirements, Nasdaq listed companies should ensure that their director compensation questions in their D&O questionnaires are broad enough to elicit all of the types of compensation contemplated by the new rule, including non-cash compensation and other payment obligations such as health insurance premiums and indemnification arrangements. Updating your D&O questionnaires to pick up the additional nuances in the new rule may also help qualify for a safe harbor that excuses noncompliance by companies that undertake “reasonable efforts” to identify all relevant golden leash arrangements and that promptly discloses such arrangements following their discovery.
Note: The NYSE has not adopted such a rule, so NYSE-listed companies do not need to update their D&O questionnaires.
Consult Auditor Regarding Process for Gathering AS-18 Related Party Information. The Public Company Accounting Oversight Board (PCAOB) adopted AS-18 effective for fiscal years beginning on or after December 15, 2014, requiring independent auditors to review company disclosures of related party transactions using a broader definition of “related party” than that required by Item 404 of Regulation S-K. Some auditors are requesting that companies obtain more information on related parties than typically has been gathered in D&O questionnaires. A company might need to gather names of directors’ family members and any entities that the director or his or her family members control or exert significantly influence. Before distributing D&O questionnaires, a company should consult with its independent auditor to determine if the questionnaires need to be updated or if the company will need to supplement its usual D&O questionnaire process for purposes of AS-18.
Continue Iran “Section 219” Disclosures. Although a number of sanctions implemented against Iran by the United States and certain other nations were lifted in January 2016 pursuant to the Joint Comprehensive Plan of Action (JCPOA), many sanctions were not affected by the JCPOA, and the “Section 219” disclosure requirements remain in effect. Consequently, companies whose securities are traded in the United States must still report business dealings in Iran in their periodic reports and file the related IRANNOTICE with the SEC. Accordingly, D&O questionnaires should continue to ask about Iran-related activities.
Other 2017 Proxy and Annual Reporting Matters
ISS and Glass Lewis 2017 Policy Updates. In November 2016, Glass Lewis and ISS released their 2017 proxy voting guidelines. As expected, both implemented their new policies on overboarding, previously announced in 2016, to recommend against directors who sit on more than five public company boards (down from six) or are CEOs of public companies who sit on the boards of more than two other public companies. Both also addressed governance issues following an initial public offering. Glass Lewis clarified its approach to board evaluation, succession planning and refreshment, stating that it believes a robust board evaluation process focused on the assessment and alignment of director skills with company strategy is more effective than solely relying on age or tenure limits. ISS introduced an analysis of factors it will consider in reviewing management proposals for ratification of director pay programs or approval of equity plans for non-employee directors, and it clarified the impact on its analysis of management equity plan proposals of the payment of dividends on unvested awards and a one-year minimum vesting period. As noted above, ISS has revised and rebranded its governance rating QualityScore model. Companies that have experienced a significant adverse change to their recently published QualityScore from last year’s QuickScore rating should consider using the ISS data verification portal before filing their proxy statement to determine if any requests for corrections should be submitted to ISS.
SEC Interim Final Rule Expressly Permits Companies to Include a Summary in 10-K Filings. On June 9, 2016, the SEC’s interim final rule expressly permitting companies to provide a summary of business and financial information in their 10-K filings took effect. New Item 16 of Form 10-K authorizes, but does not require, companies to include a summary of the information required by the Form 10-K, provided that each item in the summary includes a cross-reference by hyperlink to the related, more detailed disclosure item elsewhere in the report or, if applicable, to the related exhibit. The SEC’s rules did not prohibit companies from voluntarily providing 10-K summaries prior to adoption of the new rule, and several were doing so. Accordingly, the new rule will likely have little impact except to require companies to include hyperlinks and meet the other minimal requirements of the rule.
No Need to Mail Annual Report to the SEC. In November, the SEC posted a new C&DI permitting companies to satisfy the proxy statement rule requirements that call for annual reports sent to security holders to be mailed to the SEC by posting an electronic version of the annual report to the company’s corporate website. The C&DI says that the report will be considered available to the SEC if it is accessible on the company’s website for at least one year after posting.
Virtual-Only Annual Meetings. In 2016, a growing number of companies—including S&P 500 companies HP, Intel, Comcast and PayPal—opted to hold their annual shareholder meeting exclusively online (i.e., a virtual meeting without a corresponding physical meeting). A hybrid meeting format, supplementing the physical shareholder meeting with the option to attend online, has been popular with many companies for several years, but the rise of virtual-only meetings among high profile companies represents a significant shift. Both the Council of Institutional Investors (CII) and CalPERS, among other high-profile investors and investor groups, oppose virtual-only annual meetings, preferring the hybrid format. Advocates argue that the virtual-only format promotes cost savings and increases opportunities for shareholder participation. Critics, on the other hand, assert that the virtual-only format allows companies to control the questions that shareholders ask and prevents shareholders from interacting with management, which limits the ability of shareholders to hold company management accountable. A company interested in moving to a virtual-only annual shareholder meeting should, as an initial matter, confer with counsel to confirm that the laws of its state of incorporation permit virtual-only meetings and the requirements for such meetings. While Delaware moved to permit virtual-only meetings several years ago, not all state corporate laws permit a virtual-only shareholder meeting. Outreach to gauge the responses of large shareholders to the proposal also may be desirable.
What to Watch for Beyond the 2017 Proxy Season
In light of the upcoming administration change, and Chair White’s announced plans to depart the SEC at the end of the current administration, the SEC’s rulemaking priorities are expected to shift. We address here only adopted rules with future implementation dates, changes to which would require new rulemaking, including new notice and comment periods.
Pay Ratio Disclosures in the 2018 Proxy Season. The 2018 proxy season is the first time that public companies will be required to make the CEO Pay Ratio Disclosures, adopted by the SEC on August 5, 2015. The CEO Pay Ratio Disclosures rule requires disclosure of (1) the median of the annual total compensation of all employees, excluding the CEO; (2) the annual total compensation of the CEO; and (3) the ratio of these two totals.
On October 18, 2016, the SEC issued five C&DIs (Questions 128C.01-05), which provide the first guidelines for the Pay Ratio Disclosures. The guidance is limited, but the reports clarify that companies must pick a date within the last three months of their fiscal year to determine the employee population that will be used to calculate the median of annual total employee compensation. The population of employees includes employees that the company or its subsidiaries determine compensation for, regardless of whether the workers are considered employees for tax or employment law purposes, but it excludes third-party contract workers whose compensation is determined by unaffiliated third parties.
The C&DIs reduce some of the flexibility that seemed to exist for companies under the Pay Ratio Disclosure rules when selecting a compensation measure to determine the median employee compensation. Companies previously thought that they could use only cash compensation of employees to determine the median employee figure, but the SEC guidance states that the compensation should “reasonably reflect” annual compensation of employees and this determination varies based on the company’s particular set of facts and circumstances. For example, a company cannot use cash compensation alone to determine the median employee if the company distributes equity awards “widely.” The guidelines pose a new challenge since companies will have to use their judgement to determine what “reasonably reflects” and “widely” mean.
Companies should begin strategizing now to prepare for the Pay Ratio Disclosure rule since it will take time to collect and analyze the compensation data in order to accurately prepare the disclosure. For more information on the Pay Ratio Disclosure rules, please see our prior update.
Resource Extraction Payments Disclosure in the 2019 Proxy Season. On June 27, 2016, the SEC adopted rules to require resource extraction companies to disclose payments over $100,000 made to the U.S. federal government or to foreign governments for the commercial development of oil, natural gas or minerals. Companies must also disclose payments made by a subsidiary or entity controlled by the company.
Companies are required to file annual reports with the SEC on Form SD detailing these payments no later than 150 days after the end of the company’s fiscal year. Although companies will not be required to comply with the rules until their fiscal year ending on or after September 30, 2018, companies should begin planning now for the disclosure since it may take significant time to implement systems and controls to track and report such payments.