Securities and Governance Updates – January 2017

As part of BakerHostetler’s commitment to serve as a strategic business partner, we are pleased to publish this first edition of our Securities & Governance Bulletin. This resource is designed to keep executives, corporate counsel and governance professionals apprised of regulatory and legal requirements affecting businesses with U.S. operations. We will continue to publish the Securities & Governance Bulletin periodically, as regulatory developments and business cycles warrant. If there are specific topics that you would like us to discuss from time to time, please forward your suggestions to

By Suzanne K. Hanselman, John J. Harrington, Erin H. McBride and Olivia K. Mapes

Proxy Access Developments

The adoption of proxy access bylaws has continued over the past year, and we expect that trend will continue. Several hundred companies, including a significant number of S&P 500 companies, have now adopted proxy access bylaws. The primary terms of proxy access bylaws generally have coalesced around the 3/3/20/20 formulation — shareholders who have beneficially owned 3% or more of the company’s outstanding common stock continuously for at least three years (or a group of no more than 20 shareholders meeting such requirements) may include in the company’s proxy statement a number of eligible director nominees equal to no more than 20% of the board (or, in some cases, the greater of two directors or 20% of the board). However, there continues to be significant variation in how the 3/3/20/20 formulation is implemented, and the secondary features of adopted bylaws and investor focus have begun to shift to some of these details. Below are some noteworthy developments related to proxy access in 2016.

SEC No-Action Relief on Rule 14a-8 Shareholder Proposals

During the 2016 proxy season, more than 40 companies obtained no-action relief from the staff of the Division of Corporation Finance (Staff) of the Securities and Exchange Commission (SEC), allowing those companies to exclude Rule 14a-8 shareholder proposals related to the adoption of proxy access as “substantially implemented” under Rule 14a-8(i)(10) if the company had adopted a proxy access bylaw that contained a variation of the now-standard 3/3/20/20 formulation, for the most part regardless of whether secondary terms matched the terms of the proponent’s request. In granting no-action relief, the Staff expressed the view that each company’s adoption of a proxy access bylaw containing these thresholds achieved the “essential objective” of the shareholder proposal.

However, the Staff has found the “substantially implemented” argument less persuasive when considering no-action requests to exclude shareholder proposals dealing with amendments to existing proxy access bylaws (also known as “fix-it” proposals). Features of fix-it proposals have included reducing the beneficial ownership threshold from 5% to 3%, increasing the number of board seats available for proxy access nominees, eliminating holding requirements beyond the annual meeting date, easing the requirements related to loaned shares and renominations, and eliminating caps on the number of shareholders permitted to aggregate holdings to reach the beneficial ownership threshold. A company that relies solely on a previously adopted proxy access bylaw and takes no further action in response to a fix-it proposal will generally not be able to exclude the proposal as substantially implemented.

On the other hand, a company may be successful if it amends its proxy access bylaws to address at least partially the issues raised in the fix-it proposal. For example, after receipt of a fix-it proposal, each of NVR Inc. and Oshkosh Corp. amended its existing proxy access bylaw to address some of the changes requested by the proponent, including lowering the required ownership threshold from 5% to 3%. The Staff granted no-action relief to each company under Rule 14a-8(i)(10), indicating that the companies’ policies, practices and procedures compare favorably with the guidelines of the proposal, and therefore the companies had substantially implemented the proposal. In these situations, although the companies did not address all or even most of the issues raised by the proposal, they did make the significant change of lowering the beneficial ownership from 5% to the standard 3%, as well as some other changes.

How the Staff will deal with different fix-it proposals and company responses going forward remains to be seen, but it appears that the particular facts and circumstances will dictate the results.

First Proxy Access Nomination

For all the attention given to proxy access and the rapid adoption of it by companies in the past couple of years, until very recently, it had never been utilized by a shareholder to make a director nomination. Any shareholder that nominates a director pursuant to a company’s proxy access bylaw must file a Schedule 14N with the SEC. On November 10, 2016, investment firm GAMCO Asset Management Inc. (GAMCO) filed the first — and to date, only — Schedule 14N with respect to a proxy access nomination for National Fuel Gas Co. (NFG). However, on November 23, 2016, in a letter to GAMCO publicly furnished as an exhibit to a Form 8-K, NFG objected to the nomination, citing noncompliance with a standard proxy access bylaw provision requiring that a shareholder utilizing proxy access represent that it (a) acquired the requisite shares “in the ordinary course of business and not with the intent to change or influence control” and (b) does not have that intent when making the nomination. The letter noted GAMCO’s history of Schedule 13D filings and active pursuit of a spin-off strategy. Shortly thereafter, on November 28, 2016, GAMCO indicated in a Schedule 13D amendment that it would no longer pursue proxy access.

While it has become clear in the past year that many companies will provide proxy access to shareholders, it remains unclear how frequently it will be utilized by shareholders and how proxy access elections will play out.

Proxy Advisory Firms

When shareholder proposals regarding proxy access have been submitted to shareholder votes, they have been among the most successful shareholder proposals and generally receive significant support. Both Institutional Shareholder Services Inc. (ISS) and Glass, Lewis & Co. (Glass Lewis) generally support proxy access. ISS’ 2017 voting guidelines state that ISS will generally recommend in favor of management or shareholder proposals on proxy access that have the following features: (i) 3% beneficial ownership, (ii) a holding period of no longer than three continuous years, (iii) minimal or no limits on the number of shareholders permitted to form a nominating group, and (iv) a cap on the number of proxy access nominee seats at no less than 25% of the board. The guidelines state that ISS will also review the reasonableness of any other restrictions on the right of proxy access. In the past, in the context of assessing responsiveness of a board after a shareholder proposal received majority support, ISS identified potentially and especially problematic proxy access provisions. The especially problematic provisions are treating individual funds in a fund family as separate shareholders and imposing any post-meeting ownership requirements.

Glass Lewis’ voting guidelines indicate that it generally supports proxy access as a means to ensure that significant, long-term shareholders have an ability to nominate candidates to the board. However, it considers each proposal on a case-by-case basis. Specifically, the guidelines state that Glass Lewis considers specified minimum ownership and holding period requirements, as well as company size, performance and responsiveness.

For 2017, ISS’ QualityScore (formerly QuickScore) now includes four newly weighted questions about proxy access, focusing on whether a company has implemented proxy access and, if so, on ownership threshold and duration, any cap on proxy access board members, and aggregation limits.

Interplay With Universal Proxy Cards

In October 2016, the SEC proposed rules that would create a “universal proxy card” system in nonexempt proxy solicitations for contested director elections. Read our alert describing the SEC’s universal proxy card proposal. While the future of that rulemaking is uncertain in light of the administration change, for any companies that have adopted or are considering adopting proxy access, it is worth following developments and considering the potential impact of such a system and the interplay with proxy access bylaws.

Proxy access and a universal proxy card system are similar in that they expand the ways that a shareholder could gain access to the board or conduct a contested election, beyond the traditional proxy contest involving competing slates. However, the SEC’s proposal makes clear the view that a universal proxy card system should not be viewed as a substitute for proxy access bylaw provisions. A proxy access bylaw can be viewed as providing a shareholder with access to the registrant’s proxy card and proxy statement, alleviating for the shareholder the cost and burden associated with preparing and mailing a proxy statement and soliciting on its own card (although presumably the nominating shareholder would still bear costs associated with conducting a campaign to elect its nominees). Under the proposed universal proxy card system, on the other hand, the shareholder would, in effect, get access only to the registrant’s proxy card and would be required to prepare and mail its own proxy statement and solicit at least a majority of the voting power.

Although there are clear differences between a proxy access bylaw and the proposed universal proxy card system, there is virtually no experience with the application of proxy access bylaw provisions in practice. The adoption of any new universal proxy card system, whether as proposed or as revised in response to comments, could warrant revisiting some aspects of customary proxy access bylaw provisions.

SEC Focus on Proxy Card Details

On March 22, 2016, in the midst of last year’s proxy season, the staff of the SEC Division of Corporation issued a new Compliance and Disclosure Interpretation (C&DI) with its guidance regarding descriptions of Rule 14a-8 shareholder proposals on company proxy cards. The Staff issued the C&DI in response to complaints received by shareholder proponents claiming company proxy cards lacked specificity in describing their proposals. Rule 14a-4(a)(3) requires that the form of proxy “identify clearly and impartially each separate matter intended to be acted upon … whether proposed by the registrant or by security holders.” The C&DI reiterates that point, stating that the proxy card “should clearly identify and describe the specific action on which shareholders will be asked to vote,” regardless of whether it is a management or shareholder proposal.

The staff also provides the following examples of generic descriptions that it would not view as complying with Rule 14a-4(a)(3):

  • A management proposal to amend the company’s articles of incorporation to increase the number of authorized shares described as “a proposal to amend our articles of incorporation”
  • A shareholder proposal to amend the company’s bylaws to allow shareholders holding 10% of the company’s common stock to call a special meeting described as “a shareholder proposal on special meetings”
  • “Shareholder proposal #3,” described as merely “a shareholder proposal on executive compensation,” “a shareholder proposal on the environment” or “a shareholder proposal, if properly presented”

Although the C&DI is based on Rule 14a-4, which sets forth the requirements for the form of proxy, companies should also consider the description of shareholder proposals in the related voting instruction card that is distributed to street name shareholders, as well as the descriptions of the proposals in the proxy statement. In addition, Rule 14a-16(d), which addresses the requirements of a company’s Notice of Internet Availability of Proxy Materials, includes language similar to that of Rule 14a-4, and states that the notice must contain a “clear and impartial identification of each separate matter intended to be acted on.”

Read about the C&DI on the SEC website.

Voting Options in Director Elections

In connection with the October 2016 proposed rules for a universal proxy card system, the SEC proposed amendments to Rule 14a-4(b) to require an against voting option and an abstain voting option (in lieu of a withhold voting option) on proxy cards when applicable state law gives effect to those votes (i.e., when a majority vote standard applies), as well as amendments to Schedule 14A to mandate proxy statement disclosure of the effect of a withhold vote when available (i.e., when a plurality vote standard applies). The SEC noted in the proposing release that the Staff has observed ambiguities and inaccuracies with respect to some disclosures in this area. We also understand that the Staff issued verbal comments to some registrants with majority voting standards during 2016, requesting changes to proxy card presentations along these lines to comply with current requirements. Rule 14a-4(b) (Instruction 2) currently requires an against voting option or similar voting option “in lieu of, or in addition to” the withhold voting option if majority voting applies. While the proposed rules are highly unlikely to be effective for the 2017 proxy season, registrants should nonetheless review their proxy card presentations and related disclosures for compliance with current rules and staff views in this area.

ISS and Glass Lewis Voting Policies Updates and Considerations for the 2017 Proxy Season

Last fall, ISS and Glass Lewis both released updates to proxy voting guidelines for shareholder meetings held in 2017 (on or after January 1 for Glass Lewis and on or after February 1 for ISS). Companies should review the voting guidelines applicable to any management or shareholder proposals being submitted to a vote to understand the likely recommendation of ISS and Glass Lewis. In crafting proxy disclosure, companies should clearly address the factors used by the proxy advisory firms in forming their vote recommendations and, if a negative recommendation is anticipated, include the company’s counterarguments to help persuade shareholders to support management’s position despite the negative recommendation from ISS or Glass Lewis. In addition, the policy updates provide insight into the direction proxy advisory firms, investors and other corporate governance watchdogs are heading. The following is a brief summary of certain revisions and additions to each proxy advisory firm’s voting policies for the 2017 proxy season and considerations for preparing proxy disclosure in light of the policy changes.

Director Over-boarding — ISS and Glass Lewis

Both ISS and Glass Lewis revised their voting policies with respect to directors who serve on multiple boards. Citing an increased amount of time necessary to devote to board service, both firms have reduced the number of public company boards a nonexecutive can serve on from six to five. For CEO directors, both ISS and Glass Lewis will consider serving on two public company boards, including the executive’s own board, to be over-boarding. Nonexecutive directors serving on six public boards and CEO directors serving on three public boards will receive a withhold recommendation or an against recommendation from ISS, and Glass Lewis generally will recommend a withhold or an against but will consider the following factors in deciding whether the director has sufficient time to dedicate to a board:

  • Size and location of the companies where the director serves
  • The director’s duties and roles on various boards, including large privately held companies
  • Tenure and attendance

If the company can articulate a sufficient rationale for the director’s continued board service or if the excessive directorships are within a consolidated group of companies, then Glass Lewis may refrain from an against recommendation for an over-boarded director.

New Public Companies — ISS and Glass Lewis

ISS and Glass Lewis have revised their voting guidelines with respect to newly public companies that have charter provisions considered to be materially adverse to shareholders. In the past, the proxy advisory firms allowed some leeway for newly public companies.

ISS generally will vote against directors if, prior to or in connection with an IPO, the company adopted a multiclass capital structure with unequal voting rights or adopted bylaw or charter provisions materially adverse to shareholder rights unless the company has a reasonable sunset provision. Under its former policy, ISS took into account the company’s commitment to submit the restrictive provisions to a shareholder vote within three years, but it will no longer recognize this exception.

If a board at a newly public company has approved governing documents that restrict the shareholders’ right to effect change, Glass Lewis will consider a negative vote against governance committee members and/or board members serving at the time the governing documents were adopted. The recommendation will depend on the severity of the concern, and Glass Lewis will review specific areas of governance, such as:

  • The adoption of anti-takeover mechanisms (e.g., a poison pill or classified board)
  • Supermajority vote requirements to amend governing documents
  • Exclusive forum or fee-shifting provisions
  • Whether shareholders can call special meetings or act by written consent
  • The voting standard for director elections
  • Shareholders’ ability to remove directors without cause
  • The presence of evergreen provisions in the company’s equity compensation arrangements

This is a change from Glass Lewis’ previous policy of generally refraining from making voting recommendations on the basis of governance standards during the first year following a company’s IPO. Glass Lewis will take into account a commitment to submit the adverse provisions to a shareholder vote at the first annual meeting following the IPO, or the existence of a sunset provision.

Restrictions on Shareholders’ Rights to Amend Bylaws — ISS

ISS has a new policy to recommend against governance committee members if the “company’s charter imposes undue restrictions on shareholders’ ability to amend the bylaws,” which include:

  • Prohibiting the submission of binding shareholder proposals
  • Imposing share ownership or holding period requirements on shareholder proponents that exceed those set forth in SEC Exchange Act Rule 14a-8
  • Other requirements that unduly restrict shareholders’ ability to amend the bylaw

Equity Incentive Plans — ISS

Companies submitting an equity compensation plan for shareholder approval should note that ISS is adding a new factor to the Equity Plan Scorecard (EPS) it uses to evaluate such plans. ISS will consider whether the plan allows for dividends to be paid on unvested awards. Full points will be awarded if the plan expressly prohibits the payment of dividends for all award types before the vesting of the underlying award. The accrual of dividends to be paid on or after vesting is acceptable. No points will be awarded if there is no such prohibition or if the prohibition applies only to certain award types, even if the company has a disclosed a practice of not paying dividends until vesting.

In addition, ISS modified its minimum vesting factor and will award full points under the EPS only if the plan includes a minimum one-year vesting requirement for all award types and the minimum vesting cannot be reduced by individual agreement. ISS still allows a carve-out to the minimum vesting provision for awards accounting for no more than 5% of the shares issuable under the plan.

Amendments to Cash and Equity Plan — ISS

ISS clarified its approach to evaluating proposals to amend cash and equity incentive plans. ISS generally will recommend a vote for proposals to amend executive cash and equity plans if (i) the proposed amendments are merely administrative, or (ii) the proposal seeks approval for Section 162(m) purposes only and the plan is administered by “independent outside directors.” ISS will review plans on a case-by-case basis if the company is presenting the plan to shareholders for the first time after its IPO or if the administrative or Section 162(m) proposal is bundled with other material plan amendments.

Shareholder Ratification of Nonemployee Director Compensation — ISS

Under a new policy, when evaluating management proposals requesting shareholders to ratify nonemployee director compensation, ISS will review proposals on a case-by-case basis. ISS will consider whether the equity plan under which nonemployee director grants are made is also on the ballot and warrants support based on the criteria for nonemployee director equity plans described below. ISS also will assess qualitative factors relating to director compensation, including the magnitude of director compensation relative to similar companies, director stock ownership guidelines, the company’s disclosure regarding director compensation and whether there are meaningful limits on director compensation.

Nonemployee Director Equity Plans — ISS

ISS intends to update and expand the list of factors it uses to evaluate nonemployee director equity plan proposals if the plan, when combined with existing equity plans, will exceed the cost or burn rate benchmarks applicable to the company. The intent is to align the list with the qualitative factors enumerated in ISS’ new policy on shareholder ratification of nonemployee director compensation discussed above.

Board Evaluations and Refreshment — Glass Lewis

Glass Lewis clarified its approach to reviewing board evaluations, succession planning and refreshment. In addressing the perceived problem of long-tenured directors, Glass Lewis believes a “robust” board evaluation process combined with a board assessment of the need for a change in board composition is more effective for refreshment than are mandated age or term limits. The evaluation process should focus on the alignment of the board’s skill sets and areas of expertise with the company’s strategy.

Considerations for Proxy Disclosure

Director Nominees

Companies should be mindful about disclosure related to director nominees. Companies should ensure that they have correct information with respect to board service by having directors update their questionnaires to include directorships with both public and private companies. At a minimum, companies should require directors to notify the board promptly of any changes in employment or board service. Companies should also consider requiring advance notice before a director agrees to serve on a new board, to protect against over-boarding and to avoid other potential issues, such as conflicts of interest, compensation interlocks, antitrust concerns, etc.

Care should be taken in crafting voluntary disclosure regarding a director’s prior public company and private company board service because, although such disclosure may be useful in describing a director’s qualifications, skills and experience, it could cause confusion about the number of boards on which a director currently serves. Directors should be made aware of the over-boarding issue, especially if they serve on companies considering or planning an IPO.

Governance Disclosures

Companies should review and enhance proxy disclosure related to governance issues, such as the board evaluation process, board diversity, director tenure, and the alignment of board members’ skills and qualifications with the company’s strategy. As board refreshment becomes more of an issue for the proxy advisory firms, a company’s rationale for the nomination of long-serving directors is key.

Newly public companies should review and understand the impact of problematic charter provisions. If amendment or elimination of such provisions is impractical or undesirable, companies should include disclosure explaining the rationale for such provisions to counter a likely negative recommendation on director nominees by ISS and/or Glass Lewis. The board of directors also should be made aware of the impact of a negative recommendation on director elections. Companies that have implemented a majority vote provision should assess the likelihood of an affected director’s failing to garner majority support.

Equity Plans

Companies should be mindful, in drafting equity plan disclosure, of the factors used for scoring the Equity Plan Scorecard (EPS). The disclosure should expressly address the treatment of dividends on unvested awards. Companies that do pay dividends on unvested awards should include disclosure to support the practice. Proxy disclosure on minimum vesting should be drafted with an eye to the new ISS guidelines.

Director Compensation

In light of the increase in lawsuits filed alleging breach of fiduciary duties in connection with payment of excessive director compensation, some companies are submitting director compensation to shareholders for ratification, and many other companies are having shareholders approve stand-alone director equity plans with award limits. Companies submitting such proposals should draft disclosure that addresses the qualitative factors reviewed by ISS. As director compensation comes under more scrutiny, companies may want to consider enhanced disclosure regarding the compensation of directors, including the underlying rationale, any limits on cash or equity awards, and equity retention guidelines.


In addition to a substantive review of their proxy disclosure, companies should consider whether changes could be made to the presentation of information considered key to proxy advisory firms and investors. The use of summaries, tables and charts to highlight certain information decreases the chances of its being overlooked, which can help avoid surprises when the proxy advisory firms’ report on recommendation is released.

Reminder: Say-on-Pay Frequency Vote

For the vast majority of companies that held their first “say-on-pay frequency” vote in 2011, their 2017 annual meeting proxy statements must again include the nonbinding proposal. Rule 14a-21(b) requires issuers to include a separate ballot item to allow shareholders to vote on whether the mandated advisory vote on executive compensation, called “say on pay,” should be conducted every one, two or three years. This so-called say-on-pay frequency vote must be submitted to shareholders at least every six years. Because the rule required the initial vote be taken at the first annual or other meeting of shareholders held on or after January 21, 2011, most companies will be submitting the proposal again this year.

In preparing the disclosure related to this proposal and the say-on-pay proposal, companies should be mindful of Item 24 of Schedule 14A, which calls for a brief explanation of the general effect of each vote, including whether the vote is non-binding, the current frequency of the say-on-pay vote and when the next vote will be taken.

Because the say-on-pay frequency vote is non-binding, a company must make a determination as to how frequently to hold the vote and disclose that decision in the Form 8-K disclosing its annual meeting voting results or in an amendment to that Form 8-K. The amendment to the Form 8-K must be filed no later than 150 calendar days following the annual meeting and at least 60 calendar days before the deadline for the submission of shareholder proposals for the next annual meeting. This Form 8-K disclosure is required even if the company included its recommendation for frequency in the proxy statement and the shareholders approved the same frequency. Many companies overlooked this Form 8-K requirement in 2011.

Most companies conduct the say-on-pay vote annually, consistent with the recommendation of both ISS and Glass Lewis, and we would expect that to continue to be the norm.

There are a few exceptions to the 2017 say-on-pay frequency voting requirement. Smaller reporting companies were not required to hold their first say-on-pay frequency vote until the 2013 proxy season. In addition, emerging growth companies (EGCs) are exempt from holding the vote so long as they remain EGCs.

Division of Corporation Finance No Longer Requires 7 Copies of Glossy Annual Report

It is no longer necessary for companies to mail to the SEC seven copies of their glossy annual reports to shareholders, as required by Rule 14a-3(c) under the Exchange Act. In a C&DI published on the SEC’s website in November 2016, the Staff indicated it would not object if registrants posted their annual reports to shareholders on their corporate websites and kept the reports posted for one year. Registrants that had previously submitted their annual reports to shareholders on EDGAR pursuant to Rule 101(b)(1) of Regulation S-T in lieu of mailing can also rely on website posting going forward.

Notwithstanding this interpretation, any registrant that incorporates any portion of its annual report to shareholders into its Form 10-K pursuant to Instruction G will still be required to file the relevant portions of the annual report as an exhibit to the Form 10-K pursuant to Item 601(b)(13) of Regulation S-K.

Non-GAAP Update

As most registrants are likely well aware, in May 2016, the staff of the SEC’s Division of Corporation Finance made significant updates to its Compliance & Disclosure Interpretations (C&DIs) with respect to non-GAAP financial measure disclosures. The new and updated C&DIs followed a series of public statements by SEC commissioners and senior SEC staff raising concerns about non-GAAP disclosures and compliance with Regulation G and Item 10(e) of Regulation S-K. While much of the content of the new and updated C&DIs reflected existing staff positions, overall, the C&DIs signaled a stricter staff approach to Regulation G and Item 10(e) compliance going forward. The covered topics range from technical compliance matters to, potentially more significantly, identification of certain practices that could be considered misleading.

Since the C&DIs were issued, the Division of Corporation Finance has issued hundreds of comment letters focused on non-GAAP disclosures and citing the new and updated C&DIs. These comments have covered all aspects of the C&DIs, but it appears that the Staff is very focused on, and taking a narrow approach to, compliance with the “equal or greater prominence” rule with respect to accompanying disclosure of the comparable GAAP measures. It also has been widely reported that the Division of Enforcement is conducting inquiries into Regulation G and Item 10(e) compliance with respect to historical non-GAAP disclosures.

Read our alert describing the new C&DIs in more detail. Although our experience is that most registrants have already reviewed their non-GAAP disclosures in light of the new guidance and many have made changes to their presentations during 2016, for calendar-year registrants beginning a new reporting year, now is a good time to revisit whether any further changes to non-GAAP presentations are appropriate.

Dodd-Frank Executive Compensation and Reporting Rundown: What’s Completed, Pending and Not Yet Proposed — and How That May Change

By Janet A. Spreen and R. Kevin Saunders

Since the inception of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), Republican lawmakers, as well as regulated companies, have staunchly opposed various aspects of the act, including those relating to executive compensation and conflict minerals disclosure. They argue that the cost of compliance for reporting companies diverts valuable resources from productive investment, thus hindering the ability of U.S. companies to compete globally, without providing a commensurate benefit to investors.

Implementation of the Dodd-Frank provisions has spanned several years, with some aspects clearly given higher priority than others. For those provisions that remain to be implemented, as well as those that are in effect but remain the target of this criticism, we now expect some pullback on these regulations because of the shift in the congressional majority and the positions of the Trump administration. We have already seen Rep. Jeb Hensarling, R-Texas, chairman of the House Committee on Financial Services, sponsor the Financial CHOICE Act (CHOICE Act), with the aim of substantially overhauling, and in some cases entirely repealing, provisions of Dodd-Frank. Additionally, President Donald J. Trump stated as part of his campaign that he would “dismantle Dodd-Frank.”

The fate of these rules depends on many variables, including the willingness of Congress as a whole to make changes, administrative discretion to implement and enforce provisions of Dodd-Frank, and procedural requirements to justify the need for the change. (Read the Committee on Capital Markets Regulation’s recent report explaining the legal process that must be followed to make regulatory changes to Dodd-Frank. The Committee on Capital Markets Regulation is a research organization with academic members and representation from across the financial industry.)

The following provides a brief summary of the status of various executive compensation-related provisions of Dodd-Frank, as well as the conflict minerals disclosure rules, and provides some predictions as to whether compliance will continue to be required.

Already Adopted and Effective

Say on Pay: The say-on-pay provisions of Dodd-Frank (Say-on-Pay Rules) have been in effect since January 2011, requiring:

  • A nonbinding shareholder vote on executive compensation at least once every three years
  • A nonbinding shareholder vote on the frequency of the say-on-pay vote
  • Disclosure of “golden parachute” arrangements in connection with specified change-in-control transactions
  • A nonbinding shareholder vote on golden parachute arrangements in connection with these change-in-control transactions

The CHOICE Act would limit the Say-on-Pay Rules, requiring a vote only if there were material changes in a company’s executive compensation. However, the current Say-on-Pay Rules seem unlikely to be repealed, since they are aligned with institutional shareholder policies and are generally viewed as an accepted governance practice. Any reduction in the requirements might be overridden through pressure from groups like ISS to allow shareholders to voice their views about a company’s pay practices.

Compensation Committees — Independence and Advisors: Section 952 of Dodd-Frank added Section 10C to the Securities Exchange Act of 1934 (Exchange Act), which directed the SEC to adopt rules prohibiting national securities exchanges from listing equity securities of any company (other than those specifically exempted) that does not comply with requirements relating to:

  • Independence of the compensation committee
  • Independence of committee advisors
  • Committee authority to retain advisors
  • Committee funding for advisors

Under the SEC rules adopted in June 2012, the exchanges’ listing standards now require each member of a company’s compensation committee or any other board committee that oversees executive compensation to be (i) a member of the board of directors; and (ii) “independent,” as defined by the exchanges after considering relevant factors, including (a) the source of compensation of the committee member (e.g., consulting, advisory or other fees paid by the company to the member), and (b) whether the committee member is affiliated with the company or any of its subsidiaries or affiliates. The exchanges were given discretion to set minimum compensation committee independence standards after considering the foregoing factors, among others, and to provide for exemptions from the independence requirements in some circumstances.

The SEC approved new NYSE and NASDAQ listing standards relating to compensation committees in 2013, mandating full compliance by October 2014.

These requirements have been in effect for over two years without facing any significant opposition. and with multiple other Dodd-Frank provisions drawing the immediate attention of Republican lawmakers, it seems likely that these rules will remain in effect.

Conflict Minerals: In August 2012, the SEC adopted rules (Conflict Minerals Rules) addressing the Dodd-Frank provisions that require reporting companies that manufacture products containing certain minerals to disclose whether the minerals used originated from the Democratic Republic of the Congo (DRC) or any country that shares a border with the DRC. These “conflict minerals” include columbite-tantalite (coltan), cassiterite, gold, wolframite and derivative metals of these minerals (which include tin, tantalum and tungsten), and the rules require companies to report on the due diligence measures taken to determine the source and chain of custody of these minerals, as well as to describe the products that use or contain them, where they were processed, and from which country they originated.

In October 2012, a group of business organizations filed suit against the SEC, challenging the Conflict Minerals Rules on several grounds, including under the First Amendment to the U.S. Constitution. The litigation resulted in the U.S. Court of Appeals for the District of Columbus Circuit’s striking down, on First Amendment grounds, the disclosure provision that would have required a company to state that its products containing the minerals have “not been found to be ‘DRC conflict free’” if its diligence on the source of the minerals yielded certain results or, in some cases, was inconclusive, but the remainder of the rules were upheld.

In April 2014, the SEC’s Division of Corporation Finance issued a statement to clarify how companies should approach the disclosure requirements in light of the appeals court ruling. This statement confirmed that no company is required to describe its products as “DRC conflict free,” having “not been found to be ‘DRC conflict free’” or “DRC conflict undeterminable,” but in these circumstances, companies should disclose, for those products, the facilities used to produce the conflict minerals, the country of origin of the minerals, and the efforts to determine the mine or location of origin. In addition, if a company voluntarily elects to describe any of its products as “DRC conflict free” in its Conflict Minerals Report, it can do so if it has obtained an independent private sector audit as required by the rule; otherwise, an independent audit will not be required.

The October 2012 legal challenge resulted in a substantial gutting of the rule’s intended effect of shaping corporate behavior through disclosure regarding whether the source of the minerals aided in the funding of armed conflict in the DRC region. However, the diligence and the bulk of the reporting obligations remain in effect. It would seem that in light of the burden versus the effect of the rules, the Conflict Minerals Rules would be a likely target of the new administration; however, companies should continue their diligence efforts to remain on track for the May 31, 2017, reporting deadline because repealing the rule may not be a top priority in the coming months, and any change would take time to implement.

Adopted but Not Yet Effective

Pay Ratio Disclosure: In August 2015, the SEC adopted a new Item 402(u) of Regulation S-K (Pay Ratio Rules) to implement the pay ratio disclosure required by Dodd-Frank. The disclosure must first appear in the executive compensation section of proxy statements and 10-K filings covering the first full fiscal year commencing on or after January 1, 2017. The final Pay Ratio Rules require reporting companies to disclose:

  • The “median” of the annual total compensation for “all employees” other than the principal executive officer (PEO)
  • The annual total compensation of the PEO
  • The ratio of these two amounts

Companies must also provide narrative disclosure explaining the pay ratio and the methods used to determine the pay ratio. As discussed in our Client Alert “SEC Adopts Pay Ratio Rules,” issued August 17, 2015, these disclosure requirements may appear simple at first glance, but as companies have started to work through how they will approach gathering the data necessary for these calculations, it is becoming more apparent that there are many unanswered questions and that costly administrative measures may be needed to ensure compliance.

The rules provide some detailed instructions on the dates to use for the measurements, how often the median employee must be identified, and when compensation can be annualized and adjusted for differences in cost of living. However, applying each of these details on an employee-by-employee basis raises more questions and more opportunities for presenting more or less favorable data. Furthermore, companies with international employees must take a look at privacy restrictions to ensure that any transmission of compensation data outside of the country of employment is consistent with local law or, alternatively, whether it can be excluded under the data privacy exemption.

The SEC appears to have recognized some of these challenges and opportunities as well and, on October 18, 2016, released five Compliance & Disclosure Interpretations (C&DIs) — Questions 128C.01 through 128C.05 — that dive further into the compliance weeds. These C&DIs address primarily:

  • Considerations for determining whether the compensation measure used to identify the median employee meets the “consistently applied” standard set forth in the rules
  • The Staff’s position that the date used to identify the company’s employee population from which it will identify its median employee (which must be within three months of the end of its fiscal year) need not be included within the period for measuring the compensation that will determine who is the median employee, and that compensation from the company’s latest prior fiscal year can be used so long as there were no material changes to its employee population or compensation arrangements
  • Considerations as to whether and how to include furloughed employees
  • Considerations regarding the circumstances, if any, under which independent contractors could be required to be included as employees of the company when calculating the pay ratio

Though the Trump administration’s position on the Pay Ratio Rules, specifically, is unknown, the stated desire to reduce compliance burden and cost suggests the rules would be a target for repeal. Under the CHOICE Act, the Dodd-Frank provisions requiring the Pay Ratio Rules would be eliminated. This has fostered speculation that the Pay Ratio Rules could be one of the first pieces of regulation on the incoming administration’s chopping block.

Pending further developments, calendar-year reporting companies should continue to expect to include the pay ratio disclosure in their 2018 proxy statements and therefore begin the data-gathering efforts that will be required to do so. This is because the CHOICE Act (or any other congressional action) would eliminate only in part the Dodd-Frank provision requiring pay ratio disclosure, and additional regulatory action would be needed to affect Item 402(u) of Regulation S-K. The CHOICE Act also likely would not take effect until mid-2017, at the earliest, or as late as early 2018, so for any repeal of the Pay Ratio Rules, early 2018 seems more feasible.

Proposed but Not Yet Adopted

Pay for Performance: Dodd-Frank requires companies (other than emerging growth companies) to include in their annual meeting proxy materials information regarding the relationship between executive compensation actually paid and the company’s financial performance, taking into account any change in the value of its stock and dividends (Pay for Performance Rules). The Pay for Performance Rules proposed by the SEC in April 2015 would add new Paragraph (v) to Item 402 of Regulation S-K, requiring a table identifying:

  • Total executive compensation reported in the Summary Compensation Table for the CEO
  • An average of the reported amounts for the remaining named executive officers (NEOs)
  • Executive compensation actually paid to the CEO and on average for the other NEOs, which would be the total compensation as disclosed in the Summary Compensation Table, with adjustments for the amounts included for pensions and equity awards
  • Total shareholder return (TSR) on an annual basis
  • TSR on an annual basis of the companies in a peer group

Using the information in the table, a company would also have to provide a description of:

  • The relationship between the executive compensation actually paid and the company’s TSR
  • The relationship between the company’s TSR and the identified peer group’s TSR

After a transition period, the disclosure would be required to cover the five most recently completed fiscal years, with smaller reporting companies required to provide the disclosure only for the three most recently completed fiscal years.

Companies should not expect to comply with the proposed Pay for Performance Rules in 2017 and possibly later, as final rules still have not been adopted. The CHOICE Act does not address the Pay for Performance Rules, so it is unclear what efforts may be taken to prevent final rules from taking effect. Institutional investors, however, will continue to advocate for aligning executive compensation with company performance and related disclosure, and may exert pressure where possible.

Clawback Policies: In July 2015, the SEC proposed rules under Dodd-Frank requiring the national securities exchanges to adopt listing standards mandating that listed companies have a policy to recover from current and former executive officers any incentive-based compensation based on financial information that was subsequently corrected in an accounting restatement (Clawback Policy Rules). Read our Client Alert for additional discussion of the proposal.

Under proposed Clawback Policy Rules:

  • Companies would generally be required to recover or claw back erroneously awarded incentive-based compensation triggered by an accounting restatement that is attributable to an error that is material to previously issued financial statements, irrespective of whether there is any “wrongdoing.”
  • There would be little discretion in deciding whether to pursue recovery of erroneously awarded compensation, and companies would not be permitted to indemnify or reimburse executives for recovered compensation.
  • The recovery policy would apply to each executive officer as defined in Rule 16(a) under the Exchange Act, regardless of whether the executive officer had any role in the preparation of the financial statements.
  • The amount to be recovered would be the amount received by the executive officer that exceeds the amount he or she would have received had the incentive-based compensation been determined based on the restated financial statements.
  • Incentive-based compensation that would be subject to recovery includes compensation granted, earned or vested based on attainment of any financial reporting measure, on stock price or on total shareholder return but not equity awards that are strictly time-based.
  • The recovery obligation would apply to any excess compensation applicable to performance during the last three completed fiscal years preceding the date on which the company is required to restate.
  • The recovery obligation would apply to erroneously awarded compensation received by current and former executive officers on or after the effective date of the new rules — not the effective dates of the listing standards implementing the rules — that results from attaining a financial reporting measure based on financial information for any fiscal period ending on or after the effective date of the rules.

Because the SEC has not finalized its Clawback Policy Rules, it is unlikely that companies will be required to adopt the proposed clawback policies in 2017 or even soon thereafter. The CHOICE Act proposes a more limited policy requirement, under which executives would be affected only if they had control over the financial reporting that resulted in a restatement. Many companies have adopted clawback policies in anticipation of the final rules as a good governance practice and because of investor interest. It is likely that these policies will remain common, but there will be flexibility to establish the scope and level of discretion that a company may have in applying them.

Hedging Disclosure: In February 2015, the SEC proposed rules implementing the Dodd-Frank disclosure requirement regarding company policies on hedging of company stock by employees and directors (Hedging Disclosure Rules). Under the proposed rules, companies would be required to disclose in any proxy statement or information statement for the election of directors:

  • Whether any employees (including officers) or directors are permitted to purchase financial instruments or otherwise engage in transactions that are designed to or have the effect of hedging or offsetting any decrease in the market value of the company’s equity securities
  • Any permitted and prohibited transactions and categories of people permitted or prohibited from hedging

It appears unlikely that companies would need to comply with the Hedging Disclosure Rules in 2017 or in the foreseeable future. Final rules have not been proposed, and the CHOICE Act aims to repeal the Dodd-Frank disclosure requirement. However, like the requirements discussed above, this is another area in which companies have been and are expected to continue implementing policies voluntarily that limit hedging by the board and executive management.

Section 16 Update — Rule 16b-3(e) Exemption Challenge

By Samuel F. Toth and Janet A. Spreen

A number of companies have received a letter under Section 16 from a shareholder demanding disgorgement of an insider’s profits from market purchases matched with sales of shares to the company to satisfy tax withholding or the payment of an option exercise price. These sales to the company were identified on the insider’s Form 4 as exempt dispositions under Rule 16b-3(e) because the right to use shares for these obligations was approved by the board or a committee of nonemployee directors as part of the initial award agreement, exempt from the disgorgement provisions.

The shareholder has now filed two lawsuits seeking to recover the alleged profits where the company, not surprisingly, has declined to seek recovery. The shareholder/plaintiff argues that the withholding and exercise payments were not exempt dispositions because they were not “automatic” or specifically approved in accordance with Rule 16b-3(e) (e.g., by the board or a committee of nonemployee directors). In support of this argument, the plaintiff points to SEC Compliance and Disclosure Interpretation (C&DI) No. 123.16 [May 23, 2007], which addresses whether approval of a grant that by its terms provides for automatic reloads satisfies the Rule 16b-3(d) requirement that there be specific approval of the reload grants. The staff of the SEC Division of Corporation Finance’s response states that “[a]pproval of a grant that by its terms provides for automatic reloads would satisfy the specificity of approval requirements under Rule 16b-3(d) for the reload grants, unless the automatic reload feature permitted the reload grants to be withheld by the issuer on a discretionary basis” and that “[t]he same result applies under Rule 16b-3(e) where the automatic feature is a tax- or exercise-withholding right.” The complaint also argues that the tax withholdings were not exempt because the shares were withheld in advance of when a tax liability would be due, but it does not provide additional support for this reasoning.

Section 16 practitioners have generally viewed company discretion to prohibit the use of shares to satisfy withholding or the payment of the exercise price as potentially problematic for claiming the Rule 16b-3 exemption under this C&DI, but this shareholder has extended the interpretation to require that the withholding be automatic or that there be specific board or committee approval of a particular disposition of shares. While we view this shareholder’s position as incorrect, dealing with such demand letters and litigation can be costly and distracting, and it remains to be seen whether a court ruling refuting these arguments will be issued in these cases. Thus, companies may want to consider having directors provide specific approval for upcoming withholding transactions or making such withholding automatic to preclude a shareholder from targeting its insiders with such claims.

Corporate Governance Considerations: Implications of 2016 Delaware Chancery Court and Delaware Supreme Court Decisions

By Robert A. Weible and Matthew L. Raby

This article highlights selected 2016 Delaware Court of Chancery and Delaware Supreme Court decisions that have implications in areas of continuing importance to corporate boards and their advisors. These decisions focus primarily on:

  • Analyses of director independence
  • When a standard of review more onerous than the business judgment rule will be invoked, and the circumstances under which that can be avoided
  • The role of disclosure in making and settling shareholder challenges to mergers and similar transactions
  • Contract-based governance standards for, and review of actions taken by, noncorporate entities
  • Whether and how extra-contractual fraud claims arising from transactions can be negated

Those who would prefer a highly distilled summary of the import of these decisions can skip directly to “The message” section at the end of each segment below.

Director Independence Analyses

Whether a board’s challenged transactional decisions will be reviewed under the lenient business judgment rule standard, or the onerous entire fairness standard, frequently turns initially on whether a majority of the board was both disinterested and independent with respect to the decisions. Similarly, whether a shareholder bringing a derivative claim will be excused from having first to demand that the board bring the claim turns on the directors’ disinterest and independence.

Calesa Associates, L.P. v. American Capital, Ltd., Court of Chancery, decided February 29, 2016:

  • Confirmed that each director’s status will be determined separately by a detailed review of the materiality of any purportedly tainting influence — such as financial, commercial or social links to controlling shareholders, other directors or executives, or a transaction counterparty

Sandys v. Pincus, Court of Chancery, decided February 29, 2016:

  • Similarly confirmed the director-by-director and fact-intensive nature of independence determinations
  • Confirmed that a director’s independence for NYSE or NASDAQ listing purposes does not control the issue

Sandys v. Pincus, Delaware Supreme Court, decided December 5, 2016:

  • Upheld the principles underlying the Calesa Associates and lower-court Sandys decisions but attached significance to two challenged directors’ lack of NASDAQ independence in disagreeing with the chancery court’s February finding of their independence
  • As if to underscore the absence of a litmus test for this determination, an unusual and strong dissent from the supreme court majority’s decision raised issues regarding the plaintiff’s pleadings concerning the materiality of the alleged taints affecting those directors

The In re EZCorp, City of Miami, Larkin v. Shah and In re Books-A-Million decisions discussed below also set forth and cite to worthy treatments of the director independence analysis.

The message: Though it may not be practicable to structure a board to ensure independence and disinterest for every situation that may arise, a board should conduct and document a rigorous and objective assessment of each putatively independent member’s financial, commercial and social independence from any controlling shareholder, management, or other board member or potentially related third party, both before the member’s election to the board and when any transaction or event arises that could bring his or her independence or disinterest into question. Counsel must ensure that this review includes consideration of the factually closest Delaware decisions while recognizing that the only conclusion that ultimately will matter will be that of a court presented with the issue.

Standard of Review Considerations

Delaware’s traditional standards of review for challenged transactional decisions are the lenient business judgment rule standard, the intermediate enhanced scrutiny (or Revlon) standard and the onerous entire fairness standard. A number of 2016 Delaware decisions addressed the traditional and situational factors bearing on the application of these standards.

In re EZCorp Inc. Consulting Agreement Derivative Litigation, Court of Chancery, decided January 25, 2016:

  • Held that the entire fairness standard applies to any transaction between a controlling shareholder and the controlled company, not just to squeeze-out mergers, and invoked the entire fairness standard because the challenged transaction involved self-dealing by the controlling shareholder in consulting agreement arrangements
  • Held that a “human controller” of a directly controlling entity can be held personally liable for a duty of loyalty breach
  • Held that a controlling shareholder owes fiduciary duties to noncontrolling shareholders
  • Observed that entire fairness review for a controlling shareholder transaction could be reduced to business judgment rule review if the six MFW Worldwide conditions (discussed under In re Books-A-Million, Inc. Stockholders Litigation, below) were met

Calesa Associates, L.P. v. American Capital, Ltd., Court of Chancery, decided February 29, 2016:

  • Confirmed that the entire fairness standard is also invoked when less than half of the directors approving a challenged transaction are both disinterested and independent with respect to the transaction
  • Confirmed that fact-specific analysis is required to determine when a non-majority shareholder is a controlling shareholder
  • Conducted a fact-specific analysis of disinterestedness and independence of challenged directors

In re Chelsea Therapeutics International Ltd. Stockholders Litigation, Court of Chancery, decided May 20, 2016:

  • Confirmed that even independent and disinterested directors could breach their duty of loyalty by acting other than in good faith (i.e., acting for any purpose other than furthering the best interests of the corporation and its shareholders).

In re Riverstone National, Inc. Stockholder Litigation, Court of Chancery, decided July 28, 2016:

  • Found that a merger’s extinguishment of potential derivative claim against a majority of the board was a material benefit to affected directors not shared by common shareholders, eliminating their disinterested status and thus invoking entire fairness review, which required directors to prove fair price and fair dealing in a recommended merger

Singh v. Attenborough, Delaware Supreme Court, decided May 6, 2016:

  • Confirmed, in a post-closing damages case that otherwise would have been subject to Revlon enhanced scrutiny review, that a merger vote by a fully informed, uncoerced majority of disinterested shareholders invokes the “irrebuttable” business judgment review standard, leaving available only a claim for waste
  • Confirmed that absent a “cleansing” shareholder vote, the liability standard for damages for an unexculpated duty of care breach would be gross negligence

In re Volcano Corporation Stockholder Litigation, Court of Chancery, decided June 30, 2016:

  • Held that tender of shares by a majority of disinterested, uncoerced, fully informed shareholders in a two-step merger under DGCL Section 251(h) had the same cleansing effect as a disinterested, uncoerced, fully informed merger approval vote would have in a one-step merger, invoking the irrebuttable business judgment rule standard of review for post-closing claims when the Revlon enhanced scrutiny standard otherwise would have applied

City of Miami General Employees’ and Sanitation Employees’ Retirement Trust v. Comstock, Court of Chancery, decided August 24, 2016:

  • Held that a transaction otherwise not subject to entire fairness review but otherwise subject to Revlon enhanced scrutiny review, for injunctive relief purposes, would instead be reviewed under the irrebuttable business judgment rule standard (see the discussion of Singh v. Attenborough, above) for purposes of post-closing damages claims, because the transaction was approved by a fully informed, uncoerced vote of disinterested stockholders
  • Noted that the entire fairness standard also could be invoked by a demonstration that a self-interested fiduciary had deceived the board in its transaction deliberations

Larkin v. Shah, Court of Chancery, decided August 25, 2016:

  • Held that a transaction not subject to entire fairness review because of the absence of a controlling shareholder on the other side of the transaction, but otherwise subject to entire fairness review because a majority of the directors were conflicted, would instead be reviewed under the irrebuttable business judgment rule standard for purposes of post-closing damages claims because the transaction was approved by a fully informed, uncoerced vote of disinterested shareholders
  • Conducted fact-specific analyses of a claim of director interest based on a director’s employer’s need for liquidity and of a claim that a less-than-majority shareholder was nonetheless a controlling shareholder

In re Books-A-Million, Inc. Stockholders Litigation, Court of Chancery, decided October 10, 2016:

  • Held that in a going-private squeeze-out merger with a controlling shareholder, the irrebuttable business judgment rule standard of review, instead of the entire fairness standard, applied because the six conditions required for invoking that standard in a conflicted controlling shareholder transaction, under Kahn v. M & F Worldwide Corp. (Delaware Supreme Court 2014), were present: (i) the controller conditioned the transaction from the outset on approval of both a special committee and a majority of the minority shareholder, (ii) the special committee was disinterested and independent, (iii) the special committee was empowered to select its own advisors freely and to say no to the transaction, (iv) the special committee met its duty of care in negotiating a fair price, (v) the vote of the minority was fully informed, and (vi) there was no coercion of the minority
  • Held that a special committee can satisfy its duty of care by negotiating diligently with the assistance of advisors, but “goes one better” by taking the additional step of gathering additional information through a market canvass

In re OM Group, Inc. Stockholders Litigation, Court of Chancery, decided October 12, 2016:

  • Held that a transaction otherwise not subject to entire fairness review but otherwise subject to Revlon enhanced scrutiny review, for injunctive relief purposes, would instead be reviewed under the irrebuttable business judgment rule standard for purposes of post-closing damages claims, despite “disquieting narrative” regarding the board’s process, because the transaction was approved by a fully informed, uncoerced vote of disinterested shareholders

The message: For conflicted transactions other than with controlling shareholders and sale of control transactions, the imperative to observe procedural best practices remains because the entire fairness and Revlon enhanced scrutiny standards will continue to be invoked in actions seeking pre-closing injunctive relief. For post-closing damages purposes, the welcome standard-lowering effect of a fully informed, uncoerced shareholder vote puts a high premium on the scope and quality of the disclosure made in seeking transaction approval from shareholders and on the absence of threats regarding the consequences of nonapproval.

For transactions with controlling shareholders, controllers willing to satisfy the Kahn v. M & F Worldwide Corp. conditions — and able to demonstrate that they have done so — can enjoy the most lenient standard of review. Controllers unwilling or unable to meet those conditions will still need to be able to demonstrate the entire fairness to the corporation and its unaffiliated shareholders of the challenged transaction.

The Role of Disclosure in Making and Settling Transaction Challenges

Even before the focus of the cases discussed above on the standard-lowering effect for damages purposes of fully informed shareholder votes, the adequacy of disclosure by boards in seeking shareholder approval of transactions has long been a focus in shareholder challenges to transactions and in the settlement of those challenges. Decisions rendered in 2016 may reduce some of the pre-closing litigation clutter that has accompanied transactions historically.

In re Trulia, Inc. Stockholder Litigation, Court of Chancery, decided January 22, 2016:

  • In a ruling capping a progression of decisions starting in late 2015, stated pointedly that Delaware would approve settlements in which the dominant consideration for a shareholder class release is further disclosure (and a healthy fee for plaintiffs’ counsel) only if the supplemental disclosure addresses a plainly material misrepresentation or omission (i.e., “not a close call”) and the release encompasses nothing more than the disclosure claims and fiduciary duty claims regarding the sale process if the record shows that the latter claims have been investigated sufficiently
  • Addressed claims regarding the scope of required disclosure of investment bankers’ analyses, saying that the requisite fair summary of the bankers’ work does not need to provide sufficient data to allow shareholders to perform their own independent valuation, and that although management’s projections and internal forecasts are not per se necessary for a fair summary, they are of “special importance” because they may contain unique insights into valuation of the company that cannot be obtained elsewhere

In re Zoom Corporation Stockholder Litigation, Court of Chancery, decided August 4, 2016:

  • Held, in a mootness fee proceeding following plaintiffs’ voluntary dismissal of claims for themselves only, after defendants made some of the demanded disclosure (all “consistent with [the] Court’s recommended procedure under … Trulia”), that plaintiffs could be awarded a fee (in this case, $50,000 of the requested $275,000) for extracting disclosure that is “helpful” to the class even if it is not material

Nguyen v. Barrett, Court of Chancery, decided September 28, 2016:

  • In dismissing a post-closing damages claim based on alleged disclosure deficiencies, the court noted that to sustain a pre-closing disclosure-based claim, the plaintiff must demonstrate that the alleged omissions or misrepresentations are material, but sustaining a post-closing disclosure-based claim imposes an even higher burden of pleading a nonexculpated breach of duty (i.e., a breach of the duty of loyalty), which requires showing the absence of disinterest or independence for a majority of the board, or actions in bad faith (i.e., intentional dereliction or conscious disregard of duty)
  • Also observed pointedly that “where a plaintiff has a claim, pre-close, that a disclosure is either misleading or incomplete in a way that is material to shareholders, that claim should be brought pre-close, not post-close,” at “a time when the Court can insure an informed vote”

The message: These cases reinforce, and to some degree enhance, the litigation-minimizing value of following best practices in transaction execution and of ensuring full and fair disclosure in materials used in seeking shareholder approval of transactions.

Noncorporate Entity Governance

Noncorporate Delaware entities, such as master limited partnerships and limited liability companies, can eliminate their “default” director-equivalent fiduciary duties in favor of only the duties that are imposed by contract so long as the governing partnership, operating or similar agreement does so unambiguously and does not leave perceived gaps to be filled by the legally inescapable “implied covenant of good faith and fair dealing.”

Dieckman v. Regency GPLP, Court of Chancery, decided March 29, 2016:

  • Confirmed this principle, applied it to eliminate the common-law duty of disclosure that would otherwise apply in seeking a unitholder vote on an issue, upheld the contract-based unitholder approval safe harbor mechanism, and held that the implied covenant of good faith and fair dealing could not create a disclosure obligation because the partnership agreement had addressed that obligation by extinguishing it, leaving no contractual gap for the implied covenant to fill
  • Noted that the partnership agreement could not legally negate application of federal securities laws, under which the plaintiffs could still seek relief

Brinckerhoff v. Enbridge Energy Company, Inc., Court of Chancery, decided April 29, 2016:

  • Reaffirmed the legal efficacy of a master limited partnership’s (MLP) contract-based governance regime in an MLP “dropdown” transaction, noting that a different outcome may have been obtained if traditional corporate governance standards were applied.  

Employees Retirement System of the City of St. Louis v. TC Pipelines GP, Inc., Court of Chancery, decided May 11, 2016:

  • Refused to invoke the implied covenant of good faith and fair dealing to inject a “good faith” standard into a contractual special approval mechanism, holding that the agreement supplied as much guidance as the unitholders would have anticipated at the time of contracting, and dismissing a complaint involving another dropdown transaction

The message: Delaware’s law in this area turns significantly on intricate parsing of the governing contract, and presents high uncertainty regarding when and how the implied covenant of good faith and fair dealing might be invoked to fill perceived contractual gaps. A January 20, 2017 decision by the Delaware Supreme Court, in Dieckman v. Regency GPLP, illustrates this uncertainty. The court, in overruling the Court of Chancery Dieckman decision reviewed above, invoked the covenant to supply an obligation of the general partner not to mislead unit holders when seeking their approval, which would have been “too obvious to need” to be stated explicitly. A draftsman positioned to create or amend a partnership or LLC governance agreement must be as explicit as possible regarding the decision-making standards that will — and will not — apply to a conflict-of-interest transaction. Perhaps more importantly, the reality of a party’s conduct in implementing a contract-based governance mechanism, and the court’s perception of that conduct, may influence the ultimate outcome significantly.

Negating Extra-Contractual Fraud Claims

Parties to merger and other acquisition agreements commonly disclaim liabilities based on information provided outside the four corners of the agreement. Several recent decisions provide drafting guidance on how that liability can best be avoided.

FdG Logistics LLC v. A&R Logistics Holdings, Inc., Court of Chancery, decided February 23, 2016:

  • Expanded on a developing line of Delaware decisions holding that exclusive representations clauses must be drafted from the viewpoint of the acquirer in order to relieve the selling company from liability based on information provided during the negotiating process
  • Further clarified that exclusive representations clauses and integration clauses must be drafted from the point of view of the aggrieved party (or all parties to the contract), to ensure the preclusion of fraud claims for extra-contractual statements under Delaware law

IAC Search, LLC v. Conversant LLC, Court of Chancery, decided November 30, 2016:

  • Held that a separate “seller release” section is not necessary to protect the selling company so long as the agreement includes a properly drafted acknowledgment from the perspective of the buyer
  • Here, a properly drafted buyer acknowledgment clause in conjunction with the integration clause constituted a clean anti-reliance provision and prevented the buyer from bringing charges based on information outside of the agreement

Two additional cases, one from the Superior Court of Delaware and one from the United States District Court for the District of Delaware, shed additional light on this developing line of decisions.

The Chemours Company TT, LLC v. ATI Titanium LLC, Superior Court of Delaware, decided July 27, 2016:

  • Extended this same principle to include supply agreements
  • Here, the supply agreement did not include an exclusive representations clause or buyer acknowledgment clause — though the agreement did contain a standard integration clause, it failed to disclaim reliance on extra-contractual statements unambiguously from the perspective of the purchasing company, and the purchasing company’s complaint survived a motion for summary judgment

Universal American Corp. v. Partners Healthcare Solutions Holdings, L.P., United States District Court for the District of Delaware, decided March 31, 2016:

  • Extended the protections of exclusive representations clauses to the period between signing and closing

The message: Though some sections of an agreement may commonly be dismissed as boilerplate, case law is continuously developing, and wording matters. Inadequate exclusive representations clauses are a prime example of seemingly innocuous passages that could lead to future liability. When negotiating and drafting exclusive representations and integration clauses, it is essential to remember that an effective disclaimer must be written from the point of view of the aggrieved party.

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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