Governance & Compliance Insider

On February 6, 2019, the SEC's Division of Corporation Finance released Compliance and Disclosure Interpretations (identical Questions 116.11 and 133.13) advising companies on how they should disclose directors' self-identified specific diversity characteristics (such as race, gender, ethnicity, religion, nationality, disability, sexual orientation or cultural background) in proxy statements. In brief, Corp Fin would expect the company's discussion of directors' experience, qualifications, attributes or skills pursuant to Item 401(e) of Regulation S-K to identify these self-identified diversity characteristics to the extent that they were considered by the nominating committee, and the individual director consented to the disclosure of those characteristics. Similarly, in these circumstances, the description of how a board implements any policies it follows with regard to the consideration of diversity in identifying director nominees under Item 407(c)(2)(vi) should include a discussion of how the company considers self-identified diversity attributes. With board diversity at an increasing premium, and an expanding definition of diversity, self-identified diversity is likely to become a more frequent practice during the director recruitment and nomination process.  Particularly in ambiguous circumstances, those companies that rely on self-identification without a more thoughtful examination of a director candidate's historic affiliations and their engagement in the claimed communities, and without consideration of the diversity of thought or perspective that the candidate is ultimately expected to contribute, will do so at their own hazard and at the candidate's hazard, as suggested by Elizabeth Warren's unfortunate claim to Native American ancestry based on 1/64 to 1/1024 ancestry and the ensuing backlash.

ISS released its annual update of frequently asked questions on its US Compensation Policies on December 20, 2018 (preliminary updates had been released in November). The updates are effective for shareholder meetings occurring on or after February 1, 2019. There are nine new or materially updated questions, which are summarized below: #19 Will any of the quantitative pay-for-performance screens change in 2019?  No.  The screens will continue to use GAAP/accounting performance measures, but ISS will display Economic Value Added (EVA) measures on a phased-in basis over the 2019 proxy season and will continue to explore their future use to add insight to financial performance.  (EVA can measure a company's residual wealth by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis.) #21 Given the use of TSR in ISS' quantitative screen, does ISS prefer companies use TSR as an incentive program metric?  While it recognizes investors' preference for objective and transparent metrics, ISS does not endorse or prefer the use of total shareholder return (TSR) or any specific metric in executive incentive programs. #42 How does ISS analyze "front-loaded" awards intended to cover future years?  ISS is unlikely to support grants that cover more than four years (ie, the grant date plus three future years), and for these types of grants, commitments not to grant additional awards over the covered period should be firm.  Usual pay-for-performance considerations will be more closely scrutinized. #47 Which problematic practices are mostly likely to result in an adverse recommendation?  Additional problematic pay practices that are likely to result in adverse vote recommendations on compensation committee members and/or say on pay proposals now include: (1) excessive termination payments (not just change in control payments) exceeding three times base pay and annual bonus, and (2) a "good reason" termination definition that presents windfall risks. #48 How does ISS evaluate "Good Reason" termination definitions?  ISS will scrutinize "Good Reason" definitions to ensure that the circumstances are reasonably viewed as an adverse constructive termination, and to determine whether there is a potential windfall risk.  Circumstances reflecting potential performance failures, such as bankruptcy or delisting, will be considered problematic. #50 If a company becomes a "smaller reporting company" under the SEC's revised definition, how will ISS assess reduction in compensation disclosure?  ISS notes that smaller reporting companies (SRCs) are still required to hold say on pay votes, and so while they may use scaled compensation disclosure requirements, SRCs should continue to provide sufficient disclosure to enable investors to make an informed say on pay vote.  This means that SRCs should think carefully before eliminating CD&As, and at minimum, ensure that there is sufficient narrative for shareholders to meaningfully assess compensation philosophy and practices. #59 How would ISS view any compensation program changes made in light of the removal of 162(m) deductions?  While shifts away from performance-based compensation to discretionary or fixed pay elements did not make the list of problematic pay practices most likely to result in an adverse recommendation, ISS will still consider these shifts to be problematic pay practices and will view them negatively. #67 How does ISS apply its policy around "excessive" levels of non-employee director pay?   If ISS determines that a NED’s pay is a quantitative pay outlier (see FAQ below), it will perform a qualitative evaluation of the company’s disclosed rationale to determine if concerns are adequately mitigated.  The updated FAQs list a number of circumstances that will typically mitigate concern around high non-employee director (NED) pay, including onboarding grants, special payments related to corporate transactions or special circumstances, and payments for specialized scientific expertise as may be necessary in certain industries.  As a reminder, last year, ISS had announced a policy to recommend against board members responsible for approving NED pay when there is a recurring pattern of excessive pay magnitude without a compelling rationale in two or more consecutive years.  ISS subsequently updated its methodology to identify pay outliers, and in consideration of the updates, ISS had postponed issuing adverse recommendations until meetings occurring on or after February 1, 2020. #68 What is ISS' methodology to identify non-employee director pay outliers?  The updated FAQs clarify that the methodology identifies pay outliers above the top 2-3% (vs the top 5%) of all comparable directors within the same two-digit GICS group and index grouping (eg, S&P 500).  The revised methodology acknowledges that there are pay premiums for non-executive chairs and lead independent directors, and in limited instances, the methodology also makes allowances for narrow distributions of NED pay, where there is not a pronounced difference in pay between the top 2-3% of directors and the median director.

ISS recently announced the 2019 updates to its proxy voting policies, which can be found here and which will be applied to annual meetings held on or after February 1, 2019. Among the various updates provided by ISS, the following policies are particularly relevant for our clients, because they expand the circumstances in which ISS may recommend votes against director candidates: Absence of Board Gender Diversity. Effective for meetings held on or after February 1, 2020, companies included in the Russell 3000 and S&P 1500 will be subject to greater scrutiny regarding board gender diversity. ISS will recommend a vote "against" or a "withhold" vote for the chair of a company's nominating committee (or other directors on a case-by-case basis) if there are no women on the company's board. ISS will consider certain mitigating factors in the event a company does not have any female directors, including a firm commitment statement in the proxy statement to appoint at least one female director to the board in the near term, the presence of a female on the board at the preceding annual meeting, and other relevant factors that ISS may deem applicable. One rationale for the change is that investors are showing a greater preference for increased boardroom gender diversity, with ISS reporting that only 3% of surveyed investors did not believe that a lack of gender diversity in the boardroom is problematic, while over 80% of surveyed investors believed that a lack of gender diversity is problematic. In addition, ISS reported the results of a recent study that found that female directors are more likely to possess the skills most sought after by boards, including, among other skills, audit, strategic planning, risk management, and corporate social responsibility. Poor Board Meeting Attendance. ISS also codified its approach to poor attendance by directors at board meetings without the director providing a reasonable justification for the director's poor attendance. In this case-by-case approach, ISS will continue recommending votes "against" or a "withhold" vote for directors with poor attendance and will also recommend voting "against" or a "withhold" vote for other directors in the following situations: After three years of poor attendance by any director, ISS will recommend a vote "against" or "withheld" from the chair of the nominating or governance committee. After four years of poor attendance by any director, ISS will recommend a vote "against" or "withheld" from the full nominating or governance committee. After five years of poor performance by any director, ISS will recommend a vote "against" or "withheld" from all director nominees. The policy may apply in certain situations involving non-consecutive years of poor attendance. Management Ratification Proposals. Similar to the new Glass Lewis policy on conflicting & excluded proposals, ISS is codifying its policy to recommend a vote "against" or "withheld" from individual directors, members of the governance committee, or even the full board, when a board asks shareholders to ratify existing charter or bylaw provisions, unless they align with best practice. ISS will take into account the following factors when making its recommendations: the presence of a shareholder proposal addressing the same issue on the same ballot; whether the provision at question was adopted in response to the above-mentioned shareholder proposal; the board's rationale for seeking the ratification of the provision; the disclosure of the actions to be taken by the board if the ratification proposal fails; the level of impairment to shareholder rights caused by the existing provision that the board is seeking to have ratified; the history of proposals on the same provision at prior company shareholder meetings; the company's ownership structure; and whether the board of used ratification proposals to exclude shareholder proposals in the past. The rationale for this policy is that the use of board sponsored proposals to ratify existing charter or bylaw provisions increased significantly during the most recent proxy season in response to the SEC's grant of no-action relief to certain companies that sought to exclude shareholder proposals from the ballot by including a conflicting proposal to ratify a charter or bylaw provision. Lack of Board Responsiveness to Failed Ratification Proposals. ISS will undertake a board responsiveness analysis if a majority of votes were cast against a proposal seeking to ratify an existing charter or bylaw provision at the prior year's meeting and the board fails to act. This change is being made to align this policy with the ratification proposal policy discussed above. Including Five-Year TSR in Initial Screen of Director Performance Evaluations. ISS updated its policy to consider not only one- and three-year, but also five-year, total shareholder returns in the initial screen of whether a company has exhibited sustained poor performance . Previously, five-year TSR was a secondary factor in the analysis. This change is intended to reduce the number of companies that undergo scrutiny for poor performance. In addition to policy changes that may affect ISS's support for director candidates, ISS also updated its financial performance methodology and its voting policies with regard to reverse stock splits and social and environmental proposals: Use of EVA Data in Financial Performance Assessment. During the 2019 annual meeting season, ISS research reports on companies in the U.S. and Canada will feature Economic Value Added (EVA) data as a supplement to GAAP-based measures. Moving into 2020, ISS will consider the inclusion of EVA-based measurements as part of its Financial Performance Assessment methodology. Circumstances in which ISS will Support Reverse Stock Splits. ISS made two changes with respect to the approval of reverse stock splits: First, ISS will recommend a vote "for" a reverse stock split if (1) the number of authorized shares available to the company is also proportionately reduced or (2) the effective increase in authorized shares is equal to or less than the allowable increase calculated in accordance with ISS policy. Second, rather than recommending a vote "against" a reverse stock split proposal that does not include the two factors listed above, ISS will take a case-by-case approach based on several factors, including but not limited to the following factors: (1) whether the company has received a notification of potential delisting from a stock exchange, (2) there is substantial doubt about the company's ability to continue as a going concern without additional financing, (3) the rationale provided by the company, or (4) other factors as applicable. Impact of Significant Controversies on Social and Environmental Proposals. ISS expanded the factors it will examine on a case-by-case approach to social and environmental proposals make clear that it will also consider whether there are significant controversies, fines, penalties or litigation associated with the company's social or environmental proposals.

Human nature being what it is, the law, in its wisdom, does not presume that directors will be competent judges of the fair treatment of their company where fairness must be at their own personal expense.[1] According to the Delaware Supreme Court in In re Investors Bancorp, Inc. Stockholder Litigation, when equity awards are granted to directors under a stockholder-approved equity incentive plan that gives directors discretion to determine the size of the awards, the awards are subject to the “entire fairness” standard of review. This decision may expand stockholder litigation in the area of director compensation. When reading the recent opinion issued by the Delaware Supreme Court in In re Investors Bancorp, Inc. Stockholder Litigation, it is tempting to regard the dispute as a perfect example of “pigs get fat, hogs get slaughtered” and minimize the issues raised by the case. After all, on the heels of stockholder approval of an equity compensation plan, the 12-person Bancorp Board awarded themselves over $51 million in equity grants from plan; the non-employee directors each received grants valued at approximately $2 million (as compared to average awards of approximately $176,000 for non-employee directors at peer companies). Your company’s board, you tell yourself confidently, would never act in such a manner. However, even the most prudent of Boards needs to consider the implications from the In re Investors Bancorp decision. But first, let’s step back and look at a bit of background in the case: In June 2015, stockholders approved Bancorp’s Equity Incentive Plan (the “EIP”), which reserved 30,881,296 common shares for various types of equity grants for the Company’s 1,800 officers, employees, non-employee directors, and service providers, of which up to 30% were available to be granted to non-employee directors. Two weeks following stockholder approval of the EIP, the Board approved the grants noted above. Disclosure of the equity grants resulted in three stockholder complaints being filed in the Court of Chancery alleging breach of fiduciary duties by the directors for awarding themselves excessive compensation. The Court of Chancery dismissed the complaint because the EIP contained “meaningful, specific limits on awards to all director beneficiaries.” In other words, because stockholders approved the EIP, which the Court of Chancery noted contained meaningful limits, the ratification defense came into play, which allowed the Board’s actions to be reviewed under the business judgement standard. In December, the Delaware Supreme Court reversed the Court of Chancery’s decision and determined that the “entire fairness” standard applied. The Delaware Supreme Court noted that because director compensation determinations are inherently self-interested, those decisions will be reviewed under the business judgment rule only where fully-informed stockholders approve (i) specific compensation decisions or (ii) self-executing plans (plans with fixed criteria). However, if a stockholder-approved equity incentive plan gives directors discretion within general parameters when compensating themselves, then the “entire fairness” standard is appropriate. As the Supreme Court noted: We think, however, when it comes to the discretion directors exercise following stockholder approval of an equity incentive plan, ratification cannot be used to foreclose the Court of Chancery from reviewing those further discretionary actions when a breach of fiduciary duty claim has been properly alleged. As the Court of Chancery emphasized in Sample, using an expression coined many years ago, director action is “twice-tested,” first for legal authorization, and second by equity. When stockholders approve the general parameters of an equity compensation plan and allow directors to exercise their “broad legal authority” under the plan, they do so “precisely because they know that that authority must be exercised consistently with equitable principles of fiduciary duty.” The stockholders have granted the directors the legal authority to make awards. But, the directors’ exercise of that authority must be done consistent with their fiduciary duties. Given that the actual awards are self-interested decisions not approved by the stockholders, if the directors acted inequitably when making the awards, their “inequitable action does not become permissible simply because it is legally possible” under the general authority granted by the stockholders. So, what does this mean for Boards and Compensation Committees? If designing a new equity incentive plan, or amending an existing plan, consider whether self-executing awards to non-employee directors are appropriate or desired. If self-executing awards are not desired, determine if the plan contains significant and meaningful limitations on awards, as this might assist with the defense against a claim that the Board violated its fiduciary duties. If equity awards to directors are unusual in size compared to prior awards, consider making the awards subject to stockholder ratification at the next stockholders’ meeting. Have the Board and Compensation Committee pay close attention to compensation at peer companies and its own historical pay practices. Significant deviations from either may be more likely to trigger stockholder litigation under the new standards.   [1] Footnote 2 to Investors Bancorp opinion, citing Gottlieb v. Heyden Chem. Corp., 90 A.2d 660, 663 (1952)

Following the 2016 election, corporate governance circles have focused intently on what will happen in the nation’s capital with regard to a potential roll back of the current regulatory regime. While attention given to Congress and the SEC for the possible direction of corporate governance is not misplaced, future changes in this arena will most likely come from investors, and they have their own agenda which is very different from that of the Trump administration. Regardless of, or perhaps in response to, any changes in the U.S. governance regulatory framework, investors and groups of investors are likely to continue to push for actions and disclosures beyond what is mandated and will use the their voting power to effect change. Public companies should also anticipate increased demand for the use of metrics and related disclosures that facilitate comparison, including in non-traditional performance areas such as certain environmental, social and governance matters where investors see a strong tie to long-term value creation. Read the full article here, as posted on the Harvard Law School Forum on Corporate Governance and Financial Regulation.

As the 2017 proxy season winds down, one clear take-away is that shareholder proposals attempting to modify the terms of previously adopted mainstream proxy access bylaws did not fare well. Many of these proposals focused solely on the aggregation limit, seeking to increase the number of shareholders (usually 20) that are required to meet the minimum ownership threshold (usually 3% of outstanding shares) in order to nominate a director using the company’s proxy statement. Other proposals tried to amend multiple terms of the proxy access bylaw in order to make the provisions more shareholder-friendly. To date, none of these so-called “fix-it” amendments to mainstream proxy access provisions has received majority support, and the average support for all such proposals has been less than 30%. In addition, some companies were able to exclude proposals to amend the aggregation limits from their proxy statements by making a case under the SEC no-action process that the proposal had been “substantially implemented” where the company could provide specific information to support the view that it already had a meaningful proxy access right in place. Other companies facing fix-it amendments to multiple provisions were successful in excluding the proposal as “substantially implemented” where the company acted to adopt one or more of the amendments. See our prior memo here: Recent Developments in Proxy Access. Meanwhile, the trend of adopting mainstream proxy access provisions continues apace. Approximately 175 additional companies have adopted proxy access provisions since the end of the 2016 proxy season, and virtually all shareholder proposals seeking the adoption of proxy access bylaws have received majority support this year. More than 60% of companies in the S&P 500 now have some form of proxy access provision. The mainstream model adopted by a broad range of these companies allows shareholders owning 3% of shares outstanding for at least 3 years to nominate up to 20% of the board (or at least two members) with an aggregation limit of 20 shareholders to reach the ownership threshold. The ability of the mainstream model to withstand fix-it shareholder proposals this proxy season bodes well for this approach and may discourage fix-it proposals in future years.

The House passed the Financial CHOICE Act on Thursday as part of the new administration’s bid to overhaul Dodd-Frank. It is not expected to get through the Senate in its current form, but it does provide an interesting read. While current disclosure requirements have become too lengthy and cumbersome in many respects, the proposed change to Say-on-Pay voting frequency requires a materiality determination that may prove difficult for companies to implement. Currently, public companies are required to provide their shareholders with an advisory vote on executive compensation no less than once every three years. Most companies hold the vote annually. The Financial CHOICE Act would modify this requirement so that the vote is held “[e]ach year in which there has been a material change to the compensation of executives of an issuer from the previous year.” So, each year the issuer would have to determine if there has been a material change to executive compensation when deciding what proposals are put before shareholders at the annual meeting. I expect many issuers would continue to hold an annual vote to seek feedback from their shareholders even if there was no material change in compensation. However, given the high profile nature of a negative say-on-pay result, would issuers shy away from the advisory vote in a year of poor company performance (absent an obviously material change to executive compensation)? Will an issuer’s determination not to include the advisory vote bring on another wave of proxy disclosure litigation? Could an issuer determine not to hold a say-on-pay vote for multiple years in a row? Fewer say-on-pay advisory votes may not be problematic for issuers with strong corporate governance and shareholder engagement. However, for other issuers, say-on-pay advisory votes provided shareholders with a powerful (albeit imprecise) means of communicating their displeasure to the Board of Directors.

Companies that permit the grant of early exercise incentive stock options (“ISOs”) do so primarily to limit the impact of the alternative minimum tax (“AMT”). However, due to fairly counterintuitive tax regulations, structuring options in this fashion can expose optionees to negative tax consequences in the event of a disqualifying disposition. Read more about the tax effects of early exercise ISOs and how the tax results compare to alternate structures in our recent eUpdate here: www.dorsey.com/newsresources/publications/client-alerts/2017/04/unexpected-risks-of-early-exercise-isos

As the 2017 proxy season begins to unfold, proxy access continues to be a focus of shareholder proposals. Last year, companies that had already adopted mainstream proxy access bylaws, or that were planning to put mainstream proxy access bylaws up for a shareholder vote, were largely successful in being able to exclude shareholder proposals to adopt proxy access bylaws on the grounds that such proposals had already been “substantially implemented.” This year, companies have received a wave of new shareholder proposals seeking to amend their existing proxy access bylaws. Until recently, the SEC staff had generally denied requests to exclude such proposals. In two recent no-action letters, however, the staff has provided relief where the company adopted several of the requested amendments. In addition, for the first time in the United States, a shareholder attempted to use a proxy access bylaw to nominate a director candidate and to have that candidate included in the company’s proxy statement. Read more about these recent developments in our full summary here: https://www.dorsey.com/newsresources/publications/client-alerts/2016/12/recent-developments-in-proxy-access

On November 17, 2016, Glass Lewis opened enrollment for its 2017 Issuer Data Report (IDR) program.  This program will cover companies in the United States, Canada, United Kingdom, Switzerland, Norway and all EU countries on a first-come, first-served basis.  Space is limited, so the enrollment will close on the earlier of January 6, 2017, or as soon as the annual limit for each of the the markets is reached. There is no charge for the IDR program, which enables public companies to see a data-only version of its Glass Lewis Proxy Paper report prior to Glass Lewis completing its analysis and recommendations relating to the company’s annual shareholder meeting.  The IDR allows companies to confirm the accuracy of the information used in Glass Lewis’ corporate governance analysis, including information relating to directors and board composition, governing documents, independent public auditor, compensation practices, summary compensation data and equity plans.  The IDR does not contain the Glass Lewis analysis or voting recommendations. Enrolled companies will receive their IDR approximately three to four weeks prior to their shareholder meeting.  While Glass Lewis generally provides companies 48 hours to review the IDR, in some circumstances, Glass Lewis will limit the review time to 24 hours.  Companies can provide corrections to Glass Lewis, with the public documentation supporting such corrections. For more information or to enroll, go to https://www.meetyl.com/issuer_data_report.