Governance & Compliance Insider

As more annual meetings may be held virtually this year, and many board meetings are being held telephonically due to social distancing or travel restrictions caused by COVID-19, working remotely has created a number of logistical challenges for companies, including the gathering of manually executed signature pages for electronic filings with the SEC. The Staff of the SEC has now provided guidance to help address this concern. On March 24, 2020, the Staff* of the three divisions of the SEC issued a staff statement regarding Rule 302(b) of Regulation S-T, which generally requires filers to obtain manual signatures for all documents filed electronically with the SEC, on or before the time of the electronic filing. The Staff still expects that those subject to Regulation S-T will comply with Rule 302(b) to the fullest extent practicable based on their particular facts and circumstances. However, in light of the COVID-19 pandemic, the Staff indicated it will not recommend enforcement action with respect to Rule 302(b) under the following circumstances: The signatory retains a manually signed signature page or other document (such as a power of attorney) and provides the document to the filer “as promptly as reasonably practicable,” for retention pursuant to Rule 302(b); The document indicates the date and time when the signature was executed; and The filer establishes and maintains policies and procedures governing this process. The signatory may also provide to the filer an electronic record (such as a photograph or pdf) of the document when it is signed. Based on this statement, the Staff would permit a filing on the basis of a manual signature which is scanned and emailed, or otherwise electronically delivered, to the filer, but even electronic delivery would not be necessary as long as the filer’s policies and procedures provide for identification of the signatory and confirmation of the date and time of the signature, for example by an email or phone call. The Staff notes that if a signatory is telecommuting, the signatory could execute a hard copy of the signature page remotely, and deliver the page to the filer upon his or her return to the place of business. However, it is less clear whether a filing can be made on the basis of a purely electronic signature, for example, on a board portal document. And in fact, the Staff reiterates the language of Rule 302(b)’s adopting release, that the requirement to retain the paper original of authentication documents was “established to provide a satisfactory means by which signatories could authenticate and adopt their typed signatures appearing on filed documents for evidentiary purposes.” Filers that are subject to Regulation S-T should establish and maintain policies and procedures to ensure that they receive the original documents, whether by mail or at the next in-person meeting, if they are planning to rely on the relief provided by the Staff statement. *The statement was a joint statement of the staff of the Division of Corporation Finance, the Division of Investment Management and the Division of Trading and Markets. It reflects the views of the three divisions indicated and is not a rule, regulation or statement of the Securities and Exchange Commission.

On January 14, 2020, the U.S. House of Representatives passed HR 4335, the “8-K Trading Gap Act of 2019” (the “Act”) by a bipartisan vote of 384 to 7. The Act is designed to stop company insiders from trading during the 8-K trading gap, as described below. While many companies have insider trading policies in place which would already prevent such trades, a 2015 Columbia Law School paper found that insiders are more likely to engage in open market purchases of their own company’s stock when the firm is about to reveal new agreements with customers and suppliers, and that, when engaging in such purchases, insiders are correct about the directional impact of the 8-K filing more often than not. The Act would require the SEC to adopt rules, within one year of the Act’s enactment, to require all SEC reporting companies to establish and maintain policies, controls and procedures reasonably designed to prevent their executive officers and directors from trading in or otherwise transferring the company’s securities during the 8-K trading gap, that is, between the occurrence of the event triggering the Form 8-K filing and the filing itself. For Section 7 (Regulation FD) furnished disclosures and Section 8 (Other Events) filings, the prohibition on trading would apply from the date the company determines it would disclose the event on Form 8-K. The Act gives the SEC authority to exempt certain transactions, including transactions under a 10b5-1 plan which was adopted outside of an 8-K trading gap. The Act will now pass to the Senate, where it appears likely to pass, although the timing of passage is uncertain.

On February 11, 2019, the Staff of the Division of Corporation Finance granted no-action relief permitting Johnson & Johnson to omit a shareholder proposal from its proxy statement.  The shareholder proposal requested mandatory arbitration of shareholder claims arising under the federal securities laws. The Staff relied on Rule 14a-8(i)(2), which permits exclusion of a proposal that, if implemented, would cause the company to violate any state, federal or foreign law to which it is subject.  Johnson & Johnson argued that the proposal, if implemented, would result in a violation of both federal and state law, but the SEC granted no-action relief specifically on the basis of state law.  Among the company's submissions, the Staff recognized of the legal authority of the New Jersey Attorney General, who issued an opinion that implementation of the proposal would result in a New Jersey state law violation. The decision was sufficiently significant that SEC Chair Jay Clayton issued an accompanying statement, noting that mandatory arbitration provisions have garnered a great deal of attention, and that it is a complex matter requiring careful consideration. Chairman Clayton supported the Staff's recommendation, citing the New Jersey Attorney General's submission.  Chairman Clayton also agreed with the Staff's decision not to address the legality of mandatory shareholder arbitration under federal securities laws, and he expressed the view that any SEC policy decision on this subject should be made by the Commission instead of the Staff. Rule 14a-8(i)(2) permits the exclusion of shareholder proposals that would result in a violation of any state, federal or foreign law, including but not limited to corporate and securities laws.  Other examples where the Rule 14a-8(i)(2) exception has been successfully invoked include a written consent proposal that violated state laws requiring unanimous shareholder written consent (Lowe's Companies (March 10, 2011)) and a proposal to amend governing documents to require that at least 50% of board nominees shall be minorities (Safeway Inc. (March 28, 2005)). As with Rule 14a-8(i)(1), which permits exclusion of proposals that are not proper subjects for shareholder action, the company must provide a supporting opinion of counsel when the basis for exclusion is a matter of state or foreign law, and in cases involving Delaware law, the Staff may request a legal interpretation from the Delaware Supreme Court.  The Staff will permit proponents to convert mandatory proposals into precatory proposals if the mandatory nature of the proposal creates the potential violation.

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.

The SEC adopted new rules today that will require disclosure of a company’s hedging policies in proxy statements or information statements relating to the election of directors. The new rules are set forth in new Item 407(i) of Regulation S-K and require a company to describe any practices or policies it has adopted regarding the ability of its employees, officers or directors to engage in hedging transactions. The disclosure requirements can be satisfied by providing a “fair and accurate summary” of the hedging practices or policies, or by disclosing the practices or policies in full. If a summary is provided, it must include (i) the categories of persons covered by the policy or practice and (ii) the categories of hedging transactions that are specifically permitted or specifically disallowed. However, if a company has not established a hedging policy or practice it must disclosure that fact or state that hedging transactions are permitted. The rules do not require that companies prohibit or limit hedging transactions, or that companies adopt a policy relating to hedging. However, we expect that most companies will amend their current policies to address hedging if it is not already covered in existing policies. Implementation Dates: Except for “smaller reporting companies” and “emerging growth companies”, the new disclosure rules apply for proxy statements or information statements filed during fiscal years beginning on or after July 1, 2019. For “smaller reporting companies” and “emerging growth companies”, the rules apply for proxy statements or information statements filed during fiscal years beginning on or after July 1, 2020. Foreign private issuers will not be subject to the new disclosure requirements.

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.

In order to facilitate discussion on the role of proxy advisory firms at the upcoming Roundtable on the Proxy Process, which is scheduled for November 2018, the SEC staff has determined to withdraw two no action letters that provided comfort to investment advisers in relying on proxy advisory firm recommendations: In Egan-Jones Proxy Services (May 27, 2004), the staff had confirmed that by voting based on the recommendations of an independent proxy advisory firm, an investment adviser could demonstrate the absence of a conflict of interest, and the fulfillment of fiduciary duties, provided that the investment adviser should first ascertain, among other things, whether the proxy advisory firm "(a) has the capacity and competency to adequately analyze proxy issues and (b) can make such recommendations in an impartial manner and in the best interests of the adviser's clients." In Institutional Shareholder Services, Inc. (September 15, 2004), the staff had confirmed that investment advisers should evaluate the independence of proxy advisory firms based on the facts and circumstances, and that a number of ways include a thorough review of the firm's conflict procedures and the effectiveness of their implementation; case-by-case evaluation of the proxy advisory firm's relationship with issuers; or other means to ensure the integrity of the firm. The withdrawal of these no action letters opens up for discussion, and creates uncertainty around, the circumstances in which investors may rely on proxy advisory firm recommendations and when a firm may be considered independent.  The withdrawal is the latest development in the call for additional rulemaking around proxy advisory firms.  Last December, the House passed the Corporate Governance Reform and Transparency Act of 2017, which would require proxy advisory firms to register with the SEC, disclose potential conflicts of interest and codes of ethics and publicize methodologies for formulating proxy recommendations.  Then earlier this year, six members of the Senate Banking, Housing and Urban Affairs Committee sent letters to ISS and Glass Lewis requesting information regarding their eligibility for exemption from proxy rules, accuracy of reporting and potential conflicts of interest. The SEC staff has not to date signaled any changes to its guidance in Staff Legal Bulletin No.20, which among other topics, addresses considerations that an investment adviser may wish to take when it retains a proxy advisory firm, an investment adviser's ongoing duty to oversee a proxy advisory firm that it retains, and an investment adviser's duties to ascertain the material accuracy of the facts upon which a firm's recommendations are based. The impact of proxy advisory firms' recommendations on institutional investor voting is debated.  A study by Choi, Fisch and Kahan (2010) found that proxy advisory firms have modest influence on voting outcomes, with an estimate that ISS recommendations shift 6%-10% of investor voting.  Similarly, a survey by Rivel (2016) found that only 7% of institutional investors say that proxy advisory firms are the "most influential" contributors to their policies, and that generally established best practices are the primary source of their voting policies and decisions.  A study by McCahery, Sautner, and Starks (2016) of 143 institutional investors concluded that they rely on the advice of proxy advisory firms to complement their decision making, rather than relying on them exclusively. However, investor voting decisions often are highly correlated with proxy advisory firm recommendations.  According to a report published by the Manhattan Institute in May 2018, a sample of voting records for 713 institutional investors in 2017 showed that they are significantly likely to vote in accordance with proxy advisory firm recommendations across a broad spectrum of governance issues.  For example, 95% of institutional investors vote in favor of a say on pay proposal when ISS recommends for it, while only 68% vote in favor when ISS is opposed. This correlation may suggest that proxy advisory firms have more influence than institutional investors appreciate or acknowledge.  It may also indicate that governance practitioners form a community, whether they work for investors or proxy advisory firms, and that they develop and are influenced by a common set of trends and "best practices," resulting in investor voting policies that synch with ISS or Glass Lewis voting policies.

A recent SEC consent order against The Dow Chemical Company reminds companies that when evaluating whether or not to disclose a payment or benefit to an executive as a perk in a proxy statement, the fact that the item has a tangential business purpose, or is convenient for the company, is insufficient grounds to exclude the item as a perk.  In order to be excluded as a perk, the item must be "integrally and directly" related to the performance of the executive's duties.  Examples of items that typically should be classified as perks include country club memberships for mixed business and personal use, commuting expenses, and personal guests who join a business flight on the corporate jet. While companies may perceive individual perks as insignificant or as justifiable business expenses, these items can be significant in the aggregate, in hindsight and through a regulatory lens.  The consistent failure to disclose perks over a period of years may result in Commission sanctions and negative publicity, particularly for larger public companies and for companies who for a variety of reasons are the subject of closer Commission scrutiny. As background, on July 2, 2018, the SEC entered into a consent order against Dow, settling claims that from 2011 through 2015, the company did not adequately evaluate and disclose approximately $3 million in executive perks as "other compensation" in its proxy statements.  These authorized but undisclosed perks included personal use of the Dow aircraft and other expenses.  The consent order notes that though Dow applied procedures regarding the evaluation and disclosure of its executives' perks, it did not follow the Commission's standard regarding disclosure of perks, which provides that: • An item is not a perquisite or personal benefit if it is integrally and directly related to the performance of the executive’s duties. • Otherwise an item is a perquisite or personal benefit if it confers a direct or indirect benefit that has a personal aspect without regard to whether it may be provided for some business reason or for the convenience of the company, unless it is generally available on a non-discriminatory basis to all employees. Instead, the consent order finds, Dow incorrectly applied a standard whereby a business purpose related to the executive’s job was sufficient to determine that a benefit would not be a perquisite that required disclosure. Notably, the consent order also sanctions Dow for its disclosure controls.  According to the order, Dow did not adequately train employees in key roles, including those tasked with drafting the CD&A section of the proxy statement and compiling the executive compensation tables, to ensure that the proper standard was applied for perks disclosure.  Dow also had inadequate processes and procedures to ensure proper reporting of perks.  In addition to a $1.75 million penalty, the consent order requires Dow to hire an independent consultant for one year to review and make recommendations on Dow's policies, procedures, controls and training related to the evaluation of whether payments and other expense reimbursements should be disclosed as perks under securities laws.  

The Securities and Exchange Commission (the "SEC") announced Tuesday that Altaba, the entity formerly known as Yahoo! Inc., has agreed to pay a $35 million penalty to settle charges that it misled investors by failing to disclose one of the world’s largest data breaches in which hackers stole personal data relating to hundreds of millions of user accounts. According to the SEC’s order, within days of the December 2014 intrusion, Yahoo’s information security team learned that Russian hackers had stolen what the security team referred to internally as the company’s “crown jewels”: usernames, email addresses, phone numbers, birthdates, encrypted passwords, and security questions and answers for hundreds of millions of user accounts.  Although information relating to the breach was reported to members of Yahoo’s senior management and legal department, Yahoo failed to properly investigate the circumstances of the breach and to adequately consider whether the breach needed to be disclosed to investors.  The fact of the breach was not disclosed to the investing public until more than two years later, when in 2016 Yahoo was in the process of closing the acquisition of its operating business by Verizon Communications, Inc. In the order, the SEC finds that Yahoo's post-breach disclosure in quarterly and annual reports was too general, stating that the company faced only the risk of, and negative effects that might flow from, data breaches.  The company failed to disclose the actual breach or its potential business impact and legal implications. In addition to deficiencies in Yahoo's disclosure to investors, the SEC’s order found that Yahoo did not share information regarding the breach with its auditors or outside counsel in order to assess the company’s disclosure obligations in its public filings. Finally, the SEC’s order found that Yahoo failed to maintain disclosure controls and procedures designed to ensure that reports from Yahoo’s information security team concerning cyber breaches, or the risk of such breaches, were properly and timely assessed for potential disclosure. In its Statement and Guidance on Public Company Cybersecurity Disclosures, released earlier this year, the SEC reiterates that public companies are required to disclose material risks and incidents, including those related to cybersecurity, in their current and periodic reports.  The SEC encourages companies to continue to use current reports to disclose material cybersecurity-related information promptly as this practice reduces the risk of selective disclosure.  Furthermore, beyond requirements explicitly found in SEC regulations, companies are also required to disclose material information and revisit previous disclosure, especially during a cybersecurity investigation, as may be necessary to ensure the company’s filings are not misleading.  Notably, perhaps in recognition of how rapidly the scope of a breach may evolve, the SEC provides that companies “have a duty to correct prior disclosures that the company determines were untrue at the time it was made, or a duty to update a disclosure that becomes materially inaccurate after it is made.”  See our earlier memo for a summary of the SEC's guidance. In evaluating the range of potential disclosure for quarterly and annual reports, companies should consider that cybersecurity breaches or the risk of such breaches may trigger disclosure in the Management's Discussion and Analysis, if the breach presents a material event, trend or uncertainty that has had or is reasonably likely to have a material effect on results of operations, liquidity or financial condition.  Furthermore, financial statements may need to reflect costs incurred, insurance proceeds and contingent liabilities resulting from claims.  A cybersecurity breach may also need to be addressed in the description of business, discussion of legal proceedings and effectiveness of internal controls and disclosure controls and procedures. Even before the next quarterly or annual report, companies should consider whether the information available on the cybersecurity breach is material and should be communicated to investors in a current report in order to reduce the risk of selective disclosure in violation of Regulation FD.  If material information on a cybersecurity breach is not publicly disclosed in a current report, companies should consider whether it is appropriate to impose an event-specific blackout on trading in the company's stock, in accordance with applicable insider trading policies.  Determining the population of employees and other individuals who know, or in hindsight should have known, about the breach, and who should be subject to the event-specific blackout, deserves careful consideration, as demonstrated by the Equifax experience, where high-ranking executives traded in the company's stock after a cybersecurity breach was discovered but before it was announced.      

This week, during his opening remarks at the 2017 National Conference of the Society for Corporate Governance, SEC Commissioner Michael Piwowar remarked on prospects for repealing or delaying the CEO pay ratio rule. Under the rule, most public companies must disclose the median of the annual total compensation of all employees (including non-U.S., part-time, temporary and seasonal workers), except for the CEO; the annual total compensation of the CEO; and the ratio of the two amounts, as calculated under proxy rules. The disclosure must be prepared for fiscal years beginning on or after January 1, 2017, which would be disclosed in 2018 proxy statements. Emerging growth companies, smaller reporting companies and foreign issuers are not subject to the rule. Commissioner Piwowar expressed his support for repealing the rule, which would require Congressional action. In terms of delaying effectiveness of the rule, he stated that public commentary would determine whether that alternative is feasible in light of the associated costs and benefits of implementing the rule. Though the latest comment period on the rule has ended, he urged interested parties to continue to submit comment letters describing specific reasons why the rule is burdensome, as well as proposed fixes. During the latest comment period, the SEC received approximately 180 unique comments, with 150 of those comments in favor of the rule. Given the approaching 2018 proxy season, we advise companies not to count on a repeal or delay of the rule. Companies should continue preparing for the CEO pay ratio disclosure, and keep in mind that there is significant latitude for how the ratio may be calculated, in accordance with Item 402(u) of Regulation S-K and related guidance in C&DIs 128C.01-128C.05. In particular: The median employee, which must be identified once every three years absent a significant change, may be identified from a survey of the entire employee population, a statistical sample or other reasonable method. A de minimis exemption allows companies to exclude non-U.S. employees who account for 5% or less of their employees, including employees whose inclusion would result in a violation of foreign privacy data laws. If certain employees are excluded, then all employees from that jurisdiction must be excluded. Companies may use a consistently applied compensation measure (“CACM”) other than annual total compensation to identify the median employee, as long as the CACM reasonably reflects the annual compensation of employees. For example, total cash compensation could be a CACM unless the company also distributed annual equity awards widely among its employees. Companies may select a determination date within three months prior to the end of their fiscal year, in order to determine employee population from which to identify the median. In applying the CACM to identify the median employee, companies are not required to use a compensation period that includes the determination date. Nor are they required to use a full annual period. As an example, the SEC states that a company may use annual total compensation from its prior fiscal year so long as there has not been a change in the registrant’s employee population or employee compensation arrangements that would result in a significant change of its pay distribution to its workforce. Workers whose compensation is determined by an unaffiliated third party may be excluded from the pay ratio calculation. This population may include leased workers, independent contractors who determine their own compensation, and even workers whose minimum level of compensation is set by the company. Companies should consider testing alternative methodologies in order to assess the quality and consistency of results. While there is considerable latitude to design a pay ratio methodology, companies should let reason be their guide and be prepared to explain the decisions that they make. Companies are required to describe in their proxy statements the methodology used, as well as any material assumptions, adjustments and estimates. Not surprisingly, CEO pay ratios have varied significantly depending on the companies surveyed and the methodology. The AFL-CIO’s annual report on CEO pay calculated a CEO-to-worker-pay ratio of 347-to-1 for 2016, based on the average total compensation package for 400 of the S&P 500 CEOs of $13.1 million last year, and the average annual cash income only (excluding fringe benefits) for America’s 100,525,000 rank-and-file workers of $37,632. In contrast, a 2016 Mercer study found the ratio among respondents to be less than 200-to-1.

While passage in the House seems likely, the Financial Choice Act may undergo significant changes before it may pass in the Senate. Here is a summary of certain governance and executive compensation provisions that are included in the discussion draft: Prohibit Universal Proxy Ballots. Currently, companies are not required to use a universal proxy ballot in the event of a proxy contest, so shareholders receive one ballot listing candidates nominated by the board of directors and separate ballot(s) listing candidates nominated by the shareholder proponents. The Financial CHOICE Act would prohibit the SEC from requiring that companies use a universal proxy ballot. Modernize Shareholder Proposal Thresholds. The Financial CHOICE Act would increase share ownership thresholds for submitting shareholder proposals, from ownership of 1% of outstanding shares or $2,000 for one year, to 1% of outstanding shares for three years; increase resubmission thresholds; and prohibit proposals by a proxy other than the shareholders. Amend Frequency of Say-on-Pay Votes. Currently, under the Dodd-Frank Act, non-binding shareholder votes approving executive compensation must occur at least once every three years. The Financial CHOICE Act would amend the frequency to “each year in which there has been a material change to the compensation..." Require proxy advisory firms to register with the SEC and to provide companies with an opportunity to review and provide meaningful comment on draft recommendations. The registration application would include a certification that the firm has the financial and managerial resources to consistently provide proxy advice based on accurate information. The firm would be required to disclose the procedures and methodologies used in developing proxy voting recommendations, its organizational structure, whether or not it has a code of ethics, any potential or actual conflict of interest, and its policies and procedures to manage conflicts of interest. The registration would be updated as there are material changes, and at least on an annual basis. Repeal CEO Pay Ratio Disclosure. The Financial CHOICE Act would repeal the section of the Dodd-Frank Act which requires companies to disclose the ratio of pay between CEOs and the median employees. Acting SEC Chairman Michael S. Piwowar’s has requested an expedited review of unanticipated challenges to implementing the CEO pay ratio disclosure rule. Repeal Incentive-Based Compensation Disclosure by Covered Financial Institutions. The Financial CHOICE Act would repeal the Dodd-Frank provision which requires enhanced disclosure and reporting of incentive-based compensation by covered financial institutions. This Dodd-Frank Act provision targets excessive compensation and compensation that could lead to material financial loss. More broadly, President Trump has issued an executive order mandating that the Department of the Treasury review financial regulations, including the Dodd-Frank Act. Repeal Disclosure of Hedging Policies. The Financial CHOICE Act would repeal the Dodd-Frank requirement that companies disclose whether employees or directors may engage in hedging transactions in the company’s equity securities. Limit Clawbacks. Under the Dodd-Frank Act, companies that haven’t developed and implemented compensation clawback polices cannot be listed on national securities exchanges and associations. The Financial CHOICE Act would limit the scope of the clawback rule to current and former executives who had “control or authority over the financial reporting that resulted in the accounting restatement.” Pay vs. Performance Disclosure. The future of the pay versus performance provision is uncertain because it isn’t addressed by the Financial CHOICE Act or Hensarling’s memo. Section 953(a) of Dodd-Frank requires companies to disclose the relationship between executive compensation actually paid and the financial performance of the company.

Last Friday, ISS released new and updated FAQS on U.S. Equity Compensation Plans, as summarized below. These FAQs provide new and updated guidance on ISS’s evaluation of equity compensation plan proposals, including treatment of performance-based awards in burn rate calculations, bundling of plan amendment proposals, updates to ISS’s Equity Plan Scorecard (EPSC) policies, and the EPSC as it applies to newly public companies. Since 2015, ISS has evaluated proposals for equity compensation plans and certain amendments to these plans using the EPSC. The ESPC analysis is based on three pillars: Plan cost ("shareholder value transfer" or SVT), relative to the company's market and industry peers, Plan features, and The company's historical grant practices, including its 3-year average burn rate relative to market and industry peers. ISS scores proposals according to factors under each of these three pillars, using its proprietary model. Proposals may receive a maximum of 100 total points, with a threshold of 53 points required to receive a favorable recommendation (absent egregious factors). Summary of New and Updated FAQs 19. If a company grants performance-based awards, how will the shares be accounted for the purposes of calculating burn rate? Both time- and performance-based awards will be counted in the year in which they are granted for the burn rate calculation, but performance-based awards will be counted in the year in which they are earned if the company provides a table of awards granted and earned each year for the past three years, either in the 10-K or proxy statement. There’s a sample table in the FAQ. The aggregate of performance-based awards from all plans to all participants must be disclosed, and not just awards for NEOs. For performance awards that are subject to additional time vesting, the shares generally will be counted at the end of the time-vesting period if the number is disclosed. ISS advises companies to continue to make the additional disclosure, so that ISS may capture performance awards going forward and to provide a clear view of the year-to-year status of the performance award program. 28. How does ISS evaluate an equity plan proposal seeking approval of one or more plan amendments? If the proposed amendments do not request additional shares (or other modifications deemed to potentially increase cost), ISS will make a recommendation based on an analysis of whether the amendments are deemed to be “overall beneficial or contrary to shareholders’ interests.” If the proposed amendment is bundled with a material new share request (or are deemed to potentially increase cost), or this is the first time shareholders may vote on the plan, then ISS generally will support the amendments if there is a passing EPSC score, unless the amendments represent a “substantial diminishment to shareholders’ interests.” ISS will generally support proposals seeking approval of performance measures for Section 162(m) tax deductibility purposes, unless they are bundled with other plan amendments. For ISS’s treatment of bundled amendments, see FAQ #30. 30. How are proposals that include 162(m) reapproval along with plan amendments evaluated? ISS encourages companies to unbundle plan amendments from proposals seeking 162(m) reapproval, since the latter are generally supported by ISS (see FAQ #28). ISS will analyze bundled amendments to determine whether they are, on balance, positive or negative with respect to shareholders' interests. ISS may consider both an EPSC score and/or the balance of positive and negative impacts from the bundled amendments. 32. How does ISS view a plan amendment to increase the tax withholding rate applicable upon award settlement? This type of amendment is generally viewed as an administrative change neutral to shareholders' interests. However, if the plan contains a liberal share recycling feature (such as recycling of shares tendered as payment for an option exercise, shares withheld to cover taxes, shares added back that have been repurchased using stock option exercise proceeds, and stock-settled awards where only the actual shares delivered are counted against the plan reserve), then a company can mitigate ISS’s concern by providing that only the number of shares withheld at the minimum statutory rate may be recycled, even if the tax withholding is at a higher rate. See also, Nasdaq Doesn’t Require Shareholder Approval of Equity Compensation Plan Amendments to Increase Tax Withholding. 36. What changes were made to the EPSC policy for 2017? Effective for meetings as of Feb. 1, 2017, the following adjustments will apply to EPSC evaluations: Payment of dividends on unvested awards (new factor): Full points will be earned if the equity plan expressly prohibits, for all award types, the payment of dividends before the vesting of the underlying award. Accrual of dividends that are only payable upon vesting is allowed. No points will be earned if this prohibition is absent or incomplete (i.e. not applicable to all award types). Minimum vesting terms (updated factor – see also, FAQ #47): Full points are awarded only if the equity plan specifies a minimum vesting period of one year for all equity awards. Also, no points will be earned if the plan allows for the administrator to reduce or eliminate the one-year vesting requirement. Companies are permitted to carve out 5% of equity awards granted under the plan, which do not have to be subject to the minimum vesting requirement. Burn rate data: For companies with between 33 and 36 months of trading history at the applicable quarterly data download date, the EPSC model index will be based on whether the company has disclosed three years of burn rate data. Special Cases models apply for companies with 32 or fewer months of trading history. Factor scoring adjustment (see also, FAQ #42 and 43): Scoring for certain EPSC factors has been adjusted, though ISS does not provide specifics under its proprietary model. 41. How will equity plan proposals at newly public companies be evaluated? Newly public companies, including recent IPOs, spinoffs, and bankruptcy-emergent companies, may be evaluated under an EPSC model that includes fewer factors. In addition to these FAQS, ISS also released new and updated FAQs on U.S. Executive Compensation Policies and updated Pay-for-Performance Mechanics (which details ISS’s new Relative Pay and Financial Performance Assessment).

Over the last few months, the SEC has obtained a string of cease and desist orders against SEC reporting companies, both domestic and foreign, to enforce an often overlooked rule adopted under Dodd-Frank.  Rule 21F-17 provides that “[n]o person may take any action to impede an individual from communicating directly with the [SEC] staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement … with respect to such communications”. Many practitioners thought little about this rule until this summer.  In recent cease and desist orders involving Health Net, BlueLinx and Anheuser-Busch InBev, the SEC has made clear that it believes that a confidentiality clause violates Rule 21F-17 if, read on its face, it would prevent an individual from voluntarily communicating with the SEC regarding potential securities law violations (something that is not “required by law”) or if the clause would require the individual to obtain anyone’s consent or provide notice to anyone in order to engage in such communications.  In other words, the SEC now views “standard” confidentiality clauses included in employment, separation, confidentiality and other agreements and policies entered into with employees and other individuals as violating U.S. federal securities laws unless they include a specific carve out allowing whistleblowing. In recent months, the SEC has imposed fines ranging from $250,000 to more than $6 million on companies using such clauses in their agreements, and required such companies to take remedial actions, including informing current and former employees of their right to communicate with the SEC regarding potential securities law violations.  In several cases, the SEC did not allege that any of the affected persons was a whistleblower or had been impeded from being a whistleblower, just that the language used in the agreements was impermissible.  The SEC has also taken the position in recent actions that any purported waiver of an individual’s right to obtain a whistleblower award from the SEC is impermissible. While the cease and desist orders have, to date, been limited to SEC reporting companies, Rule 21F-17 does not appear limited to public companies.  Accordingly, private companies subject to U.S. jurisdiction should also consider their compliance with Rule 21F-17. Because the offending language is language that many consider “standard” for employment, separation, confidentiality and other agreements, as well as corporate governance policies such as codes of conduct and ethics, many companies will need to modify their corporate governance policies and their existing and template agreements to comply with the new interpretations.  We have developed language for confidentiality clauses and corporate governance policies that is intended to comply with the SEC’s new interpretations, and have worked with a number of companies to implement compliance regimes.  For further information or for assistance in complying with Rule 21F-17, please contact the author or your other Dorsey contacts.

ISS has published an executive summary of 2017 updates to its benchmark proxy voting policies for the Americas, EMEA, and Asia-Pacific regions.  The updated policies will generally be applied to shareholder meetings on or after February 1, 2017. U.S. policy changes are summarized below, and companies should keep them in mind as they consider policies on director compensation, dividend and vesting policies for stock awards, and shareholder rights to amend bylaws.  For companies contemplating IPOs, governance structures that have a material adverse impact on shareholder rights, including multi-class shareholder structures, generally will lead to recommendations against director candidates.  It’s worth noting that in certain situations where ISS finds a practice problematic, it will result in ongoing (versus one-time) recommendations against directors (see the last two policies described below). In December 2016, ISS will release a complete set of updated policies, and it will release updated Frequently Asked Questions ("FAQ") documents on certain U.S. policies, including the Equity Plan Scorecard. Non-Employee Director Pay:  While ISS does not evaluate stand-alone non-employee director (“NED”) plans according to its Equity Plan Scorecard he EPSC model, these plans do receive a standard cost evaluation for Shareholder Value Transfer (SVT).  Under the updated policies, NED pay proposals will be evaluated across “a broader range of factors and more nuanced consideration of director pay.”  ISS will assess advisory proposals seeking shareholder approval of NED pay, and certain NED equity plan proposals that are determined to be relatively costly, considering the following, additional qualitative factors: The relative magnitude of director compensation as compared to companies of a similar profile; The presence of problematic pay practices relating to director compensation; Director stock ownership guidelines and holding requirements; Equity award vesting schedules; The mix of cash and equity-based compensation; Meaningful limits on director compensation; The availability of retirement benefits or perquisites; and The quality of disclosure surrounding director compensation. This policy update is consistent with recent judicial scrutiny of director compensation.  In Calma v. Templeton, the Delaware Chancery Court denied Citrix’s motion to dismiss the plaintiff’s breach of fiduciary duty claim against the Citrix board of directors, and furthermore, held that director compensation decisions would be judged by the heightened entire fairness standard (versus the deferential business judgment rule), where the director compensation program did not include “meaningful limits.” Dividends and Minimum Vesting for Stock Awards:  ISS added a factor on dividend payments on unvested awards.  ISS will award full points if the equity plan expressly prohibits dividend payments for all award types before the vesting of the underlying award.  Accrual of dividends payable upon vesting is acceptable.  No points will be earned if this prohibition is absent or incomplete (i.e. not applicable to all award types).  Notably, a company's general practice of not paying dividends until vesting, if it is not memorialized in the plan document, is insufficient to earn full points. The minimum vesting factor was also updated so that an equity plan must specify a minimum vesting period of one year for all award types under the plan in order to receive full points for this factor.  No points will be earned if the plan allows for individual award agreements that reduce or eliminate the one-year vesting requirement. Restrictions on Shareholder Amendments to Bylaws:  ISS will make ongoing recommendations against governance committee members if the company's charter imposes undue restrictions on shareholders' ability to amend the bylaws.  These restrictions include but are not limited to a prohibition on the submission of binding shareholder proposals or ownership/holding requirements for such shareholder proposals that exceed those in the SEC’s Rule 14a-8. IPOs with Multi-Class Shareholder Structures:  If prior to or in connection with a company's public offering, the company or its board adopted bylaw or charter provisions materially adverse to shareholder rights, or implemented a multi-class capital structure in which the classes have unequal voting rights, ISS will generally recommend withhold or against votes on directors individually, committee members, or the entire board (except new nominees, who should be considered case-by-case).  Unless the adverse provision and/or problematic capital structure is reversed or removed, ISS will recommend a vote case-by-case on director nominees in subsequent years.  

Glass Lewis released its updated policy guidelines for the 2017 proxy season for several countries, including the United States and Canada.  The most significant change in the United States guidelines relates to director overboarding and was expected.  The changes to the United States guidelines include: Director Overboarding Policy As indicated in last year’s guidelines, in 2017, Glass Lewis will generally recommend voting against a director who: Is an executive officer of any public company and serves on a total of more than two public company boards, or Serves on a total of more than five public company boards. Glass Lewis generally will not recommend that shareholders vote against overcommitted directors at the companies where they serve as an executive. Board Evaluation and Refreshment With respect to board evaluation, succession planning and refreshment, Glass Lewis clarified that it believes “the board should evaluate the need for changes to board composition based on an analysis of skills and experience necessary for the company, as well as the results of the director evaluations, as opposed to relying solely on age or tenure limits.” Governance Following an IPO or Spin-Off With respect to corporate governance at newly-public entities, Glass Lewis will review the terms of the company’s governing documents in order to determine whether shareholder rights are being severely restricted from the outset.  If Glass Lewis believes that the board has approved governing documents that significantly restrict the ability of shareholders to effect change, Glass Lewis will consider recommending shareholders vote against members of the corporate governance committee or directors that served at the time of adoption of the particular governing documents. For 2017, Glass Lewis has outlined the specific areas it reviews when determining if shareholder rights are being restricted, including: The adoption of anti-takeover provisions, such as a poison pill or classified board Supermajority vote requirements to amend governing documents The presence of exclusive forum or fee-shifting provisions Whether shareholders can call special meetings or act by written consent The voting standard provided for the election of directors The ability of shareholders to remove directors without cause The presence of evergreen provisions in the company’s equity compensation arrangements The updated proxy guidelines can be found here.