Governance & Compliance Insider

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)

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

On March 9, 2017, the Senate Banking Committee passed a series of four bills focused on deregulation, including one that would make it easier for privately held companies to issue stock awards through equity compensation plans. Each of the bills was a bipartisan effort. One bill eases certain restrictions on reporting on exchange traded funds (ETFs). The bill would address securities laws and regulations that discourage broker-dealers from publishing research on ETFs by directing the Securities and Exchange Commission (SEC) to provide a safe harbor for research reports that cover ETFs. The second bill proposes to ease reporting thresholds for privately held corporations when issuing stock awards. Currently, under Item 701 under the Securities Act of 1933, as amended, if the sales price or amount of securities sold in any 12-month period under a private company’s equity compensation plans exceeds $5 million, then the company must provide certain information to the holders of the equity compensation securities, which many companies consider onerous and inappropriate for a privately held corporation. The bill would increase that threshold to $10 million and have it adjusted for inflation. A third bill would raise to 250 from 100 the number of investors venture capital funds can acquire before triggering SEC registration requirements under the Investment Company Act of 1940, as amended. The final bill would credit stock exchanges for any fees they have overpaid the SEC. The bills have been reported to the Senate, placed on the Senate legislative calendar and are awaiting further action by the Senate. Companion bills in the House are moving through the House Finance Committee.

2016 was a busy year for securities law developments, with the SEC adopting and proposing new rules and issuing significant interpretations that will affect SEC reporting companies in the coming years. We have highlighted a few of these recent developments in this post as companies prepare for the upcoming reporting cycle. With the new incoming U.S. administration it is important to note that some of the rules that were adopted by the SEC in the past few years may be repealed or amended, and some of the rules that are currently being finalized by the SEC may not be adopted or may be further modified or delayed. New Rules and Interpretations Proxy Cards – “Clear and Impartial” On March 22, 2016, the SEC released a proxy card interpretation, which serves as a reminder that proxy cards must “clearly and impartially” identify each item to be voted on by shareholders. The full text of the SEC’s interpretation can be found here: https://www.sec.gov/divisions/corpfin/guidance/exchange-act-rule-14a-4a3-301.htm Paper Copies of Annual Reports On November 3, 2016, the SEC released an interpretation which stated that companies may post an electronic version of its annual report to shareholders on its corporate web site by the dates specified in Rule 14a-3(c), Rule 14c-3(b) and Form 10-K, respectively, in lieu of mailing paper copies or submitting it on EDGAR. The report must remain accessible for at least one year after posting. See our previous post on this topic here: http://governancecomplianceinsider.com/sec-staff-makes-life-a-little-easier-for-reporting-companies-by-permitting-annual-reports-to-shareholders-to-be-posted-on-company-websites/ NASDAQ Golden Leash On July 1, 2016, the SEC approved a change to the NASDAQ Listing Rules that will require NASDAQ listed companies to publicly disclose “golden leash” arrangements. “Golden leash” arrangements are generally defined as agreements or arrangements made by activist shareholders to pay a director or director nominee in connection with his or her service on, or candidacy for, a company’s board of directors, usually in connection with a proxy fight. The final rules for “Golden Leash Arrangements” are described further in our complete summary here: https://www.dorsey.com/newsresources/publications/client-alerts/2016/07/disclosure-of-golden-leash-arrangements Form 10-K Summary Disclosure On June 1, 2016, in accordance with the Fixing America’s Surface Transportation Act (the “FAST Act”), the SEC issued an interim final rule amending Form 10-K by adding a new Item 16 to permit companies to provide certain summary disclosure in the annual report, provided that each item in the summary includes a cross-reference by hyperlink to the related more detailed disclosure in the report to which the item relates. The new summary section is not required and the SEC has provided issuers with flexibility on how best to prepare the summary. The full text of the SEC’s interim final rule can be found at the following link: https://www.sec.gov/rules/interim/2016/34-77969.pdf The FAST Act is further described in our summary here: https://www.dorsey.com/newsresources/publications/client-alerts/2015/12/fast-act-company-disclosure-capital-markets-access Non-GAAP financial measures On May 17, 2016, the SEC issued new interpretations regarding the use of non-GAAP financial information by public companies. The new interpretations provide specific guidance for certain types of non-GAAP financial information including providing examples on how to describe GAAP measures with equal or greater prominence and how to avoid making non-GAAP measures misleading. See our summary here: https://www.dorsey.com/newsresources/publications/client-alerts/2016/05/tighten-use-of-non-gaap-financial-measures Pay Ratio Disclosure Most public companies will be required to make the pay ratio disclosure following their first full fiscal year beginning on or after January 1, 2017. For a typical, calendar-year reporting company, the first pay ratio disclosure would be made in its proxy statement for its 2018 annual meeting. The SEC released an interpretation on October 19, 2016 to provide additional guidance on the upcoming disclosure requirements. For a summary of the interpretations see our discussion here: https://www.dorsey.com/newsresources/publications/client-alerts/2016/10/new-cdis-help-issuers For a discussion of the final rules see our summary here: https://www.dorsey.com/newsresources/publications/client-alerts/2015/08/sec-issues-final-rule-for-pay-ratio-disclosure Disclosure of Government Payments by Resource Extraction Issuers On June 27, 2016, the SEC adopted rules requiring disclosure of government payments by resource extraction issuers.  The rules will require resource extraction issuers to disclose payments made to the U.S. federal government or foreign governments, including foreign subnational governments, for the commercial development of oil, natural gas or minerals. Resource extraction issuers are required to comply with the new rules starting with their fiscal year ending no earlier than September 30, 2018.  A resource extraction issuer with a December 31 fiscal year end will be required to file its first resource extraction payment report no later than 150 days after December 31, 2018, which is May 30, 2019. The full text of the final rules are found here: https://www.sec.gov/rules/final/2016/34-78167.pdf Proposed Rules Mining Disclosure Rules The SEC proposed new rules relating to disclosure by companies engaged in material mining operations in SEC reports. The proposed rules were subject to a comment period that was extended to September 26, 2016. The SEC is in process of reviewing the comments and we anticipate that new proposed rules or final rules will be released in 2017. The proposed rules are summarized here: https://www.dorsey.com/newsresources/publications/client-alerts/2016/07/new-mining-disclosure-rules Clawback Policies On July 1, 2015, the SEC proposed rules regarding clawback policies and disclosure, requiring the recovery of incentive-based compensation of officers in cases of material non-compliance with accounting reporting requirements. The SEC received comments on the proposed rules and the SEC is in the process of drafting new rules. We anticipate that new rules will be adopted in 2017. The proposed rules are summarized here: https://www.dorsey.com/newsresources/publications/client-alerts/2015/07/sec-issues-proposed-rules-for-clawback-policies Proxy Cards – Universal Ballots On October 26, 2016, the SEC proposed the mandated use of universal ballots in contested director elections at annual meetings. A universal ballot or proxy card is a single proxy card that includes the names of both management and dissident nominees. The universal ballot would allow shareholders to vote for any combination of director nominees using one proxy card. The proposed rules are summarized here: https://www.dorsey.com/newsresources/publications/client-alerts/2016/10/sec-proposes-universal-ballots

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).