Unlike in past years, there are no new disclosure requirements which need to be reflected in this year’s proxy statement; however, with ongoing shareholder activism and the desire of companies to communicate effectively with their shareholders, this year provides an opportunity to review and improve prior disclosures. In this memo we survey the current status of recent rule changes and disclosure initiatives, provide a preview of some still pending rulemaking efforts and review a couple of other governance matters for issuers to consider.
View our recent seminar on the upcoming 2014 Proxy Season and view the PowerPoint presentation here.
Independent Compensation Committees
In 2012, the SEC adopted final rules as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), directing the stock exchanges to adopt new standards for independent compensation committees and mandating that compensation committees be given new authority and responsibility for the engagement of compensation advisers. The new rules required actions by issuers in both 2013 and 2014.
Actions Required by July 1, 2013:
- Compensation committees were required to have authority to hire compensation consultants, independent legal counsel and other compensation advisers (collectively, “compensation advisers”) and exercise the sole responsibility to oversee the work of any compensation advisers retained to advise the committee.
- Listed companies were required to provide adequate funding to pay reasonable compensation to compensation advisers retained by a compensation committee.
- Before engaging a compensation adviser, a compensation committee must consider the factors that could potentially impact the independence of the compensation adviser, including at least the six factors listed in the applicable exchange rules.
- NYSE listed companies were required to have compensation committee charters reflecting this expanded authority.
Actions Required by the Earlier of the First Annual Meeting after January 15, 2014, or October 31, 2014:
- For issuers listed on NYSE, NASDAQ or the NYSE MKT, the compensation committee must be comprised of independent directors in accordance with the new rules.
- A NASDAQ listed issuer must establish a compensation committee if it does not have one and have a compensation committee charter that reflects the expanded responsibilities and authority established by these rules.
- A NASDAQ listed issuer must also certify its compliance with the new compensation committee rules to NASDAQ on a new form which is expected to be issued in early 2014.
Compensation Committee Independence Requirements
Following NASDAQ's recent rule changes regarding the independence standards for serving on the compensation committee, the independent director criteria for NYSE, NASDAQ and the NYSE MKT are virtually identical. Each exchange retained its current standards for director independence which continue to apply to members of the compensation committee and then added new independence criteria that apply only to members of the compensation committee. Each member of the compensation committee must be determined by the board of directors to be “independent” based on a consideration of (a) the source of compensation to a director, including “any consulting, advisory or other compensatory fee paid by the issuer” to the director; and (b) whether the director is “affiliated with the issuer, a subsidiary of the issuer or an affiliate of a subsidiary of the issuer”. Each exchange states that the board should consider these factors when determining if such source of compensation or affiliation would impair a director’s ability to make independent judgments about the company’s executive compensation, and each exchange rejected a bright-line cap on share ownership by a member of the compensation committee or the member’s affiliates. Issuers also may want to consider adding some questions to their D&O questionnaire to elicit information relevant to this independence determination See “Drafting Considerations” below.
Conflict Minerals Rules
In response to the extreme levels of violence in the Democratic Republic of the Congo (“DRC”), which Congress felt was financed in part by the trade of “conflict minerals,” Congress directed the SEC to adopt regulations requiring additional disclosure by SEC reporting companies that use conflict minerals in product manufacturing. The rules require public companies to complete a three-step analytical process to determine if conflict minerals are used in the manufacturing of their products, and if so, to determine the country of origin of the conflict minerals. Conflict minerals include tantalum, tin, tungsten and gold. Compliance with these new requirements has been a significant undertaking in 2013 for subject companies. Some large companies have been tracking and cleaning their supply chains over the last few years as a result of these rules. In 2014, these efforts will continue to ramp up as companies prepare to report for the 2013 calendar year on new Form SD. The first report is due on June 2, 2014.
On May 30, 2013, the SEC issued its long anticipated guidance on the conflict minerals rules. Notably, the FAQs provided significant relief for certain kinds of manufacturers, particularly those in the food industry.
A legal challenge to the conflict minerals rules was led by the National Association of Manufacturers and the U.S. Chamber of Commerce. In June 2013, the D.C. District Court upheld the rules. That decision was appealed and oral arguments were heard on January 7th. At least two of the three judges on the panel reportedly raised concerns with the rules during the hearing. The SEC has not stayed the rules pending the outcome of the appeal and issuers should not depend on the rules being overturned on appeal.
Disclosure Relating to Iran Sanctions
This will be the second year for required disclosure under the Iran Threat Reduction and Syria Human Rights Act of 2012 (the “Iran Act”), which expanded U.S. sanctions against Iran and Syria, subjected U.S. companies to liability for Iran-related sanctionable activities conducted by their foreign subsidiaries and amended the Exchange Act to impose new disclosure obligations on SEC reporting issuers. The new reporting requirements were effective for all annual and quarterly reports filed with the SEC after February 6, 2013 and required disclosure about Iran-related activities knowingly conducted by it or its affiliates, including: activities related to Iran’s petroleum industry; activities contributing to Iran’s ability to acquire or develop weapons of mass destruction or support terrorism; activities with specified persons, including Iran’s Revolutionary Guard Corps; and activities that support Iran’s acquisition of technologies that are likely to be used to commit human rights abuses against the Iranian people or to restrict, disrupt or monitor the free flow of information. Disclosure of these activities is required even if the activities are not prohibited or sanctionable with respect to the person engaging in them.
Even companies whose activities are covered by specific authorization of a Federal department or agency, such as a general or specific license issued by OFAC, may be required to continually disclose information regarding their activities if, as part of the approved activities, the issuer conducts activities with persons identified in Executive Order No. 13224 or Executive Order No. 13382. These executive orders include, for example, a number of major Iranian banks.
Due to the lack of any de minimis exemption or materiality standard, and the broad definition of affiliate, the disclosure requirement has a broad reach. The first year’s disclosures included some instances of highly immaterial information. For example, Dell, Inc. disclosed the existence of a maintenance services software renewal transaction with Melli Bank PLC entered into by a foreign affiliate of an entity recently acquired by Dell. The total value was less than $170.
With respect to disclosure required by the Iran Act, issuers must establish and maintain procedures to confirm the activities of its affiliates throughout the year. For issuers acting within the constraints of a general or specific license or other type of authorization, in order to omit disclosure of their Iranian activities from their annual and quarterly reports, they must monitor the activities to ensure that all conditions of the applicable license are strictly observed and ensure that none of the authorized activities involve entities identified in Executive Orders 13224 or 13382. Issuers also may want to consider adding some questions to their D&O questionnaire to elicit information relevant to these disclosures regarding the Iranian activities of the company and its affiliates. See “Proxy Drafting Considerations” below.
2014 is the fourth year of say-on-pay votes and the approach and process for addressing the say-on-pay question is becoming more routine. In 2013, 74 companies failed to get majority support for their say-on-pay proposals. This represented an increase over the number of issuers which had failed votes in 2012, however 2013 was also the first year in which the large number of smaller reporting companies were required to hold say-on-pay votes. As a result, the percentage of companies that failed to get approval actually fell from approximately 2.4% in 2012 to 2.2% in 2013.
In 2014, the focus for most public companies will once again be on making the compensation discussion and analysis (“CD&A”) a clear and effective explanation of the company’s policies to support its say-on-pay proposal. There are now three years’ worth of precedents to provide sample language and presentation formats for issuers to peruse. In addition, issuers should consider the company’s compensation policies in light of the updated voting policies of the proxy advisory firms. See “2014 Policy Updates by Proxy Advisory Firms” below. This review should not dictate a company’s compensation policies and decisions, but it can inform a company’s determination of its policies, highlight topics to address in the CD&A and allow the company to anticipate potential questions from the proxy advisory firms and shareholders. Companies will also need to consider the results of the prior year’s say-on-pay votes and discuss in the CD&A how compensation decisions this year were impacted by that vote. As in prior years, if a company received less than 70% shareholder support for its say-on-pay proposal in 2013, ISS will apply heightened scrutiny to this year’s proposal. Perhaps most importantly, companies need to engage their major shareholders in a dialogue regarding executive compensation, particularly if shareholder support for prior say-on-pay proposals has been less than 75%, and to provide feedback from this dialogue to their compensation committees.
2014 Policy Updates by Proxy Advisory Firms
ISS and Glass Lewis & Co. (“Glass Lewis”) each made modest revisions to their proxy voting policies for the 2014 proxy season.
The most notable revisions from ISS for 2014 concern board responsiveness and the analysis of CEO pay. ISS will review the responsiveness of a board to any shareholder proposal that receives a majority of votes cast in a single year (in contrast to the previous policy of either two years of a majority of votes cast in a three-year period, or one year of a majority of shares outstanding). Vote recommendations on director elections with respect to majority-supported shareholder proposals will be made on a fact-specific, case-by-case basis and ISS has given its analysts more discretion on whether to recommend withhold/against votes for directors after receipt of majority support on a shareholder proposal. One of the factors to be considered by the analyst is the board’s rationale for its decision as set forth in the proxy statement. Effectively, it is a “comply or explain” policy. If a board does not fully implement a majority approved shareholder proposal, the board’s reasoning should be fully and clearly explained in the proxy statement.
ISS utilizes a number of metrics to measure the alignment of executive compensation with performance, including the Relative Degree of Alignment (“RDA”) pay-for-performance screen. This measure is a primary factor to determine ISS’s initial recommendation regarding the say-on-pay vote. In 2013, this measure was calculated as the difference between the company's total shareholder return and the CEO's total pay rank within a peer group, as measured over one-year and three-year periods, weighted 40 percent and 60 percent, respectively. In 2014, the RDA screen is limited to the three year period. Under the prior model, the current year was given a disproportionate weight as it was included in both the one- and three-year measure. However, for issuers who have made recent modifications to CEO pay in response to performance, the new measure, which equally weights all three years, will minimize the impact of those changes.
Glass Lewis also addressed board responsiveness in its 2014 updates. If a shareholder proposal seeking board declassification receives majority support of the votes cast and the board does not implement the proposal, Glass Lewis will consider recommending withhold/against with respect to all nominees up for election that served throughout the previous year, regardless of their committee membership.
Trends in Shareholder Activism
The level of shareholder activism increased slightly in 2013 after a sharp rise in shareholder proposals in 2012. In general, the number of shareholder proposals filed increased in 2013, up 6% from 2012 for Russell 3000 companies and up 4.6% for S&P 500 companies. While the standard corporate governance proposals (including board declassification, majority voting and separation of CEO/Chair roles) remain common, there was a sharp increase in proposals on executive compensation. These types of proposals include elimination of accelerated vesting in termination (change of control), elimination of supermajority voting thresholds and requirements for stock ownership guidelines. Proposals relating to board diversity tripled over 2012. Environmental and Social (E&S) proposals were dominated by political spending and lobbying disclosure proposals, environmental proposals and human rights proposals.
Another form of activism has been the rise of the “strike suit” to enjoin a shareholder meeting. In 2012 and 2013, there was a wave of lawsuits alleging inadequate or misleading disclosure in the proxy statement relating to say-on-pay or, in some cases, equity plan disclosure relating to dilution or burn rate. Issuers have been fighting back against the suits, and prevailing. In some instances, courts have dismissed the lawsuits due to lack of materiality of the information sought to be included by the plaintiffs.
The next generation of lawsuits has shifted its focus to previous compensation decisions. These cases allege that the issuer made grants or compensation decisions that didn’t comply with the requirements of Section 162(m) or exceeded the terms of the equity plan. Suits of this nature may require rescission of noncompliant grants. Issuers are cautioned to carefully monitor the terms and limits of their compensation programs when making compensation decisions.
In contrast to many recent years, there are no major new disclosure initiatives which need to be reflected in this year’s proxy statement. Nevertheless there are several steps that issuers may choose to take to promote the effectiveness and accuracy of their disclosure.
- Review a number of proxies from other companies to consider layout or organizational changes that could make your proxy easier to read and understand.
- Consider using a summary at the front of the proxy statement to highlight important information for the shareholder.
- Consider whether the use of additional graphs or charts would more clearly help your shareholders understand your compensation disclosure.
- If the board chooses not to fully implement a shareholder proposal receiving majority support, be sure to clearly explain the board’s rationale for not doing so.
- If seeking approval for an increase in equity plans, consider whether to include the type of disclosure sought in shareholder strike suits, such as burn rate, dilution and peer group comparison.
- Be careful when including non-GAAP measures in your proxy. Use of misleading non-GAAP performance measures is a focus of the SEC Financial Reporting and Audit Task Force.
- Consider revising D&O questionnaires to include questions regarding the independence of compensation committee members and compensation consultants retained by the company, as well as any Iranian related activities of the company and its affiliates.
- The SEC is continuing to focus on segment reporting. When preparing your annual documents, review your segment reporting with a critical eye.
- Review your risk factors from scratch to determine what your material risks are today.
Looming Disclosure Items for Future Years
Government Payments by Resource Extraction Issuers
The Dodd-Frank Act required the SEC to adopt rules to require resource extraction issuers (i.e., public companies engaged in the commercial development of oil, natural gas or minerals) to disclose certain payments made by them, their subsidiaries or entities controlled by them, to the U.S. government and foreign governments, including sub-national governments. Under rules adopted by the SEC in August 2012, disclosure of such payments would have been required for fiscal years ending after September 30, 2013.
Under the adopted rules, issuers would have been required to publicly file annual reports disclosing government payments made to further the commercial development of oil, natural gas or minerals in amounts equal to or exceeding $100,000 during the fiscal year. The rules contained no exemptions from disclosure as a result of confidentiality provisions in contracts, prohibitions on disclosure contained in foreign law or commercially or competitively sensitive information.
The rules were subject to legal challenge almost immediately. On July 2, 2013, in a blow to SEC rulemaking, the U.S. District Court for the District of Columbia vacated the rules requiring disclosure of government payments by resource extraction issuers and noted that the deficiencies in the rules are “grave indeed.” The court found the rules to be invalid for two reasons. First, it found that the SEC had misread the statute to require public disclosure of the mandated annual reports. Second, the court found that the SEC’s denial of an exemption for countries that prohibit payment disclosure was arbitrary and capricious.
The disclosure rules are now void, and issuers need not comply with them. The SEC did not appeal the court’s decision, so the rules have been remanded to the SEC for revision based on the court’s findings. The reproposed rules have not yet been published.
CEO Pay Ratio Rules
On September 18, 2013, the SEC adopted proposed rules requiring most public companies to disclose the ratio of the Chief Executive Officer’s annual compensation to the median annual compensation of all other employees of the company. The highly controversial disclosure rules were mandated by the Dodd-Frank Act. If final rules become effective in 2014, most public companies with calendar year-ends would be required to disclose the CEO pay ratio disclosures in early 2016 with respect to compensation earned in 2015.
The proposed rules would require disclosure of:
- the median of the annual total compensation of all employees of the registrant, except its principal executive officer (“CEO”);
- the annual total compensation of the CEO; and
- the ratio of the CEO’s compensation to the median compensation amount.
The proposed rules apply to reporting companies other than “emerging growth companies,” "smaller reporting companies” and “foreign private issuers.” Newly public companies are not immediately subject to the disclosure requirements.
“All employees of the registrant” would be defined to mean all individuals employed by a company or any of its subsidiaries and would include any “full-time, part-time, seasonal or temporary worker” as of the last day of the company’s prior fiscal year, including non-U.S. employees. In contrast, workers who are not employed by the registrant or its subsidiaries, such as independent contractors or “leased” workers or other temporary workers who are employed by a third party, would not be covered.
In determining annual total compensation, companies would not be permitted to make full-time equivalent adjustments for part-time workers, annualizing adjustments for temporary or seasonal workers or cost-of-living adjustments for non-U.S. workers.
The proposed rules present issuers with a multitude of challenges if the rules were to be adopted as proposed. Fundamentally, both the determination of a company’s employees and the calculation of annual compensation present significant, practical questions for issuers, such as: who is an employee? How is total compensation calculated? How are privacy laws for other countries to be addressed? Does it include unconsolidated entities?
Given many of the practical, logistical questions raised by the proposed rules, it is difficult to predict when or in what form rules will come into effect, if they ultimately come into effect at all. Nevertheless, as proposed, compliance with the CEO pay ratio rule would require considerable additional time, effort and expense for all covered public companies. Consequently, issuers that may be subject to the CEO pay ratio disclosure rule should carefully consider how the rule could impact their disclosure procedures, particularly with respect to collecting and analyzing data on “total annual compensation of all employees” and determining the median of such compensation.
Governance Matters to Consider in 2014
Forum Selection Bylaws
In response to the burdens of multi-jurisdiction litigation, many Delaware corporations have adopted bylaws making Delaware the exclusive venue for litigation relating to their internal affairs. A forum selection bylaw designates Delaware as the exclusive forum for litigation relating to internal corporate governance, including derivative suits, breach of fiduciary duty suits, suits brought under the Delaware General Corporation Law (the “DGCL”) and suits involving the corporation’s internal affairs.
In a June 2013 decision, the Delaware Court of Chancery of Chancery upheld the validity and enforceability of forum selection bylaws of both Chevron and FedEx. Plaintiffs in that case appealed the decision, but later voluntarily dismissed their appeal. It was widely expected that the Delaware Supreme Court would affirm the Chancery Court’s decision.
Both the Chevron and FedEx boards had adopted bylaws without stockholder approval designating the Delaware Chancery Courts as having sole and exclusive jurisdiction for any (1) derivative claims, (2) fiduciary duty claims, (3) claims under the DGCL, and (4) claims relating to the corporation’s "internal affairs." (Chevron later amended its bylaw to include federal courts located within Delaware).
In the wake of this decision by the Delaware Court of Chancery, we recommended that the boards of directors of our Delaware public company clients give serious consideration to the adoption of a forum selection bylaw. This bylaw provision can provide a significant tool for reducing the risks associated with the increase in multi-jurisdiction derivative and stockholder class action litigation relating to mergers and acquisitions and other matters relating to the internal affairs of the corporation.
For Delaware corporations, a forum selection bylaw can reduce the inefficiency and high cost of defending duplicative, multi-forum litigation simultaneously in different states and provide greater consistency in the result. By providing that the Delaware Chancery Court will have exclusive jurisdiction, the corporation also gains the advantage of experienced and well-regarded judges and the relative efficiency of the Chancery Court docket -- with presumably more predictable outcomes.
While a court in another jurisdiction is not technically bound to follow a decision rendered by the Delaware Chancery Court, we believe that most courts presented with a case involving a Delaware corporation will honor the decision based on the deference generally afforded to Chancery Court opinions in interpreting Delaware corporate law and the strength of the legal analysis underpinning the Chevron/FedEx decision. The Chevron/FedEx decision does not eliminate challenges to forum selection bylaws altogether. As the opinion acknowledges, a plaintiff who files outside Delaware (or even in Delaware) and faces a motion to dismiss based on the bylaw may argue in response that enforcing the bylaw under the circumstances would be unfair or unreasonable as a matter of federal common law, or that the board breached its fiduciary duty under Delaware law by invoking the bylaw in that particular case. There will likely be some litigation of these issues in specific cases. We believe that in most circumstances, however, forum selection bylaws will be upheld after the Chevron/FedEx decision because they will not be found to be invalid on their face and they will not be found to have involved unfair or unreasonable circumstances or a breach of fiduciary duty in their application.
The primary risk for Delaware corporations is that forum selection bylaws may draw negative reactions from stockholders or proxy advisory firms. It is not clear at this time how stockholder activists will respond to the Chevron/FedEx holding. Although forum selection provisions arguably benefit all stockholders by reducing litigation time and expense, some stockholders will likely submit proposals requesting the company to repeal the provision or put it to a stockholder vote. Knowledge of your stockholder base is crucial when considering the adoption of forum selection provisions, and we recommend engaging with your institutional holders to assess their reaction and educate them on the benefits of such provisions.
If stockholders seek to repeal the bylaw provision or put it to a stockholder vote through a proxy proposal, the proxy advisory firms, notably ISS and Glass Lewis, are likely to recommend that stockholders vote against the bylaw. ISS and Glass Lewis each set forth factors they will consider in deciding whether to recommend in favor of proposals to repeal forum selection bylaws, such as (i) whether the company has been materially harmed by stockholder litigation outside its jurisdiction of incorporation, based on disclosure in the company’s proxy statement and (ii) whether the company has certain good governance practices (an annually elected board, a majority vote standard in uncontested director elections and the absence of a poison pill, unless the pill was approved by stockholders).
Past experience indicates that, notwithstanding the presence of these factors, ISS and Glass Lewis will typically take a position opposed to forum selection bylaws, but their recommendation has not dictated the outcome of the vote. Prior to the Chevron/FedEx decision, the two stockholder proposals seeking to repeal forum selection bylaws that were put to a vote in 2012 were defeated by substantial margins despite support from proxy advisory firms, and the twelve management proposals to amend corporate charters to add exclusive forum provisions passed at nine companies, even when opposed by proxy advisory firms (which was almost universally the case).
Glass Lewis will recommend a vote against the chair of the corporation’s governance committee following the unilateral adoption of a forum selection bylaw.
In light of the potential cost and uncertainty associated with multi-forum litigation, we recommend that the boards of directors of Delaware public companies adopt a forum selection bylaw. While forum selection bylaws will not eliminate any stockholder causes of action or prevent stockholders from bringing claims or filing strike suits, the decision in Chevron/FedEx validates the use of forum selection bylaws as a means for Delaware corporations to limit multi-jurisdiction litigation and forum shopping by funneling many specifically enumerated types of stockholder litigation into a single forum. Managing litigation in this way can greatly reduce the costs and complexities associated with duplicative multi-front suits and provide greater certainty in outcomes, to the benefit all stockholders.
Guidance from PCAOB Regarding Internal Control Audits
In October, the Public Company Accounting Oversight Board (“PCAOB”) issued guidance related to the audits of internal controls over financial reporting as a result of observations by the PCAOB staff over the past three years. The PCAOB suggested that audit committees of companies for which audits of internal control are conducted may want to:
- discuss with their auditors the level of auditing deficiencies in this area identified in their auditors' internal inspections and PCAOB inspections;
- request information from their auditors about potential root causes of such findings and ask how they are addressing the matters discussed in this alert;
- inquire about the involvement and focus by senior members of the firm on these matters;
- inquire of the auditor how the controls to be tested will address the assessed risks of material misstatement for relevant assertions of significant accounts and disclosures; and
- discuss with the auditor his or her assessment of risks, evaluation of control deficiencies, and whether the auditor has adjusted as necessary the nature, timing, and extent of his or her control testing and substantive audit procedures in response to risks related to identified control deficiencies.