Similar to last year, 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 other governance matters for issuers to consider.
2015 Policy Updates by Proxy Advisory Firms
Institutional Shareholder Services Inc. (“ISS”) and Glass, Lewis & Co., LLC (“Glass Lewis”) have each released updates to their respective proxy voting guidelines. Key areas of focus include bylaw/charter amendments, board leadership, executive compensation and equity plans. The revised policies will take effect for annual meetings occurring on or after February 1, 2015. You can find the ISS policy update here and the Glass Lewis policy update here.
ISS Proxy Voting Updates
- Unilateral Bylaw/Charter Amendments
ISS will generally recommend withhold votes with respect to individual directors, committee members or the entire board if the board amends the company’s bylaws or charter without shareholder approval “in a manner that materially diminishes shareholders’ rights or that could adversely impact shareholders.” Previously, ISS has provided examples of such actions that would trigger scrutiny if done without a shareholder vote, including impairing shareholder rights to call a special meeting or act by written consent, classifying the board, lowering quorum requirements, and adopting director qualification bylaws tied to third-party compensation arrangements.
Shareholder Litigation Rights
ISS will make recommendations on a case-by-case basis on proposals seeking shareholder approval of bylaw/charter provisions impacting shareholders’ litigation rights, in particular, exclusive venue and fee-shifting bylaw provisions. When any bylaws affecting shareholder litigation rights are adopted unilaterally, ISS will also assess withhold recommendations within the context of its new policy described above.
- Equity Compensation Plans – Governance QuickScore 3.0
ISS has adopted a “scorecard” system to evaluate equity plan proposals. It now will use scorecards for each index group (S&P 500, Russell 3000, Non-Russell 3000 and IPO/Bankruptcy) in order to evaluate equity plan proposals. The scorecard approach permits a more nuanced evaluation of equity plans rather than the prior method of a series of "pass/fail" tests. Previously, ISS would recommend a vote against any equity plan if it failed any one of six pass/fail tests looking at items such as the plan’s cost to shareholders, burn rate, and perceived problematic pay practices. Going forward under ISS’s new scorecard approach, equity incentive plans will be evaluated in three “pillars” that will measure many of the same concerns: plan cost, problematic plan features and the company’s recent grant practices. While ISS sees their evaluation going forward as a more flexible viewing of the combination of the three pillars, the presence of practices ISS views as egregious (such as a liberal change-of-control definition or permitting repricing without shareholder approval) will still result in a vote against the plan proposal.The scorecard system is based on a 100 point scale with 53 points being the passing grade. Scores are based on plan cost, plan features and grant practices with different weighting applied to these factors depending upon the index group. For example, the weighting of the factors for an issuer on the Russell 3000 is plan cost (45 points), plan features (20 points) and grant practices (35 points).
Plan Cost. Plan Cost is measured by ISS’ proprietary Shareholder Value Transfer model (SVT). SVT is measured against two benchmarks: (i) new shares requested plus shares remaining for future grants, plus outstanding unvested/unexercised grants, and (ii) only new shares requested plus shares remaining for future grants. Use of the second benchmark reduces the impact of overhang.
Plan Features. The following factors can have a negative impact on the plan score: (i) automatic single-triggered award vesting upon a change in control, (ii) broad discretionary vesting authority, (iii) liberal share recycling and (iv) the absence of a minimum required vesting period (at least one year).
Grant Practices. The following factors can positively influence the plan score: (i) the company's 3-year average burn rate relative to its industry and index peers, (ii) vesting schedules for CEO equity grants during the prior three years that incentivize long term retention, (iii) estimated duration of plan, based on the sum of shares remaining available and the new shares requested, divided by the 3-year burn rate (preferably less than five or six years), (iv) the proportion of the CEO's most recent equity grants/awards subject to performance conditions (preferably greater than 33%), (v) a clawback policy that includes equity grants, and (vi) post-exercise/post-vesting shareholding requirements.
Some factors are measured on a binary basis and others provide for partial points. It is unclear how the individual factors are weighted within each pillar.
When multiple plans are on the ballot, ISS will generate an aggregate score based on the total plan costs and the worst factors among the plans. If the aggregate score passes, all the plans pass, unless any of the plans have egregious overriding factors that lead to a negative recommendation. If the aggregate score does not pass the required threshold, then (i) if each plan’s individual score is less than passing, then each plan fails, (ii) if only one plan’s individual score passes the required threshold, then only that plan passes, and (iii) if all plans’ individual scores pass the required threshold, then only the plan with the highest SVT cost (based on new shares requested + shares remaining available + outstanding grants and awards) will pass and the other plans will fail.
Equity plan proposals that only seek approval to ensure tax deductibility of awards pursuant to Section 162(m) will generally receive a favorable recommendation, provided the Board's Compensation Committee (or other administrating committee) is 100 percent independent according to ISS standards.
ISS added some useful clarity to the new scorecard system with a series of 20 FAQs on its new "Equity Plan Scorecard" which can be found here.
- Independent Chair; Separate Chair/CEO
ISS will consider the issues of the separation of the CEO and chair roles and appointment of an independent chair in a more holistic context that takes into account (i) whether the proposal is seeking an immediate change or can be implemented at the next CEO transition, (ii) the absence or presence of an executive or non-independent chair plus the CEO, (iii) recent board and executive leadership transitions, (iv) the overall governance profile and (v) company performance as measured by the company’s one-, three- and five-year TSR periods compared to its peers and the market as a whole. ISS published nine FAQs on its “Independent Chair Policy" which can be found here.
- Political Contributions
ISS continues to recommend a vote for “proposals requesting greater disclosure of a company’s political contributions and trade association spending policies and activities,” taking into consideration a number of factors including, existing disclosure and oversight as well as any recent significant controversies. ISS clarifies the factors it will consider in its analysis.
- Greenhouse Gas Emissions
ISS continues to recommend voting case-by-case on proposals calling for the adoption of greenhouse gas reduction goals from products and operations and clarifies the factors it will consider in its analysis.
Glass Lewis Proxy Voting Updates
- Reduction or Removal of Shareholder Rights without Shareholder Approval
Like ISS, Glass Lewis “may recommend that shareholders vote against the chairman of the governance committee, or the entire committee” if they unilaterally amend the company’s governing documents “to reduce or remove important shareholder rights, or to otherwise impede the ability of shareholders to exercise such right.” Examples of board actions that could trigger such a recommendation include, (i) impairing shareholders’ ability to call special meetings, (ii) increasing vote requirements for charter or bylaw amendments, (iii) limiting shareholders’ ability to pursue full legal recourse (such as mandatory arbitration of shareholder claims or fee-shifting bylaws), (iv) adopting a classified board structure and (v) eliminating shareholders’ ability to remove directors without cause.
- Board Responsiveness to Majority-Approved Shareholder Proposals
Glass Lewis expanded upon the circumstances in which it will recommend against governance committee members during whose tenure the board failed to adequately implement a shareholder proposal “relating to important shareholder rights” that received support from a majority of votes cast.
- Recommendations Following IPO
Glass Lewis has provided two new exceptions to the general rule of not issuing voting recommendations on the basis of corporate governance best practices during the one-year period following an IPO. Glass Lewis will consider recommending against directors who, pre-IPO, adopt an anti-takeover provision (such as a classified board structure) and who either do not commit to submitting it to a shareholder vote within 12 months of the IPO or do not provide a sound rationale for it. Glass Lewis will also recommend voting against governance committee members who, pre-IPO, adopt a fee-shifting bylaw.
- Director Independence
Payments of more than $120,000 to a professional services firm that employs a director may be deemed immaterial if the amount paid is “less than 1% of the firm’s annual revenues and the board provides a compelling rationale as to why the director’s independence is not affected by the relationship.”
- Executive Compensation
Where companies make one-off awards outside standard short-term and long-term compensation incentive programs, Glass Lewis instructs them to provide a thorough description of such awards, including why existing programs are not adequate and how the one-off award will affect existing compensation programs. While Glass Lewis is generally supportive of employee stock purchase plans, it describes its method for evaluating such plan proposals based upon a primarily quantitative analysis that focuses on equity value creation. Lastly, Glass Lewis advises that clawback policies should be (i) triggered upon restatement of financial results or similar indicators upon which bonuses are based, to allow the company to recoup the bonuses if performance goals were not actually achieved and (ii) subject to limited board discretion.
- Independent Chair; Separate Chair/CEO
Glass Lewis will recommend voting against the chair of a governance committee when a company has neither an independent chairman nor an independent lead director. Further, Glass Lewis will continue to generally recommend in favor of separation proposals and independent chair proposals.
Beneficial Ownership Reporting – The SEC is paying attention
On September 10, 2014, the Securities and Exchange Commission (“SEC”) announced charges against 28 directors, officers and significant shareholders of public companies for repeated failures to timely report their share ownership and transactions on Form 4, Schedule 13D and Schedule 13G. The SEC also announced charges against 6 public companies for contributing to these failures by voluntarily agreeing to assist insiders with their filings, but failing to do so on a timely basis, and by failing to report insiders’ late filings in their periodic reports. All but one of the persons named in the actions has agreed to settle the charges by paying a financial penalty ranging from $25,000 to $150,000, for a total of $2.6 million.
These actions are a reminder that filing beneficial ownership reports late, even inadvertently, can result in personal liability to officers, directors and shareholders as well as to issuers, if they have agreed to assist insiders with their filings.
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 early enough in 2015, public companies with calendar year-ends could 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.
Even though the CEO pay ratio regulations have not yet been finalized, the SEC has stated that adopting these rules is a priority. Surveys have indicated that the public (and likely many of your rank and file employees) believe the ratio to be in the double digits, while the average CEO ratio in the United States is actually in the mid-hundreds. For CEOs of retailers, restaurant chains or companies with a significant overseas workforce, the ratio may well run into the thousands. ISS has informally indicated that it will not overweight this disclosure, and will use it as just another data point. We expect most large institutional investors will view the pay ratio in a similar light. Even though the CEO pay ratio will not be an item required in your 2015 proxy statement, it is wise to begin communicating with your compensation committee this year. Potential items for early discussion include the following:
- Your CEO’s estimated pay ratio, and how this number compares within your industry, geographic region and peer group.
- Are there special circumstances that will cause your CEO’s ratio to be larger or smaller than your peers? Will you want to highlight these factors in your disclosure?
- What is expected reaction of your key investors, employees and media?
- Do you expect this number fluctuate greatly from year to year?
- Communicate the basics of the method used to identify your median employee. Bear in mind that this pool will include your global workforce as well as part-time employees.
- When do you issue your proxy statement in comparison to your peers?
Exclusion of Shareholder Proposals
There have been a couple of interesting developments this year relating to the ability to exclude shareholder proposals from a company’s proxy statement. On the one hand, the SEC permitted Whole Foods to exclude a proxy access proposal because Whole Foods intended to propose its own proxy access proposal (with significantly higher thresholds); and, on the other hand, a U.S. District Court sided with a shareholder when it determined that Wal-Mart should not have excluded a shareholder proposal from its proxy statement despite the fact that it received a favorable no-action letter from the SEC.
In the Fall of 2014, Whole Foods Market Inc. received a non-binding proposal from shareholder activist James McRitchie to allow nominees for director submitted by one or more owners of at least 3% of the company’s outstanding stock held for at least three years to be included in the company’s proxy statement. Whole Foods responded by seeking SEC no action relief if it excluded this proposal, based on its conflict with a similar proposal being submitted by management. Management’s proposal would allow nominees submitted by a single shareholder holding at least 9% of the stock for at least five years to be included in the company’s proxy statement. The SEC staff granted Whole Foods the requested relief despite the significantly higher thresholds in the management proposal. In fact, perhaps reacting in part to criticism from shareholders following the exclusion of the McRitchie proposal, the management proposal in Whole Foods’ recently filed preliminary proxy statement calls for a 5% ownership threshold rather than the 9% threshold proposed in its no-action request.
Typically, when an issuer desires to exclude a shareholder proposal from its proxy statement, it submits a no-action request to the staff of the SEC as in the case of the Whole Foods proxy access proposal described above. However, just as shareholder activists look to the courts in other contexts, proponents are now seeking relief in court when a shareholder proposal is excluded.
Trinity Church of the City of New York submitted a shareholder proposal to Wal-Mart requesting that the “board amend the compensation, nominating and governance committee charter to provide for oversight concerning the formulation and implementation of policies and standards that determine whether or not the company should sell a product that especially endangers public safety and well-being, has the substantial potential to impair the reputation of the company and/or would reasonably be considered by many offensive to the family and community values integral to the company's promotion of its brand.” The purpose of the proposal related to the question of whether Wal-Mart should continue to sell guns with magazines able to hold more than 10 rounds of ammunition The SEC permitted exclusion of the proposal on the basis that the proposal dealt with Wal-Mart’s ordinary business operations. Trinity sought relief in the courts. The U.S. District Court for the District of Delaware determined that (i) Wal-Mart should not have excluded a shareholder proposal from its 2014 proxy statement despite the fact that it received a no-action letter from the SEC allowing its exclusion, and (ii) Wal-Mart would be enjoined from excluding this proposal from its 2015 proxy statement if it were resubmitted. The court concluded that the proposal was not subject to the ordinary business exclusion because it had been cast as a board policy proposal on a matter of significant importance.
Preparation for the new revenue recognition standards will be on the agenda for companies in 2015. The new standards for recognition of revenue from contracts with customers were issued in mid-2014 by the Financial Accounting Standards Board and the International Accounting Standards Board. For public companies, the new rule takes effect for interim and annual periods beginning after December 15, 2016. The Financial Accounting Standards Board has indicated that it may defer the effective date of the new rules.
The new standards will impact revenue recognition in several ways, including changes to the amount and timing of revenue, the process used to document contracts, the applicable internal controls, and the determination of compensation based on revenue metrics. New disclosure requirements also accompany the new standards.
One point for issuers to consider is the restatement risk presented by the transition to these new standards, particularly if the Dodd-Frank clawback rules, which do not require fraud as a trigger, come into effect.
COSO 2013 – Have you adopted it?
Committee of Sponsoring Organizations of the Treadway Commission (COSO) released a new framework in 2013 which was to be effective December 15, 2014. Issuers who have transitioned to COSO 2013 will need to note the use of the new framework in their internal controls disclosure. If any material changes to the internal controls were required in connection with the transition to COSO 2013, they will also have to be disclosed. A significant number of issuers have not transitioned to COSO 2013. For the moment, the SEC has indicated that it will not question an issuer’s continued use of the 1992 framework, but issuers should be prepared to explain to the SEC their continued use of COSO 1992 in light of potential SEC comments on this subject.
Reconsideration of Audit Committee Disclosures
The substance of the audit committee report has been static for a number of years. That may be changing. Chair White asked the staff of the SEC to examine the existing audit committee report to seek ways to make it more useful to investors. The SEC is expected to issue a concept release in early 2015 exploring ways to elevate the role of audit committees. Additional voluntary disclosure regarding the activities of the audit committee is encouraged by the staff of the SEC as well as by investor governance groups. In August 2014, the EY Center for Board Matters issued a “Let’s talk: governance” report entitled: “Audit committee reporting to shareholders: 2014 proxy season update.” The report noted a “consistent movement by Fortune 100 companies to enhance the depth and scope of audit committee-related disclosures.”
The EY report reviewed the proxy statements of the Fortune 100 companies from 2012 through 2014, and noted the following:
Disclosures in general:
- Audit-related disclosures were contained in one area of the proxy, rather than dispersed throughout the document;
- An increasing number of proxies contained a direct link to the audit committee charter;
- An increasing level of additional information was included regarding the audit committee’s oversight of the external auditor’s activities (see below).
Disclosures related to the audit committee’s review and evaluation of external auditors:
- 65% of companies specified that the audit committee is responsible for the appointment, compensation and oversight of the auditor, compared to 40% in 2012.
- 46% of companies explicitly state their belief that their selection of the external auditor is in the best interest of the company and/or shareholders, up from 4% in 2012.
- 44% of companies disclosed that the audit committee was involved in the selection of the audit firm’s lead engagement partner, compared to only 1% of companies in 2012.
- 31% of companies explained the rationale for appointing their auditor, including the factors used in assessing the auditor’s quality and qualifications, up from 16% in 2012.
- 8% of companies disclosed the topics that the audit committee discussed with the auditor — beyond matters required to be discussed under regulatory rules.
Disclosures related to the audit committee’s authority to approve all audit engagement fees and terms:
- 80% of companies noted that they consider non-audit services and fees when assessing the independence of the external auditor.
- 19% of companies disclosed that the audit committee was involved in the auditor’s fee negotiations, up significantly from just 1% in 2012.
- 8% of companies acknowledged a change in fees to the external auditor and explained the circumstance for the change, doubling the percentage of companies that did so in 2012.
Disclosures related to the tenure of their external auditors:
- Auditor tenure was disclosed by half of reviewed companies, an increase from 26% in 2012.
- 28% of companies disclosed that the audit committee considers what would be the impact of rotating their external auditor, up from 3% in 2012.
Shareholder Litigation Regarding Compensation
Although largely unsuccessful in their litigation, in recent years, a handful of plaintiffs’ law firms have sought to enjoin say-on-pay and equity incentive plan votes, alleging that proxy statements are omitting material information beyond the items strictly required by the SEC rules. Although normally dismissed in summary judgment, it can nevertheless be quite costly to defend these lawsuits. As a result, some companies have settled with a monetary payment and/or issued a revised proxy proposal for amendments to their equity incentive plans. To head off future lawsuits, a number of companies have begun to include additional information when requesting additional shares for use in equity compensation such as burn rate and dilution information. Companies must balance the potential costs of lawsuit defense and the disruption of their proxy timetable with providing information in excess of the SEC rules. In many cases, supplemental information can assist in providing a compelling case for the requested plan proposal.
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.
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 first conflict minerals reports on Form SD were due June 2, 2014. This year’s report will be due June 1, 2015.
In April 2014, the SEC’s Division of Corporation Finance issued interpretive guidance on the conflict minerals rules in response to the April 14, 2014 ruling of the U.S. Court of Appeals for the District of Columbia. The ruling, which largely upheld the conflict minerals rules, concluded that the requirement that public companies report to the SEC and the public whether any of their products are “DRC conflict free,” or have “not been found to be ‘DRC conflict free,’” violates the First Amendment right to free speech. Consequently, most issuers relied upon this guidance and chose not to label their products. The court battle over labelling is not over.
In November 2014, the Court of Appeals for the D.C. Circuit granted petitions filed by the SEC and Amnesty International for panel rehearing of the issue relating to use of the product labels prescribed by the rules. The decision in American Meat Institute v. U.S. Department of Agriculture last summer upheld the labeling requirement at issue regarding country of origin. The standard applied in that case applies to disclosures of purely factual and uncontroversial information about the good or service being offered. At issue is whether the product labelling required by the conflict minerals rules falls within that standard.
Until the Court of Appeals for the D.C. Circuit issues a ruling in this case, the previous guidance issued by the SEC remains in effect.
XBRL Pilot Program
The SEC is launching a pilot program to consolidate financial statements submitted by public companies using the eXtensible Business Reporting Language (XBRL) into more readily accessible databases. The purpose is to make the data more usable for investors. Under the program, the XBRL data filed by issuers will be combined and posted for bulk downloads on the SEC’s website. The pilot program is initially focused on financial statement data from XBRL filings, but will be expanded to include footnote data in the future. The data will be consolidated as filed by issuers, with no change to any of the data.
Mortality Tables (yes, you read that right)
With respect to defined benefit plans and the related accounting considerations, one of the key assumptions to measure a plan’s cost and obligation is mortality. Many issuers rely on the mortality data published by the Society of Actuaries (SOA) in developing mortality estimates. In October 2014, the SOA published updated mortality tables reflecting improved longevity. The staff of the SEC has stated that it expects issuers to reflect this updated mortality data when making their mortality estimates for 2014. In addition, to the extent that the updated mortality estimates result in a significant change in the benefit obligation, the impact of the change in the mortality estimates should be disclosed.
The waiting game continues. Final rules have still not been adopted for CEO pay ratio, compensation clawbacks, hedging and pay-for-performance. We also continue to wait for reproposed rules for disclosure of government payment by resource extraction issuers.
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 recently 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.
- 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.
- As always, review the “known trends and uncertainties” in the MD&A. This is a focus of the SEC as part of their “broken windows” initiative and Bank of America recently settled its case with the SEC over its failure to identify known uncertainties and paid a $20 million penalty.
- Eliminate stale or duplicative information.