As our clients and friends know, each year Mintz Levin provides an analysis of the regulatory developments that impact public companies as they prepare for their fiscal year-end filings with the Securities and Exchange Commission (the "SEC") and their annual shareholder meetings. This memorandum discusses key considerations to keep in mind as you embark upon the year-end reporting process in 2017.1
As was the case last year, there are no SEC rule changes that will take effect for the 2017 year-end reporting process. There are, however, a few key issues that companies should focus on this year.
- Say-on-Frequency: Time for another shareholder vote. For companies that held their first say-on-pay vote six years ago, it is now time to revisit the say-on-frequency vote. Companies that held a say-on-frequency vote at their 2011 annual meeting are required to again include a non-binding resolution in their proxy statements to ask shareholders how often they want to conduct say-on-pay votes for the next six years: once a year, once every two years, or once every three years. Institutional Shareholder Services (ISS) has stated that based on its 2016 ISS Policy Survey, two-thirds of investor respondents indicated they preferred annual say-on-pay frequency. ISS believes that holding a say-on-pay vote every year enables the vote to correspond to the majority of the information presented in the accompanying proxy statement, and allows investors to comment upon issues in annual incentive programs in a more timely fashion. Companies that have not yet reached the six-year anniversary of their first say-on-pay vote, and thus are not required to present a say-on-frequency proposal this year, should consider adding a statement to their proxy statement to the effect that a say-on-frequency vote is not required this year (and state the year that such vote will be required) in order to inform shareholders that this vote was not simply overlooked.
- Form 8-K for Say-on-Frequency. Companies that are required to conduct their say-on-frequency vote this year must remember to report, under Item 5.07 of Form 8-K, the company's determination as to how frequently it will hold the say-on-pay vote in the Form 8-K required to be filed within four business days of the shareholder meeting (or by amendment to that Form 8-K filed no later than 150 calendar days after the date of the shareholder meeting at which the say-on-frequency vote was taken), but in no event later than 60 days prior to the deadline for the submission of shareholder proposals under Rule 14a-8 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), for the subsequent annual meeting.
- Say-on-Pay: Considerations for 2017. As in past years, shareholder support on say-on-pay resolutions in the 2016 proxy season continued to average above 90% across all companies. Say-on-pay continues to be perceived as a year-to-year item, in which success in past years is no guarantee of success in the current or future years, and companies should not become complacent about achieving the necessary support, even if they have enjoyed strong support in prior years. The advent of say-on-pay continues to cause companies to reevaluate their compensation-related disclosures in their proxy statements, in particular the Compensation Discussion &Analysis (CD&A) section, with both advocacy and disclosure in mind. In addition, issuer engagement with institutional shareholders has become an integral part of the say-on-pay process, with many companies reaching out to their largest shareholders in the months following the annual meeting to discuss pay practices.
- Director Compensation in the Spotlight. As discussed in more detail below, the Delaware courts have shifted direction towards more shareholder protection by applying an entire fairness standard of review instead of the business judgment rule with respect to claims of excessive director compensation. In order to avoid a lawsuit (or win on a motion to dismiss) companies should consider setting forth in their equity compensation plan a shareholder-approved cap (based either on a number of shares or cash value) representing the maximum amount that the company may compensate its non-employee directors in equity, which cap should be set at a meaningful limit. This cap should be included in the equity plan when the plan is next brought to shareholders for approval. In the meantime, companies should evaluate director pay each year and make adjustments accordingly and confirm that director compensation is in line with the company's peer group. Unless the courts provide clearer guidance on this topic, we expect that plaintiffs will continue to file shareholder derivative claims with regard to perceived excesses in director pay.
- Caution When Using Non-GAAP Financial Measures. Increasingly the SEC has been providing comments regarding compliance with the rules on the use of non-GAAP financial measures. As a result of its review of these disclosures, in May 2016 the SEC issued Compliance & Disclosure Interpretations (C&DIs) reflecting its concern that companies are not complying with Regulation G and are supplanting and not supplementing their press releases and SEC reports with non-GAAP financial measures and as a result, disclosure of a company's financial results is becoming distorted. Under Regulation G, companies must include a reconciliation of the differences between each non-GAAP financial measure used with the most directly comparable financial measurement from GAAP. Management also must disclose why it believes the non-GAAP measures provide useful information to investors about the company's financial condition and results of operations. In addition, many proxy statements now include non-GAAP financial measures. If non-GAAP financial measures are presented in the proxy statement for any purpose other than disclosure of target levels relating to compensation, such as to explain the relationship between pay and performance or to justify certain levels or amounts of pay, then those non-GAAP financial measures are subject to the requirements of Regulation G and Item 10(e) of Regulation S-K. However, in these pay-related circumstances only, the SEC allows a company to include the required GAAP reconciliation and other information in an annex to the proxy statement, provided the proxy statement includes a prominent cross-reference to such annex or, if the non-GAAP financial measures are the same as those included in the Form 10-K that is incorporating by reference the proxy statement's Item 402 disclosure as part of its Part III information, by providing a prominent cross-reference to the pages in the Form 10-K containing the required GAAP reconciliation and other information.
- NASDAQ Companies Must Update Director and Officer Questionnaires for Golden Leash Disclosure. Effective for proxy statements filed on or after August 1, 2016, NASDAQ Rule 5250(b)(3) requires its listed companies to disclose, either on the company website (no later than the day the proxy statement is filed) or in the proxy statement itself, the material terms of all agreements and arrangements between any director or nominee for director, and any person or entity other than the company, relating to compensation or other payment in connection with such person's candidacy or service as a director. Payments that are exempt include those that (a) relate only to reimbursement of expenses in connection with candidacy as a director; (b) existed prior to the nominee's candidacy (including as an employee of the other person or entity) and the nominee's relationship with the third party has been publicly disclosed in a proxy statement or annual report; or (c) have already been disclosed in a proxy statement or Form 8-K. After the initial disclosure, companies must continue to provide the disclosure on an annual basis only if new arrangements are entered into until the earlier of the resignation of the director or one year following the termination of the agreement or arrangement. We have updated our form of Director and Officer Questionnaire in order for companies to solicit this information from their directors.
- Section 16 in the News: Potential Section 16(b) Liability Relating to Tax Withholding and Net Exercise Transactions. We are aware of a shareholder who has submitted letters to a number of public companies seeking disgorgement of short-swing profits under Section 16(b) of the Exchange Act from Section 16 officers when the company has withheld shares to cover an officer's tax obligation or the officer has net exercised a stock option and that transaction (which is deemed to be a sale to the company) occurs within six months of the officer's open market purchase of securities of the company. The shareholder contends that the approval of a plan or agreement by the board (or an appropriate committee) that provides discretion for the insider to determine how a tax obligation may be paid, or allows for net withholding of shares to satisfy the exercise price of a stock option, creates a non-exempt disposition of securities under Section 16(b). Although we believe that these transactions should be considered exempt under Rule 16b-3(e) (which rule exempts officer and director transactions that are approved in advance by the board or an appropriate committee thereof), if the agreement that sets forth these provisions was previously approved by the board or an appropriate committee, we recommend that prior to any withholding to cover taxes with respect to equity awards, or any withholding of shares to net exercise a stock option, the board of directors or a properly constituted committee should specifically approve the transaction, including referencing the individual, agreement and exact date of the netting out of the shares to cover the tax or exercise price and the formula to be applied in such transactions, in order to provide written proof that the withholding or net exercise constitutes an exempt sale transaction under Rule 16b-3(e) and may not be matched with a non-exempt purchase.
- Pay-Ratio Get Ready: The ratio is not required to be disclosed until next year's proxy statement, but must be calculated based on 2017 compensation data. The "pay ratio" disclosure rule issued under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") was finalized by the SEC in August 2015. This rule, which is discussed in more detail below, requires companies to disclose the ratio of median employee compensation to principal executive officer compensation and is set forth as Item 402(u) of Regulation S-K. The rule requires companies to begin providing this pay ratio information in their executive compensation disclosure with respect to the fiscal year beginning on or after January 1, 2017 in time for the 2018 proxy season. All public companies will be subject to this new disclosure requirement, with the exception of emerging growth companies, smaller reporting companies and foreign private issuers.
- Status of Other Dodd-Frank Act Executive Compensation Proposals. Although the SEC proposed the three remaining Dodd-Frank Act executive compensation rules in 2015—hedging of shares by employees and directors; measuring pay for performance; and clawback of "erroneously awarded compensation—none of these three remaining rules have yet to be adopted. SEC Chair White has said that she will not adopt them before leaving office on January 20, 2017, so it remains to be seen when and whether these rules will be adopted and, if adopted, whether material changes will be made to the proposals. However, it is clear that the rules will not be in place for this proxy season.
- Status of Proxy
Access. Over 50% of the S&P 500 companies have adopted
some form of proxy access bylaw, a mechanism that allows
shareholders to nominate directors and have those nominees listed
in a company's proxy statement, thus saving the expense to a
dissident shareholder of conducting its own, separate proxy
contest. To date, we are aware of only one shareholder request to
add a director candidate using a company's proxy access bylaw
provision. However, the process did not fully play out and the
director nominee withdrew his candidacy. The board, in its review
of the candidate in compliance with its bylaws, concluded that the
candidate nominated did not meet the specifications required in the
bylaws because the company shares that were owned by the proponent
were not acquired in the ordinary course of business but with the
intent to influence control of the company based on a Schedule 13D
filing. The candidate (and the proponent backing him) did not fight
the company's determination and withdrew the nomination.
Recently, the SEC has waded back into this arena2 with a
proposal for a "universal proxy".3 This
proposal would change the way that shareholders vote in contested
elections where a proponent files a competing proxy statement with
their own slate of directors and separate proxy card (not through
proxy access, which generally involves a proposal to add only one
or two directors). The universal proxy would allow a singular proxy
card to set forth all proposed candidates so shareholders can pick
and choose amongst the company nominees and the shareholder
nominees. The SEC believes that this process would be more
equitable, as now the only way to mix and match candidates is to
attend the shareholder meeting and vote for the directors in
person. Critics of the proposal believe that a universal proxy card
will cause too much confusion and that the mix of directors elected
may not be suitable for the particular company.
Shareholder activism remains strong, and institutional shareholders are continuing to put pressure on companies to conduct their affairs in a more transparent manner, encouraging the adoption of governance policies that benefit shareholders, such as executive compensation clawbacks, stock ownership guidelines, and majority voting, and discouraging policies such as plurality voting, staggered boards, and "poison pill" plans. As the largest public companies have adopted many of these corporate governance initiatives already, institutional investors are moving their attention to smaller companies that may historically have lagged in the adoption of shareholder-friendly governance features.
We have further addressed some of these topics as well as additional items that we believe will be of interest to this year's reporting season in detail below.
New Item 16 of Form 10-K. In June 2016, the SEC adopted new Item 16 of Form 10-K that allows a company, at its option, to include a summary in the Form 10-K, but only if each item in the summary is presented fairly and accurately and includes a hyperlink to the related, more detailed, disclosure in the Form 10-K. New Item 16 provides companies with flexibility in preparing the summary and does not prescribe the length of the summary, specify the Form 10-K disclosure items that should be covered by the summary, or dictate where the summary must appear in the Form 10-K. Although Item 16 is permissive, we would expect any issuer who chooses to add a summary to conform to Item 16's conditions.4
"Pay Ratio" Disclosure Rules Finalized; First Disclosure Required in 2018 for 2017 Fiscal Year. On August 5, 2015, the SEC adopted a final rule5 implementing Section 953(b) of the Dodd-Frank Act, requiring most reporting companies to disclose the ratio of median employee compensation to principal executive officer compensation. The final rule, which adds Item 402(u) to Regulation S-K with a conforming amendment to Item 5.02(f) of Form 8-K for companies whose salary and/or bonus information is not available at the time of filing the proxy statement, requires companies to begin providing pay ratio disclosure in filings that otherwise require executive compensation disclosure for the first full fiscal year beginning on or after January 1, 2017 in time for the 2018 proxy season. All public companies will be subject to this new disclosure requirement, with the exception of emerging growth companies, smaller reporting companies, and foreign private issuers. As it will take time for companies to compile the information necessary to determine the median employee, companies should begin work on this disclosure soon if they have not already begun. In addition, this information will be deemed filed and not furnished to the SEC so companies will need to retain detailed backup of their conclusions. It remains to be seen how the media and others will interpret this information and whether the comparisons of peer companies will give rise to a new fertile ground for plaintiffs' derivative litigation. It is also possible that the U.S. Congress could repeal the rule prior to its adoption, given the recent change in administration.
The pay ratio rule requires disclosure of:
- Median Employee Compensation. The median of the annual total compensation of a company's employees, excluding its principal executive officer;
- CEO Compensation. The annual total compensation of the company's principal executive officer; and
- Pay Ratio. The ratio of the company's median employee compensation to the compensation of its principal executive officer.
In addition to the ratio itself, disclosure describing the methodology used to identify the median employee, determine total compensation and any material assumptions, adjustments (including allowable cost-of-living adjustments) or estimates used to identify the median employee or to determine annual total compensation will also be required. Consistent with the proposed rule, when identifying the median employee, the final rule requires companies to include all employees, including full-time, part-time, temporary, seasonal, and foreign employees employed by the company or any of its subsidiaries and to annualize the compensation of permanent employees who were not employed for the entire year, such as new hires. Companies may not, however, annualize the compensation of part-time, temporary, or seasonal employees. Certain consultants and other advisors who are not employees and individuals who are employed by unaffiliated third parties are not to be included in the calculation.
The SEC made changes from the proposed rule to address concerns regarding the cost of compliance with the rule and to make the rule a bit easier for companies to implement. For example, the SEC changed the timing of the date of the ratio calculation. Instead of the determination being made based solely on the number of employees employed as of the last day of a company's prior fiscal year, the final rule allows a company to choose a date within the last three months of its last completed fiscal year on which to determine the employee population. In addition, a company may identify its median employee once every three years unless there has been a change in its employee population or compensation arrangements that the company reasonably believes would result in a significant change to its pay ratio and, if within those three years, the median employee's compensation changes, the company may use another employee with substantially similar compensation as its median employee.
To address the criticism regarding the inclusion of foreign employees, the final rule allows companies to exclude foreign employees from the calculation under the following two circumstances:
- Foreign Data Privacy Law Exemption – If the foreign employees are employed in a jurisdiction with data privacy laws that make the company unable to comply with the rule without violating those laws, provided that the company obtains a legal opinion from counsel to that effect and files the legal opinion with the SEC with its disclosure filing.6
- De Minimis Exemption – If a company's foreign employees account for 5% or less of its total employees, it may exclude all foreign employees when making its pay ratio calculation. However if it chooses to exclude foreign employees, it must exclude all of them. If more than 5% of a company's employees are foreign employees, it may also exclude up to 5% of its total employees who are foreign employees. However, if a company excludes any foreign employees in a particular jurisdiction, it must exclude all foreign employees in that jurisdiction. In calculating the number of foreign employees that may be excluded under this de minimis exemption, a company must count any foreign employee exempted under the data privacy exemption.
The rule provides flexibility in identifying a median employee and does not specify a required methodology for purposes of such analysis. In determining the employees from which the median is identified, companies may choose to use their entire employee population, statistical sampling, or other reasonable methods. It is expected that most companies will hire consultants and use the statistical sampling procedure to determine their median employee. The SEC will allow a company to apply a cost-of-living adjustment in the determination of its median employee, provided the same cost-of-living adjustment is used in calculating total compensation for that employee.
Once the company identifies a median employee, the company must calculate such employee's annual total compensation for the last completed fiscal year using the definition of "total compensation" in Item 402(c)(2)(x) of Regulation S-K. The rule permits a company to include perquisites that aggregate less than $10,000 and broad-based health coverage in the calculation of total compensation, provided that the company uses the same approach in calculating the CEO's total compensation.
In October 2016 the SEC issued five CD&Is7 to provide some clarification on the determination of the median employee and the employee population. The CD&Is demonstrate that the SEC expects the determination of the median employee to be calculated using a principles-based approach based on the type of company and its compensation practices. For example, one of the CD&Is states that whether an individual is an independent contractor for tax purposes is not dispositive as to whether the individual is an employee for purposes of the pay ratio rule.
Corporate Governance Reforms in Advance of Dodd-Frank Compensation Proposals. Although, as discussed above, the Dodd-Frank Act has not yet required companies to make changes regarding hedging and pledging and clawbacks, ISS and institutional stockholders have pressured companies into adopting policies relating to these topics as part of good governance practices. Under ISS policy a company that allows its executive officers or directors to hedge company stock or pledge a significant portion of company stock may receive an "against" or "withhold" vote for directors individually, committee members, or the entire board. ISS has not established a bright-line test for what constitutes "significant" pledging, but it has indicated that a determination of whether pledging is significant will be based primarily on the number of shares pledged as a percentage of the number of shares outstanding, market value and trading volume in the company's stock as well as the company's current views on future pledging arrangements.8 ISS views both hedging and pledging as adverse to shareholder interests because these practices sever the alignment of directors and executive officers' interests with shareholders by reducing the director's or officer's economic exposure to holding company stock while maintaining voting rights. ISS believes that pledging, which often occurs in connection with a margin loan, can have a detrimental effect on a company's stock price in the event of forced sales to meet a margin call and such forced sales could also violate a company's insider trading policies. Therefore, if a company does allow these practices, and pledging is described in a company's beneficial ownership table, the company should be sure to address its policies on this practice in the CD&A section of its proxy statement.
Each year more companies are adopting clawback policies in response to investor pressure. Although many of these policies aim to comply with the Dodd-Frank Act, it seems that investors' primary concern is that companies have such a policy as opposed to the specific wording or requirements of such a policy. In addition, in 2013 certain institutional investors developed compensation recoupment principles aimed at pharmaceutical companies as many companies in the pharmaceutical industry have been increasingly entering into settlements because of executive misconduct. These recoupment policies are more rigorous than the provisions set forth by the Dodd-Frank Act and contemplate that the compensation committee would have the discretion to determine if there was any material violation of a company policy related to the sale, manufacture or marketing of health care services that has caused significant financial harm to the company and should therefore trigger consideration of a possible recoupment of incentive compensation.
Say-on-Pay Approval Requirements. ISS continues to define the standard as to what constitutes a "passing" voting percentage on a say-on-pay proposal, with 70% of the vote deemed by them to be acceptable and not require a company to alter its compensation strategy to demonstrate a stronger link between pay and performance.
ISS has not changed the way it analyzes say-on-pay this year9 and continues to recommend a vote against a say-on-pay proposal if:
- there exists a significant misalignment between CEO pay and company performance (pay for performance);
- the company maintains significant problematic pay practices; or
- the board exhibits a significant level of poor communication and responsiveness to shareholders.
In addition ISS will recommend a vote against or withhold from the members of a company's compensation committee and potentially the full board if:
- there is no say-on-pay proposal on the ballot, and an against vote on a say-on-pay proposal would be warranted due to pay for performance misalignment, problematic pay practices, the lack of adequate responsiveness on compensation issues raised previously, or a combination thereof;
- the board fails to respond adequately
to a previous say-on-pay proposal that received less than 70%
support of votes cast, with ISS looking at the following factors in
evaluating whether a company has adequately responded:
- disclosure of engagement efforts with major institutional investors regarding the issues that contributed to the low level of support;
- specific actions taken to address the issues that contributed to the low level of support;
- other recent compensation actions taken by the company;
- whether the issues raised are recurring or isolated;
- the company's ownership structure; and
- whether the support level was less than 50%, which would warrant the highest degree of responsiveness.
- the company has recently practiced or approved problematic pay practices, including option repricing or option backdating; or
- ISS views the situation as egregious.
We continue to see a trend of companies including an executive summary at the beginning of the proxy statement in an effort to highlight key messages, clearly define the company's views on pay for performance, and ensure the company has a reasonable narrative to support its decisions for last year's pay. A trend of disclosing "realized" or "realizable pay" has also continued to assist shareholders in understanding the executive compensation value actually transferred during a fiscal year and ISS's standard research report now will generally show three-year realizable pay compared to the three-year granted pay for S&P 1500 companies. ISS will discuss realizable pay in its report when its quantitative analysis results in a "high or medium" concern that a company's compensation policies are not linked to overall corporate performance and will also look at realized and/or realizable pay at smaller companies to assist it in determining whether the company demonstrates a strong commitment to a pay-for-performance philosophy.10
In assessing executive compensation, boards of directors should continue to bear in mind that their ultimate goal is not to secure a successful say-on-pay vote, but rather to attract, retain and incentivize executives who will contribute to the long-term value of the company. Directors should understand the executive compensation guidelines that ISS and similar groups promote, but should not allow this to override their own judgments as to the compensation programs and policies that are best for their companies. Directors should participate with management in soliciting favorable say-on-pay votes from major shareholders in order to overcome a negative recommendation by ISS.11
Class action law suits alleging that boards of directors breached their fiduciary duties by approving purportedly deficient proxy statement disclosure and claiming that shareholders need more information in order to cast an informed vote typically with respect to equity compensation plan approvals have continued but have not had much success in the courts. Plaintiffs typically bring these cases in state court and seek an injunction against the upcoming annual meeting until sufficient disclosure is provided in the proxy statement in order for shareholders to make an informed decision. The threat of an enjoined annual meeting has pushed many of these companies that have been sued into providing additional disclosures, thereby justifying a fee award to plaintiff's counsel. In many cases suits are never even filed as before filing a complaint plaintiff's counsel will send a demand letter to the company based on what it believes is misleading or omitted information in a proxy statement and at the same time post on its webpage that it is looking for plaintiffs. Many of these demand letters target smaller companies that do not spend their resources on expansive proxy disclosure. Unfortunately, many of these companies still end up paying a fee to plaintiff's counsel to prevent litigation from being filed and spend additional time and resources filing proxy supplements in response to plaintiffs' demands.
Therefore, companies with a low or negative say-on-pay vote and companies seeking authorization for new or additional shares to be issued pursuant to equity incentive plans should take a careful look at their disclosure to ensure that it complies with proxy statement disclosure requirements as well as consider enhanced disclosures to reduce the possibility of litigation. Many companies have boilerplate compensation policy language that is vulnerable to being exploited by plaintiffs, and which is not necessary to provide an accurate and reasonable basis for a company's compensation decisions. Some of the cases recently filed have focused on compliance with Section 162(m) of the Internal Revenue Code of 1986 by stating claims that the per share limit set forth in the company's equity plan has been exceeded or that there was inadequate or incorrect disclosure with respect to this rule in the CD&A and/or in the equity plan disclosure as language with respect to Section 162(m) was not properly drafted.
ISS 2017 Proxy Voting Guidelines. ISS has issued updates for its proxy voting guidelines for 2017 on the following topics: 12
Limitations on "Overboarding." "Overboarding" refers to the concern that directors who serve on multiple boards simultaneously will be overextended and unable to devote sufficient time and energy to the boards on which they have agreed to serve. The grace period for directors sitting on six public company boards simultaneously has ended and ISS will now recommend against directors who serve on more than five public company boards simultaneously. Directors who are public company CEOs are limited to service on two public company boards in addition to their own company's board.
Unilateral/Pre-IPO Governance Changes. Continuing its historic posture of distaste for bylaw or charter amendments that are adopted by a board "unilaterally," or without shareholder approval, ISS will recommend voting against or withholding votes from individual directors, committee members, or the entire board if prior to or in connection with an initial public offering a board amends the company's bylaws or charter without shareholder approval to classify the board or to establish supermajority voting requirements to amend the bylaws or charter. ISS also noted that a public commitment by the company to put these provisions to a shareholder vote within three years of the initial public offering is no longer a mitigating factor and instead requires a sunset provision.
Management Proposals for Shareholder Ratification of Director Compensation. ISS has adopted a voting policy for companies that choose to seek ratification of director compensation in order to protect the payments from being exposed to shareholder claims. ISS will evaluate these proposals based on the following:
- if the equity plan under which the equity grants are to be made is also being proposed for action by shareholders, whether or not that proposal warrants support from ISS;
- the relative magnitude of director compensation as compared to similar companies;
- the presence of problematic pay practices with respect to director compensation;
- director stock ownership guidelines and holding requirements;
- equity award vesting schedules;
- mix of cash and equity compensation;
- disclosure of meaningful limits on director compensation;
- the availability of retirement benefits or perquisites; and
- the quality of the director compensation disclosure in the proxy statement.
ISS Policy for Evaluating Equity Plan Proposals. For the third year, ISS is using its equity plan scorecard (EPSC) to evaluate equity compensation proposals and has made only minor revisions to its review process. It has added to its plan features a dividend policy. If the plan expressly prohibits dividends to be paid on unvested equity awards then full points will be earned, and no points will be earned if the plan is silent or incomplete even if it has been a company's general practice of not paying dividends until vesting. In addition, it will no longer allow for points if an individual award agreement may reduce the plan feature of a one-year vesting requirement.
The following are the key terms of the EPSC:
Plan Cost: The EPSC measures a company's shareholder value transfer relative to two benchmark calculations that consider:
- new shares requested plus shares remaining for future grants, plus outstanding unvested/unexercised grants, and
- only new shares requested plus shares remaining for future grants.
Plan Features: The following factors may have a negative impact on EPSC results:
- Automatic single-triggered award vesting upon a change in control, which may provide windfall compensation even when other options (e.g., conversion or assumption of existing grants) may be available;
- Broad discretionary vesting authority that may result in "pay for failure" or other scenarios contrary to a pay-for-performance philosophy;
- Liberal share recycling on various award types, which obscures transparency about share usage and total plan cost;
- Dividends payable prior to the vesting of the award as dividends should be paid only after the underlying awards have been earned and not during the performance/service vesting period; and
- Absence of a minimum required vesting period (at least one year) for grants made under the plan, which may result in awards with no retention or performance incentives.
Grant Practices: The following factors may have a positive impact on EPSC results, depending on a company's size and circumstances:
- The company's 3-year average burn rate relative to its industry and market cap peers – This measure of average grant "flow" provides an additional check on plan cost. The EPSC compares a company's burn rate relative to its market cap peers and industry.
- Vesting schedule(s) under the CEO's most recent equity grants during the prior three years – Vesting periods that incentivize long-term retention are beneficial.
- The plan's estimated duration, based on the sum of shares remaining available and the new shares requested, divided by the 3-year annual average of burn rate shares – Given that a company's circumstances may change over time, shareholders may prefer that companies limit share requests to an amount estimated to be needed over no more than five to six years.
- The proportion of the CEO's most recent equity grants/awards subject to performance conditions – Given that stock prices may be significantly influenced by market trends, making a substantial proportion of top executives' equity awards subject to specific performance conditions is an emerging best practice, particularly for large cap, mature companies.
- A clawback policy that includes equity grants – Clawback policies are seen as potentially mitigating excessive risk-taking that certain compensation may incentivize, including large equity grants.
- Post-exercise/post-vesting shareholding requirements – Equity-based incentives are intended to help align the interests of management and shareholders and enhance long-term value, which may be undermined if executives may immediately dispose of all or most of the shares.
ISS will continue to vote against equity plans that contain certain plan features that ISS deems egregious. These features, which have not changed from recent years, are:
- a liberal change in control definition that could result in vesting of awards before a change in control transaction is actually consummated;
- allowing for repricing or cash buyout of underwater options without shareholder approval;
- using the plan as a vehicle for problematic pay practices or a pay-for-performance disconnect; or
- any other plan features or company practices that are deemed detrimental to shareholder interests such as tax gross-ups.
2016 Brought Stricter Legal Standard of Review for Director Compensation
In Calma v. Templeton,13 the Delaware Court of Chancery held that restricted stock units issued to the non-employee directors of Citrix System Inc. by its compensation committee (consisting of directors who also received these awards) would be assessed under Delaware law using the "entire fairness" standard. This standard requires the company to show that the grants were fair with respect to both price and process, and it is a stricter standard to meet than the business judgment rule, or the corporate waste standard, which is what the defendants in Calma argued applied. More significantly, when reviewing the defendants' argument that the entire fairness standard did not need to be met because the equity plan received approval of the company's disinterested stockholders, the court held that the stockholders had not ratified the authorization of the grants, even though all parties acknowledged that the restricted stock units were issued to the directors in accordance with and pursuant to the terms of the company's stockholder approved equity incentive plan, which authorized grants to be made to employees, officers, and directors.
In rejecting defendants' ratification argument, the Calma court noted that "the company did not seek or obtain stockholder approval of any action bearing specifically on the magnitude of compensation to be paid to its non-employee directors." The court observed how the equity incentive plan did not specify the number of restricted stock units that the company would grant to its directors or place any "meaningful" limits or caps on any such grants; rather, the plan simply provided a relatively high cap on the amount that could be granted to any single beneficiary per calendar year. Accordingly, the court concluded that "stockholder approval of the Plan was not a 'blank check' or 'carte blanche' ratification of any compensation that the compensation committee might award to the company's non-employee directors."
The Calma case confirms that companies should no longer assume that advance stockholder approval of an equity plan that allows for directors to receive grants will be enough to insulate non-employee director compensation awards from the entire fairness review under Delaware law.
As further corroboration of this sea change, in 2016 a settlement was filed by the parties in Espinoza v. Zuckerberg, C.A No. 9745 (Del. Ch), which is a suit that was initiated in 2014 against Facebook's directors claiming that the relevant directors' average fees of $461,000 for the prior year was about 46% higher than fees paid to non-employee directors at the company's peers. In light of a potential determination by the court that non-employee director compensation should be analyzed under the entire fairness standard, defendants argued for dismissal because its non-employee director compensation was approved by a stockholder majority, namely Mark Zuckerberg, whose stake in the company granted him control over the outcome of matters put up for a stockholder vote. However, the court allowed the case to continue stating that even though Zuckerberg had majority control over any stockholder decision, the corporate formalities required to implement a directive must still be followed, and the director compensation determination was not brought properly before the stockholders.
In light of the court's decision Facebook agreed to the following settlement:
- to amend its compensation committee charter to include an annual review of all cash and noncash compensation to be paid to non-employee directors, and bring in an independent consultant to help with deciding the size and type of any potential increase; and
- to submit to a vote at its 2016 annual meeting two separate proposals for stockholder approval on compensation for non-employee directors: (i) to ratify the equity grants made in 2013, and (ii) to approve the annual compensation program for non-employee directors specifying an amount for annual equity grants and the amounts of annual retainer fees, and payment of attorneys' fees and expenses to plaintiff's counsel in an amount not to exceed $525,000.
Therefore, in order to minimize the risk of a derivative lawsuit regarding non-employee director compensation, and to comply with the "entire fairness" standard, we recommend that companies consider:
- adding meaningful director grant limits to their equity plans when asking stockholders to approve new plans or amend existing ones;
- when seeking stockholder approval of an amendment to an existing equity plan, consider proposing that the stockholders ratify director awards made under the plan during the prior year; and
- review director compensation data at comparable companies (with or without compensation consultants) and make sure director compensation is reasonable in light of these comparables (although it should be noted that the selection of comparables was successfully challenged at the motion to dismiss stage by the plaintiff in the Calma litigation.)
Annual Reports No Longer Must Be Mailed to the SEC
In November 2016, the SEC posted a new CD&I indicating that companies no longer need to mail seven physical copies of the annual report that accompanies their annual meeting proxy statements to the SEC, provided that an electronic version of the annual report is posted on the company's website and remains accessible for one year.
2017 Periodic Report Filing Deadlines
For companies that qualify as large accelerated filers and have fiscal years ending on December 31, annual reports on Form 10-K are due 60 days after fiscal year-end (Wednesday, March 1, 2017).14 Form 10-K reports continue to be due 75 days following fiscal year-end for accelerated filers15 (Thursday, March 16, 2017 for December 31 year-end companies) and 90 days after fiscal year-end for non-accelerated filers (Friday, March 31, 2017 for December 31 year-end companies).
In addition, Form 10-Q reports filed by accelerated filers and large accelerated filers continue to be due 40 days after the close of the fiscal quarter. The deadline for Form 10-Q reports for non-accelerated filers continues to be 45 days after the close of the fiscal quarter.
These changes do not affect the existing proxy statement filing deadline of 120 days after fiscal year-end for companies that choose to incorporate by reference from their definitive proxy statements the disclosure required by Part III of the Form 10-K.
Other Year-End Considerations. We also recommend that companies take the opportunity while planning their year-end reporting to consider what amendments may be necessary or desirable to their corporate documents over the coming year that may require shareholder approval. Some items to consider are:
- Does the company have enough shares authorized under its certificate of incorporation to achieve all of its objectives for the year, including acquisitions for which it may want to use its stock as currency?
- Does the company have adequate shares available under its equity compensation plans to last throughout the year?
- Does the company need shareholder approval of its equity compensation plans for continued compliance with the tax deductibility of performance-based equity awards under Section 162(m) of the Internal Revenue Code?16
- Has the company reviewed its charter and bylaws to assess any anti-takeover measures in place?
- Has the company promised any disclosure changes pursuant to SEC comments or discussions with shareholders?
To the extent that a company expects any proposal in its proxy statement to create controversy among its shareholder base, it may want to consider hiring a proxy solicitor to assist with the process of seeking the requisite shareholder vote.
1 We invite you to review our memorandum from last year, which analyzed regulatory changes that were new for fiscal year 2016, and we would be happy to provide you with another copy upon request.
2 You may recall that the SEC vacated its proxy access rule after it was challenged in a lawsuit.
3 Universal Proxy, Rel. No. 34-79164 (October 26, 2016).
4 Interim Final Rule: Form 10-K Summary (34-77969, June 9, 2016).
5 Pay Ratio Disclosure, Rel. No. 33-9877 (August 5, 2015).
6 Most practitioners believe this exemption will have little value as it will be difficult to obtain the requisite legal opinion.
7 https://www.sec.gov/divisions/corpfin/guidance/regs-kinterp.htm - Section 128C
8 Item 403 of Regulation S-K requires a footnote to the beneficial ownership table if a director or executive officer has stock subject to pledging.
9 The ISS 2017 policy in evaluating say-on-pay is available on its website at https://www.issgovernance.com/file/products/2017-us-summary-voting-guidelines.pdf and https://www.issgovernance.com/file/policy/1_u.s.-executive-compensation-policies-faq-dec-2016.pdf
10 See ISS Frequently Asked Questions on U.S. Executive Compensation Policies cited above that discusses how ISS will calculate a company's realizable pay.
11 Companies must be mindful of Regulation FD (Fair Disclosure) and not disclose material nonpublic information selectively nor risk sending mixed messages from the disclosures contained in the company's proxy statement or other SEC filings when speaking with stockholders.
12 A summary of the updates to the ISS 2017 voting guidelines can be found at https://www.issgovernance.com/file/policy/2017-americas-iss-policy-updates.pdf
14 Large accelerated filers are domestic companies that meet the following requirements as of their fiscal year-end:
- have a common equity public float of at least $700 million, measured as of the last business day of their most recently completed second fiscal quarter (i.e., for calendar fiscal year-end companies, this test would be applied as of June 30, 2016);
- have been subject to the reporting requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, for at least 12 months;
- have previously filed at least one Annual Report on Form 10-K; and
- do not qualify as small business issuers under SEC rules.
15 Accelerated filers are those that meet all of the above tests but have a common equity public float of at least $75 million, but less than $700 million, measured as of the last business day of their most recently completed second fiscal quarter (i.e., for calendar fiscal year-end companies, this test would be applied as of June 30, 2016).
16 Section 162(m) denies a publicly held corporation a deduction for compensation paid to "covered employees" to the extent the compensation exceeds $1,000,000. "Performance-based compensation" is not subject to this deduction limitation. The material terms of a performance goal under which performance-based compensation is to be paid must be disclosed to and approved by the corporation's shareholders before the compensation is paid and these goals must be disclosed to and reapproved by the shareholders every five years in order for the corporation to continue to rely on the performance-based compensation exception.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.