Tags: year-end, 2015 proxy, annual reporting season
It is time for calendar year-end public companies to focus on the upcoming 2015 proxy and annual reporting season. This Legal Update discusses the following key issues for companies to consider in their preparations:
- Pending Dodd-Frank Regulation
- Say-on-Pay and Compensation Disclosure Considerations
- Shareholder Proposals
- Proxy Access
- Compensation Committee Independence Determinations
- Compensation Adviser Independence Assessment
- Compensation Consultant Conflict of Interest Disclosure
- NYSE Quorum Requirement Change
- Director and Officer Questionnaires
- Proxy Advisory Firm and Investment Adviser Matters
- Conflict Minerals
- Management's Discussion and Analysis
- Proxy Bundling
- Foreign Issuer Preliminary Proxy Statement Relief
- Technology and the Proxy Season
Pending Dodd-Frank Regulation
Of interest to many people this proxy season is when the US Securities and Exchange Commission (SEC) will take action on four executive compensation/governance regulatory initiatives mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and what impact, if any, SEC action on these initiatives will have on proxy statements for 2015 annual meetings.
As of the date of this Legal Update, the SEC still needs to finalize (or re-propose) its pay ratio disclosure rules and to propose its clawback, hedging and pay-for-performance rules. The unified regulatory agenda published by the Office of Management and Budget of the Executive Office of the President1 targets each of these four matters for SEC action by October 2014, but it is not clear if that timetable will be met.
Proposed Pay Ratio Disclosure Rules. On September 18, 2013, the SEC proposed pay ratio disclosure rules pursuant to a Dodd-Frank mandate.2 Assuming no change is made to the transition period set forth in the proposed rules, pay ratio disclosure will not be required for the 2015 proxy season, even if the SEC adopts final rules in 2014. Should the SEC adopt final rules in 2014, the earliest that pay ratio disclosure is likely to be required for calendar-year companies would be the 2016 proxy season (with respect to 2015 compensation).
Under the pay ratio proposal, public companies would have to disclose the median of the annual total compensation of all employees other than the chief executive officer, the annual total compensation of the chief executive officer and the ratio of those amounts. As proposed, smaller reporting companies, emerging growth companies and foreign private issuers would not be subject to the pay ratio disclosure requirement.
The proposed pay ratio disclosure would cover all employees of the company and its subsidiaries as of the last day of the prior fiscal year, including employees based outside of the United States, part-time employees, temporary employees and seasonal employees. Companies would be permitted to annualize the compensation of a permanent employee who did not work the entire year. However, under the proposed rules, the compensation of temporary or seasonal workers may not be annualized, part-time employee compensation may not be measured on a full-time equivalent basis and cost-of living adjustments may not be made for non-US employees.
The proposed rules would allow companies to select a method for identifying the median employee that is appropriate to the size and structure of their businesses and compensation program. Under the proposal, companies could use reasonable estimates to calculate annual total compensation or any element of such compensation. The only required narrative disclosure would be a brief, non-technical overview of the methodology used to identify the median, and any material assumptions, adjustments or estimates used to identify the median or to determine total compensation or elements of total compensation.
For additional information about the SEC's proposed pay ratio rules, see our Legal Update dated October 2, 2013, titled "Securities and Exchange Commission Proposes Pay Ratio Disclosure Rules."3
Clawbacks. Under Dodd-Frank, the SEC must direct stock exchanges to prohibit the listing of securities if a company does not develop a policy with respect to recovery of incentive-based compensation in certain circumstances. Unlike the comparable Sarbanes-Oxley Act provision, the clawback policy under Dodd-Frank will need to cover both current and former executive officers, not just the chief executive officer and the chief financial officer. The Dodd-Frank clawback provision applies to any accounting restatement resulting from material noncompliance, whether or not the executive officer is responsible for the misconduct that led to the restatement.
Companies are permitted to wait for the final rules before adopting or amending a clawback policy for the purposes of complying with this Dodd-Frank requirement, although some companies have already adopted clawback policies pending the completion of the rulemaking process. Whether or not a company has disclosed that it has a clawback policy is something that corporate governance rating firms and investors might consider when evaluating a public company's corporate governance structure.
Implementation of the Dodd-Frank clawback provision is an important area to follow closely, as it involves rulemakings by both the SEC and the stock exchanges. However, because the SEC has not yet taken the step of proposing a clawback policy listing requirement for the stock exchanges, it is unlikely that clawback rulemaking will directly affect the 2015 proxy season.
Hedging. The SEC still needs to propose regulations to implement the Dodd-Frank requirement for companies to disclose whether employees and directors are permitted, directly or indirectly, to hedge the market value of securities granted as compensation.
Item 402(b)(2)(xiii) of Regulation S-K already requires companies to disclose any policies regarding hedging the economic risk of owning company securities. Given that the SEC has not proposed a hedging rule pursuant to Dodd- Frank, it is not likely that hedging policy disclosure requirements will change for the 2015 proxy season.
Companies may wait until the SEC adopts final rules before adopting or amending a hedging policy in response to the Dodd-Frank hedging requirement. However, anti-hedging positions of proxy advisory and corporate governance rating firms, such as Institutional Shareholder Services, Inc. (ISS), have prompted some companies to prohibit directors and executive officers (and sometimes employees in general) from engaging in hedging transactions with respect to their company's stock.
Pay-for-Performance. Dodd-Frank requires the SEC to adopt rules regarding pay-for-performance. Under these rules, companies would have to disclose material information that shows the relationship between executive compensation actually paid and the financial performance of the company, taking into account any change in the value of the company's stock and the dividends paid by the company. The SEC has not yet proposed rules for implementing this disclosure requirement. It is unlikely that a rule on this subject could be proposed and finalized in time to impact the 2015 proxy season. However, it is important to monitor this rulemaking process, particularly since it is possible that the final disclosure requirements might influence upcoming decisions to be made by compensation committees.
Say-on-Pay and Compensation Disclosure Considerations
Say-on-Pay. Shareholders, for the most part, approved their companies' say-on-pay proposals in 2014, often by wide margins. Of the Russell 3000 companies that held say-on pay votes between January 1, 2014 and September 5, 2014, the average vote result was 91 percent in favor; only 2.4 percent had their say-on-pay proposal fail. Since say-on-pay first became required in 2011, 92.2 percent of the Russell 3000 have had their-say-on-pay votes pass in all four years.4 Average support for say-on-pay for large-cap companies rose in 2014; however, the percentage of small-cap and mid-cap companies failing to secure at least 50 percent support for say-on-pay increased in 2014.5
Although say-on-pay is a non-binding, advisory vote, it can be a sensitive agenda item for executive officers and directors. Therefore, public companies often devote considerable attention to how compensation is presented in the proxy statement, especially in the compensation discussion and analysis (CD&A) section. Plain English is very important to a clear presentation. Executive summaries have become a very common (although not required) component of the CD&A. Many companies include charts and graphs, often in color, to enhance the readability of their CD&A. Some companies include a proxy statement summary at the beginning of the proxy statement that, among other matters, highlights key aspects of the executive compensation program and rationales supporting compensation decisions.
In the CD&A, companies are specifically required to discuss the extent to which compensation decisions were impacted by the results of the prior year's say-on-pay vote. This is required whether or not the proposal received the support of a majority of the shares voting. Compensation committees should be reminded of this reporting obligation so that their deliberations can specifically address the results of the say-on-pay advisory vote.
Non-GAAP Financial Measures. It has become common for companies to highlight performance measures in order to explain that compensation is performance based. To the extent that non-GAAP performance measures are disclosed, companies must pay attention to the requirements of Regulation G.
Disclosure of target levels that are non-GAAP financial measures is not subject to Regulation G, although the company must disclose how the number is calculated from its audited financial statements. In Regulation S-K compliance and disclosure interpretation number 118.09, the staff of the SEC's Division of Corporation Finance (Staff) extended this principle to the disclosure of the actual results of the non-GAAP financial measure that is used as a target, provided that this disclosure is made in the context of a discussion about target levels.
When non-GAAP financial measures are included in a proxy statement for any purpose other than with respect to target levels, a company must comply with Regulation G and Item 10(e) of Regulation S-K. For pay-related circumstances only, the Staff stated that it will not object if a registrant includes the required GAAP reconciliation and other information in an annex to the proxy statement, provided that the registrant includes a prominent cross-reference to such annex. 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 executive compensation disclosures, the Staff stated that it will not object if the company complies with these rules by providing a prominent cross-reference to the pages in the Form 10-K containing the required GAAP reconciliation and other information.6 When providing a non-GAAP performance measure in a proxy statement, for example in a proxy statement summary, a company wishing to rely on these Staff interpretations should be careful to tie such disclosure to compensation.
Negative Proxy Advisory Firm Recommendations and Responses. Proxy advisory firms, such as ISS and Glass Lewis & Co., LLC (Glass Lewis), recommend to their institutional clients how to vote on the various matters put to a vote at an annual meeting, including say-on-pay. A negative recommendation on executive pay from a proxy advisory firm will not necessarily result in a failed say-on-pay vote. There are precedents for companies receiving majority approval for their say-on-pay proposals even when a proxy advisory firm recommends votes against them, but it is likely that a negative recommendation will at least result in a lower percentage of approval.
Some companies increase their solicitation efforts if they receive a negative recommendation on say-on-pay from a proxy advisory firm. For example, they may prepare slides, a letter to shareholders, a proxy statement supplement, a script or talking points to counter assertions made in the proxy advisory firm's report or to emphasize why they believe executive compensation should be approved. However, before a company may use any additional solicitation material, the material must first be filed with the SEC.
Compensation Litigation. There have been several types of litigation instituted or threatened with respect to say-on-pay votes and proxy compensation disclosure. For example, some lawsuits alleged breach of fiduciary duty, some alleged insufficient compensation disclosures and sought to enjoin the shareholder vote and some challenged specific compensation actions. While many of these actions have failed, there have been some victories for the plaintiffs, so public companies need to be aware of the potential for compensation-related lawsuits to be brought in connection with the 2015 proxy season. Compensation disclosures should be prepared, and compensation decisions should be made, with care, especially for companies that anticipate resistance to their say-on-pay proposals.
Shareholder Engagement. While say-on-pay is advisory and non-binding in nature, it nevertheless has a practical impact. A vote against executive compensation will generate adverse publicity. It may also generate corporate governance consequences, such as poorer corporate governance ratings or increased votes against election of directors. As a result, say-on-pay has given rise to increased shareholder engagement throughout the year, because outreach to key investors has been recognized as an important element of a successful say-on-pay vote.
To the extent that a company seeks input on particular aspects of pay practices, it should contact shareholders in time to consider their responses when making compensation decisions that will be disclosed in proxy statements. Many companies include shareholder engagement as part of their proxy process, especially in the say-on-pay area, and they are often trying to reach the same large shareholders. For a more effective discussion, companies should prepare in advance to focus the scope of their calls on particular issues.
In conversations with shareholders regarding pay practices (or any other topic), companies should be careful not to selectively disclose material, non-public information. If such information is disclosed in such discussions, the company will need to disseminate such information in a Regulation FD compliant manner.
Rule 14a-8 under the Securities Exchange Act of 1934, as amended, (Exchange Act) permits shareholders who, for one year, either own $2,000 in market value or 1 percent of the voting stock, to submit a proposal that a company must include in its proxy statement, unless the proposal has specified procedural deficiencies or can be excluded based on 13 substantive grounds that are set forth in the rule.
Popular shareholder proposal topics during the 2014 proxy season included social and environmental proposals, such as proposals relating to political contributions, lobbying, climate change and sustainability. While there were numerous social and environmental shareholder proposals, they generally did not garner majority support of the shareholders voting. For example, The Conference Board, in collaboration with FactSet, reports that of the 194 social/environmental policy shareholder proposals, including 86 political issue proposals and 58 environmental/sustainability issue proposals, that were voted on by the Russell 3000 companies holding annual meetings between January 1 and June 30, 2014, only one (an animal welfare proposal) won a majority of the votes cast.7
Regardless of their voting success, social and environmental proposals can have an impact, even when they do not receive majority approval. Proponents of shareholder proposals use the company's proxy statement and annual meeting as a platform to publicize issues.
Rule 14a-8 permits failed shareholder proposals to be resubmitted in subsequent years when certain minimum approval thresholds have been achieved, enabling the subject of the losing shareholder vote to be discussed in proxy statements and at the annual meetings in future years. In addition, companies sometimes modify their practices to reflect concerns raised by shareholder proposals that did not pass (such as providing additional political contribution disclosure).
Governance-related proposals also represented a significant category of shareholder proposals in the 2014 proxy season. Certain governance proposals, such as board declassification, elimination of super-majority shareholder votes and majority voting for directors, were frequently successful in achieving majority approval in 2014. According to The Conference Board, at annual meetings of the Russell 3000 companies held between January 1 and June 30, 2014, votes in favor of proposals to declassify the board averaged 80.6 percent of the votes cast, votes in favor of proposals to eliminate supermajority vote requirements averaged 66.2 percent of the votes cast and votes in favor of proposals to change from plurality to majority voting averaged 56.5 percent of the votes cast. Shareholder proposals requesting that the board of directors have an independent chair, separate from the chief executive officer, while generally not receiving majority support, often received relatively significant levels of support. The Conference Board report shows that at meetings of the Russell 3000 companies held between January 1 and June 30, 2014 votes in favor of such proposals averaged 31 percent. (Proxy access proposals are discussed separately below.)
Shareholders also submitted compensation proposals in 2014, many of which related to equity compensation issues, such as acceleration of vesting upon a change of control or stock ownership thresholds and equity retention periods. These compensation-based shareholder proposals were in addition to the management say-on-pay proposal, giving shareholders multiple opportunities to express views on executive compensation at the same meeting.
Many of the common shareholder proposal topics from 2014 are likely to be raised again during the 2015 proxy season. In addition, there may be new proposals and proposals with increased prevalence for the 2015 proxy season, such as proposals addressing board tenure and its impact on director independence.
If a company wants to exclude a shareholder proposal (and the shareholder's associated statement of support), the company will need one or more procedural or substantive grounds to omit the proposal under Rule 14a-8. If a company believes that Rule 14a-8 specifically provides grounds to exclude the shareholder proposal from its proxy statement, it should submit a no-action request to the Staff, describing each alternative reason. In recent years, some companies have turned to the courts to seek exclusion of shareholder proposals, but such litigation has had mixed results. Most public companies rely on the Staff's no-action process when seeking to omit shareholder proposals.
When available, procedural deficiencies (such as failing to provide the requisite proof of ownership) can present a clear-cut argument supporting a no-action request to omit a shareholder proposal from the proxy statement, but only if the company notifies the proponent in writing about the defect within 14 days of its receipt of the proposal. The company does not have to notify the proponent of a defect that cannot be remedied, such as late submission of the proposal. After receiving a notice of defect, the proponent has 14 days to correct the procedural defects. Because of these deadlines, it is important for companies to have a procedure in place so that shareholder proposals are quickly reviewed by someone familiar with Rule 14a-8 to identify potential defects in time to preserve an effective basis for exclusion.
If a company must include in its proxy statement a shareholder proposal that it does not support, it should carefully draft a persuasive statement of opposition. The company must send this statement to the proponent of the proposal 30 days before the company files its definitive proxy statement. Depending on the nature of the proposal, in addition to the statement of opposition, the company might consider enhancing other sections of the proxy statement. For example, if a compensation proposal is included in a proxy statement, the company may want to emphasize its rationale on related issues in its CD&A. Similarly, if a shareholder submits a proposal involving board tenure (or otherwise raises board tenure as an issue), a company might wish to expand its description of the attributes that each director contributes to the board and the company.
There have been a number of suggestions for reform of the shareholder proposal process. SEC Commissioner Gallagher has advocated increasing the number of shares that an investor must own in order to submit a proposal for the proxy statement, as well as increasing the length of the holding period.8 Commissioner Gallagher also suggested that the SEC increase the percentage of favorable votes needed for a proposal to be re-submitted year after year. Business groups, including the US Chamber of Commerce, have submitted a rulemaking petition to the SEC asking for such change,9 but the SEC has also received opposition to the request to raise the resubmission threshold.10 Commissioner Gallagher also urged the Staff to provide additional guidance as to what constitutes a significant social policy that prevents a company from excluding a shareholder proposal as relating to the ordinary course of business. The proposed changes to the rule are very controversial, and it does not seem likely that the SEC will change Rule 14a-8 for the 2015 proxy season, although the Staff has the flexibility to issue guidance on the process based on the existing rule.
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Originally published 16 September 2014
2 Available at http://www.sec.gov/rules/proposed/2013/33-9452.pdf.
3 Available at http://www.mayerbrown.com/files/Publication/a332d849-f630-4571-9bf7-66e1974e5df4/Presentation/PublicationAttachment/827f565f-9a39-4ca0-8497-6add57a3cc78/UPDATEPay_Ratio_Disclosure_1013_V2.pdf.
4 See Semler Brossy, "2014 Say on Pay Results," September 10, 2014, http://www.semlerbrossy.com/wpcontent/uploads/SBCG-2014-Say-on-Pay-Report-2014-09-10.pdf.
5 See Broadridge Financial Solutions, Inc. and PwC Center for Board Governance, Proxy Pulse Second Edition 2014, available at http://www.pwc.com/en_US/us/corporategovernance/publications/assets/proxypulse-2nd-editionjune-2014.pdf.
7 All references in this Legal Update to The Conference Board's statistics on shareholder proposals are from The Conference Board, in collaboration with FactSet, "Proxy Voting Fact Sheet," July 2014, available at https://www.conferenceboard.org/publications/publicationdetail.cfm?publicationid=2804.
8 Commissioner Gallagher's speech is available at http://www.sec.gov/News/Speech/Detail/Speech/1370541315952.
10 See, for example, http://www.sec.gov/comments/4-675/4675-2.pdf.
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