Executive Compensation

The Eurozone crisis and ensuing populist resentment over perceived compensation excesses have given rise to a recent wave of compensation measures and restrictions in Europe. As we explain in our memo, the measures range from a cap on financial institution bonuses (the so-called “banker bonus cap”) in the EU, binding say-on-pay votes in several European jurisdictions and even criminal sanctions for violating compensation restrictions and corporate governance requirements in Switzerland. Simon Witty, a partner in our London office, explains the key aspects of these developments.

• What is the banker bonus cap?
  
  Under CRD IV, which is slated to go into effect for credit institutions (including banks) and investment firms (such as broker-dealer or wealth management firms) in January 2014, the basic rule is that bonus payments will be capped at 100% of total fixed pay or, with shareholder approval, 200% of total fixed pay. “Shareholder approval” means approval by either 66% of shareholders owning half the shares represented or, failing that, 75% of all shares represented.  The effective bonus cap can go up by up to 25%, if the pay is in the form of long-term deferred instruments (i.e., instruments deferred for a period of at least five years).
  
  But there is a lot more to the banker bonus cap than just the cap. There are, for example, rules on how much of the bonus must be comprised of equity compensation or certain capital instruments, how much must be deferred and for how long, clawbacks, mandatory deferrals or holdbacks for discretionary pension benefits and the collection of information for individuals who are paid €1,000,000 or more in any given fiscal year.
  
  
• Who will the banker bonus cap apply to?
  
  As to which institutions, the cap will apply to all credit institutions and investment firms in the EU.  The non-EU subsidiaries of institutions headquartered in the EU will also be caught, as will the EU subsidiaries of institutions headquartered outside the EU.
  
  For example, if a financial institution is headquartered in London, all of its relevant employees (including relevant employees located in New York or Hong Kong) will be affected, and, even if a financial institution is headquartered in New York or Hong Kong, its relevant employees working for an EU subsidiary will be affected.
  
  As to which employees at those institutions, the cap will not apply to all employees of a particular entity; rather, it will only affect employees whose professional activities have a material impact on the risk profile of the relevant financial institution. Examples of these employees are senior management; risk-takers; employees engaged in control functions; and employees whose total pay takes them into the same bracket as senior risk management and risk-takers.
  
  
• Which companies will be affected by the proposed say-on-pay requirements?
  
  The EU has announced a proposed mandatory EU-wide say-on-pay initiative. The U.K. is expected to implement a binding say-on-pay vote by October 2013, plus other related requirements. Another country that has received significant press coverage is Switzerland – its “Minder Initiative” introduces a binding say-on-pay vote, together with other executive compensation measures, which will come into force by March 2014. Germany and Spain have also announced say-on-pay initiatives, which will likely be binding.
  
  Our current understanding is that these developments will just affect the companies incorporated in those jurisdictions. In contrast to the CRD IV compensation restrictions, which will apply to non-EU financial institutions (at least partially), we do not have any reason to think for now that the say-on-pay initiatives will apply to, for example, U.S. or Hong Kong companies.
  
  
• How will binding say-on-pay work?
  
  In the U.K., the jurisdiction for which there is currently the most information, a binding shareholder vote will be held at least every three years on a company’s remuneration policy report, which is prospective in that it will set out the company’s future policy regarding the compensation (including “loss of office” payments) of directors, including executive directors. A company will continue to have an advisory shareholder vote each year on its remuneration implementation report, which is retrospective in that it will set out how the company’s compensation policy was implemented in the past fiscal year.

In our recent client alert, “Recent Developments in Executive Compensation,” an open question was the fate of Gordon v. Symantec Corp. (and similar cases) after the court denied a preliminary injunction to enjoin the company’s say-on-pay vote.  At the time of our client alert, a demurrer to the plaintiff’s class action complaint was pending. 

On February 22, 2013, the judge in Symantec (the same judge who granted a preliminary injunction in Knee v. Brocade Communications Systems Inc. to enjoin a vote on an equity plan proposal) issued an order sustaining the defendants’ demurrer to the plaintiff’s complaint.  The Symantec court noted that once the shareholder vote on Symantec’s say-on-pay proposal was held at its annual meeting in October 2012, the direct disclosure claim was no longer available to the plaintiff and the plaintiff’s claim then became a derivative claim subject to a pre-suit demand requirement. 

The court further stated that the plaintiff, as a substantive matter, failed to plead a sufficient disclosure claim.  In other words, the plaintiff failed to demonstrate how the information she claimed should have been disclosed (e.g., fair summary of the competitive market analysis performed by the compensation consultant, other non-compensation consulting and business services that the compensation consultant performed, criteria used to select Symantec’s peer group, etc.) could be viewed as significantly altering the total mix of information already made available to Symantec’s shareholders. 

Even though the plaintiff still has ten days to amend her complaint and this judge’s ruling in Santa Clara California State court is not binding on other courts, this result is welcome news for U.S. public companies.  It reinforces the notion we posited in our client alert – at least with respect to say-on-pay proposals, these lawsuits are likely to face significant obstacles. 
The hope is that this may augur a dismissal of at least one other similar lawsuit in the near future.  Specifically, the parties in Gordon v. Cisco Systems, Inc. (which is pending before the same judge in Santa Clara California State court) stipulated that the demurrer in Cisco should be deferred until a decision in Symantec had been reached, because (i) the issues that were raised in Cisco are substantially similar to the issues that were under consideration in Symantec at the time and (ii) both actions involve the same plaintiff, the same plaintiff’s counsel and the same counsel for defendants.  Now that Symantec has been decided, it is likely only a matter of time before this result will be replicated in Cisco. 

It is also worth noting that, while all the reports on the recent lawsuit against Apple’s proxy statement in the Southern District of New York focused on the unbundling claim made by Greenlight for the charter amendment proposal, as we previously discussed here, little known is that the judge in that case also dismissed efforts by another plaintiff to enjoin the say-on-pay proposal.  That plaintiff had claimed that Apple’s use of terms like “experiences,” “input” and “peer group data,” when describing the compensation committee’s judgment in granting long-term equity, failed to provide sufficient information.  The judge found, however, that since the plaintiff did not identify any material omission in the proxy and since the compensation discussion and analysis section included in the proxy statement was compliant with the SEC rules, the plaintiff was unlikely to succeed on the merits. 

Nonetheless, the Symantec and, in the say-on-pay preliminary injunction context, Apple successes do not mean that U.S. public companies should relax and assume that the plaintiffs’ bar will be deterred.  At least one law firm that has been particularly active in filing these types of lawsuits has recently identified several more companies which it is investigating for potential breaches of directors’ fiduciary duties in connection with say-on-pay proposals.  Given that the proxy season is upon us, we continue to recommend that companies pay extra attention to their executive compensation disclosure.

On December 20th, ISS issued two extensive FAQs on their voting policies. This post covers the compensation items (a previous post covered the non-compensation items).

Although the compensation FAQs contain a number of items previously posted by ISS, there are a few new items worth noting, including:

• For the CEO Tally Sheet table, how the present value of all accumulated pension benefits (qualified and non-qualified) is calculated (page 7).
• The FAQs explain the methodology used in evaluating a company’s pay for performance, including how an initial quantitative analysis affects the ultimate vote recommendation for say-on-pay proposals and the factors that ISS considers when it conducts a qualitative review (such as the ratio of performance- to time-based equity awards, benchmarking processes and realizable pay vs. grant pay) and how ISS will treat CEOs who have not been in the position for three years (pages 9-11).
• The FAQs indicate that realizable pay, which is only relevant for S&P 500 companies where the company’s initial quantitative screen shows a high or medium concern, will include all amounts actually paid or realized during the specified measurement period.  ISS does not use the intrinsic value of stock options for its realizable pay calculation, because it views as important the economic value of underwater options (pages 9-10).
• In exceptional cases, an ISS peer group can contain 12 companies (page 17).
• For companies with fiscal year-ends subsequent to December 31, 2012, ISS will provide the opportunity to communicate changes made to its peer group (page 18).
• The FAQs discuss the issues surrounding problematic pay practices, including how ISS views the grant of retention awards to executives who did not receive a payout after a performance cycle ended due to failure to achieve goals (pages 19-21).
• The FAQs elaborate on ISS’ say-on-golden-parachutes policy, such as how ISS would treat: (i) a company that technically triggered a change in control but did not experience a bona fide change in control, (ii) performance measures that would not have been achieved in the absence of a decision to accelerate performance-based awards, (iii) the determination of whether specific payouts are “excessive” and (iv) existing problematic change-in-control severance features (pages 22-23).  ISS indicates that the best practice for paying out performance-based awards is pro rata vesting of the award based on current achievement.  In determining whether a golden parachute payout is excessive, ISS considers factors such as the value of the payout on an absolute basis, or one or total payouts relative to the transaction’s equity value.
• The FAQs address how ISS would determine the cost of an equity compensation plan for newly public companies and companies with limited partnership units (pages 24-25).

The Second Circuit recently issued a decision that relates to whether a sale of one class of equity security and a purchase of a different class of equity security issued by the same company can be "paired" under Section 16(b) of the Exchange Act to result in required profit disgorgement by the transacting insider. The Court held that, absent any guidance from the SEC, an insider's purchase and sale of shares of different types of stock in the same company does not trigger liability under Section 16(b) where those different classes of securities are separately traded, nonconvertible and have different voting rights.

Section 16(b) provides for the disgorgement of any profit realized by an issuer insider (including a greater than 10% beneficial owner of the issuer, an officer or a director of issuer, each as defined under the Section 16 rules) from any purchase and sale, or any sale and purchase, of any equity security of the issuer within a period of less than six months.  Between December 4, 2008 and December 17, 2008, John Malone, a director and large shareholder of Discovery Communications, engaged in 9 sales of Series C stock and 10 purchases of Series A stock. The two classes of equity securities are separately registered and traded (with different ticker symbols on NASDAQ) and they are not convertible into each other. Series A has voting rights while Series C does not. In addition, during 2008 and 2009, Series A generally, though not always, traded at slightly higher prices than Series C.

In upholding the lower court's decision, the Second Circuit relied largely on a plain reading of Section 16(b)'s use of the singular term "any equity security," which supports an inference that transactions involving different equity securities cannot be paired. The Court noted, however, that Section 16(b) could apply to transactions where different classes of securities are not meaningfully distinguishable. Here, the Court distinguished the two classes of securities because they have different voting rights, are not convertible into each other and do not have a fixed value relative to each other. 

A federal district court in Texas recently upheld the right of the SEC to seek clawbacks of bonus and other compensation under Section 304 of Sarbanes-Oxley from executives who have not been accused of any wrongdoing, by denying the executives’ motion for summary judgment. In the case, SEC v. Baker, the SEC is seeking reimbursement of bonuses, incentives and compensation from the CEO and CFO of Arthrocare in connection with the company’s restatement of its financial statements. The restatements were due to alleged fraud by two senior vice presidents of Arthrocare. The SEC did not allege that the CEO and CFO committed any conscious wrongdoing.

As we have discussed, the SEC had previously sought clawbacks under Section 304 from executives not charged with personal wrongdoing. The current case in Texas is apparently only the second time that a federal court has upheld the right of the SEC to seek clawbacks where the SEC has not alleged that the executives in question participated in the wrongful conduct. (The first case, SEC v. Jenkins, was decided by a federal district court in Arizona.) The court in Baker rejected the argument that the language of Section 304 required the misconduct of the officer from whom the reimbursement was being sought and found that Section 304 “require[s] only the misconduct of the issuer”. The court also rejected arguments by the defendants that Section 304 is unconstitutional and that they are protected by the Civil Asset Forfeiture Reform Act. In addition to cases where courts have upheld the right to clawbacks, the SEC has previously reached settlements to clawback compensation under Section 304 with executives not charged with personal misconduct.

Prior to these cases, it had been generally viewed that the clawback provisions of the Dodd-Frank Act, which provide for disgorgement regardless of whether misconduct has occurred, are broader than those of Sarbanes-Oxley. While the Dodd-Frank provision remains broader in many respects, this court case brings Section 304 one step closer to the Dodd-Frank provision.

More than 18 months ago, we alerted readers about a request for information by the Department of Labor (DOL) seeking suggestions from interested parties on the possibility of using electronic media by employee benefit plan sponsors to furnish information to participants.  The current ERISA rules under the DOL prevent companies from taking full advantage of using notice and access in lieu of paper copies of proxy statements for employee benefit plan participants as a practical matter.  We wrote a comment letter to the DOL in support of moving toward easily sending plan participants electronic versions of a company’s annual proxy statement. 

However, a recent survey by the AARP, titled “Paper by Choice,” will likely retain the status quo for the time being.  In response to concerns that the financial services industry is lobbying to allow retirement plan providers to send out plan documents electronically as the default method, the survey found that of the slightly over 1,000 respondents, 75% of those over the age of 25 prefer paper over online communications and 62% currently receive only paper copies.  

Many have criticized the survey as biased, primarily because it failed to ask participants about work-related computer access, which is the touchstone the DOL uses in its electronic delivery safe harbor, and although it asked those surveyed if they read disclosures electronically, no similar question was asked of those receiving disclosures by hard copy.  Nonetheless, the survey will still likely influence the DOL’s thinking about converting plan participants from paper to electronic, holding back efforts to give companies the ability to avoid stratifying notice and access mailings and moving completely to electronic means of delivery.

Glass Lewis recently released its 2013 Proxy Season Guidelines for the 2013 proxy season, which will go into effect for shareholder meetings taking place after January 1, 2013, an abridged version of which is publicly available. These updates should be viewed in conjunction with Glass Lewis’s policies on its say-on-pay analysis, which it updated in July, as discussed here. 

One of the more notable changes is regarding board responsiveness to a “significant” shareholder vote. Glass Lewis’s new policy provides that it will scrutinize board responses to any vote by 25% or more of shareholders (excluding abstentions and broker non-votes) against management’s recommendation on any proposal, including  “against” or “withhold” from a director nominee, “against” a management-sponsored proposal or “for” a shareholder proposal. Glass Lewis will assess board responsiveness on a case-by-case basis and will include a review of the company’s public disclosures following the annual meeting at which the vote took place.

Similarly, Glass Lewis’s policy is that at companies that received a shareholder vote of greater than 25% against their say-on-pay proposals, the board shall demonstrate engagement with and responsiveness to shareholders and that they will look for disclosure to this effect. In the absence of such disclosure, Glass Lewis will recommend holding compensation committee members accountable.

The updates also provide that in evaluating proposed equity-based compensation plans,  plans shall not count shares in such a way as to understate the potential dilution or cost to shareholders (the “inverse” full-value award multipliers); should not contain excessively liberal administrative or payment terms; and should select performance metrics that are challenging and appropriate.

Given say-on-pay votes, companies are interested in understanding how their shareholders view executive compensation. At the always informative NASPP conference, Michelle Edkins from BlackRock and Ann Chapman from Capital Research both mentioned a recent paper from Charles Elson of the Weinberg Center for Corporate Governance, titled "Executive Superstars, Peer Groups and Over-Compensation – Cause, Effect and Solution."

The paper argues that tying CEO compensation to external peer group benchmarking is unnecessary at best because the practice is based on a faulty premise of easily transferable executive talent. Citing various other studies, they question the frequency of CEO turnover, in particular, movements by public company CEOs to another public company. 

The authors believe that targeting compensation levels to either the 50th, 75th or 90th percentile of this peer benchmark has led to rising executive pay. This then creates a "leapfrog effect" through networks formed by the peer grouping process, as one company's "overpayment" then ripples through other companies for which they are a peer.

Instead, the authors advocate for a complex process of diminishing the focus on external benchmarking and developing instead internally created standards based on the specific nature of individual organizations. 

It's an interesting time to discuss peer benchmarking, as we've seen the influence in the past year of proxy advisory firms relying and evaluating companies' performance against their own formulated peer groups. The use of peer groups by those firms and companies are unlikely to go away, so perhaps the important point here is not so much whether companies find the paper's conclusions to be persuasive, but that it is useful to be aware that key institutional investors are reviewing these types of studies about compensation-setting. The paper’s arguments, and other similar external criticisms, may factor into investors' assessment of companies' compensation practices as they make voting decisions.

Since our last blog post on say-on-pay litigation in January 2012, there have been several dismissals of say-on-pay lawsuits on procedural grounds – principally the failure of plaintiffs to satisfy the demand standard, which requires a plaintiff seeking to bring a derivative action to first make a demand on the corporation’s board so that it can determine whether to pursue the action. Under Delaware law, failure to make a demand may be excused if the plaintiff can raise a reasonable doubt that (1) a majority of the board is disinterested or independent or (2) the challenged act was a product of the board’s valid exercise of business judgment. In particular, a number of lawsuits were dismissed, because they could not satisfy the first prong and could not successfully establish that a failed say-on-pay vote rebuts the board’s business judgment to satisfy the second prong.

For example, in January 2012, a plaintiff, without making a pre-suit demand, filed a lawsuit against Navigant Consulting, which had increased executive compensation for 2010 despite negative shareholder return. Although the plaintiff alleged that a say-on-pay approval vote of 45% was enough to excuse the demand requirement, a federal district court in Illinois applied Delaware law and ruled that this alone was not enough to raise a reasonable doubt of the board’s valid exercise of its business judgment. The court pointed out that the plain language of Section 951 of the Dodd-Frank Wall Street Reform and Consumer Protection Act provides that say-on-pay requirements do not (1) create or imply any change in the fiduciary duties or (2) create or imply any additional fiduciary duties of the company or its board.

Similarly, in March 2012, a California federal district court dismissed a lawsuit against Intersil Corporation, where the compensation of the company’s named executive officers for 2010 had increased by an average of 41.7% over the prior year. Intersil had received 44% approval for say-on-pay. The plaintiff did not make a pre-suit demand, and the court, applying Delaware law, held that additional facts must be pled to raise a reasonable doubt that the decision was not a valid exercise of the board’s business judgment.

A few months later in June 2012, in Monolithic Power Systems, the same California federal court, again applied Delaware law and held that a 36% say-on-pay vote did not raise a reasonable doubt of the board’s valid exercise of its business judgment when it increased executive compensation. 

These cases, decided by federal courts applying Delaware law, contribute to a line of cases holding that a failed shareholder say-on-pay vote alone does not rebut the business judgment rule presumption afforded to a board’s decisions, including in the realm of executive compensation. In contrast, a prior federal case applying Ohio law, the Cincinnati Bell decision, excused pre-suit demand on the board on the basis that, under Ohio law, the business judgment rule is an affirmative defense and not an element of excusing demand. It should be noted that, shortly after the Cincinnati Bell case was decided, the case was settled and thus there will be no appeal.

Despite the Cincinnati Bell ruling, which at this point appears to be anomalous, the growing consensus appears to be that courts will continue to defer to a board’s decisions regarding executive compensation, as long as such decisions are made in good faith and pursuant to the board’s fiduciary duties. For example, in Jacobs Engineering, the Superior Court of California, applying California corporate law, which the court stated is identical to Delaware corporate law, ruled that a say-on-pay approval vote of 45% in 2011 was not enough to rebut the board’s business judgment. Similarly, in BioMed Realty Trust, a Maryland federal district court, applying Maryland law, ruled that the mere involvement by directors in a challenged transaction as well as a say-on-pay approval of 46% was not enough to raise a reasonable doubt of the board’s valid exercise of its business judgment.
           
Despite these recent dismissals, there are still three ongoing say-on-pay lawsuits pending – against Hercules Offshore, Dex One and Janus Capital Group – that were filed prior to the annual shareholder meetings held in 2012.

Plaintiffs appear to be undeterred and continue to file say-on-pay lawsuits, which typically allege low or negative approval for say-on-pay as evidence of inappropriate pay practices. For example, in July 2012, a lawsuit was filed against First Merit Corp., which received 46% approval for its 2012 executive compensation. Plaintiffs alleged that the board’s decision to raise executive compensation was inappropriate, since the company’s stock price had declined by approximately 25% during 2011 and its long-term shareholder return had been negative over the last 10-, 5-, 3- and 1-year periods. Similarly, plaintiffs filed suit against Simon Property Group earlier this month, which received a say-on-pay approval of 26%, alleging that its board improperly approved the CEO’s compensation package, which had included a $120 million retention award through 2019 that is tied to the CEO remaining employed by the company, rather than being tied to the company’s performance. This lawsuit surprised many because Simon Property had experienced high performance (e.g., as disclosed in its 2011 proxy, the company stated it falls within the 94th percentile of all companies in the S&P 500 Index over the past 10 years). Additionally, plaintiffs have filed a lawsuit related to compensation disclosure, despite receiving positive approval on say-on-pay. For example, in July 2012, plaintiffs filed suit against Johnson & Johnson, alleging breach of fiduciary duties concerning the disclosures in the company’s annual proxy statements filed from 2008 through 2012. Johnson & Johnson received a 55% say-on-pay approval in 2012. These cases are all currently pending.

We are pleased to announce the publication of Getting The Deal Through – Corporate Governance 2012. Davis Polk lawyers Arthur Golden, Thomas Reid and Sapna Dutta authored the “Global Overview” chapter. 

We note this year that, as the wave of post-financial crisis corporate governance reform continues across the globe, the impact of the significant burdens on the regulators that are responsible for implementing these reforms is becoming increasingly visible. That said, we are also seeing a subtle divergence in the nature of these regulatory efforts in different parts of the world.  In the United States, regulatory efforts have focused primarily on implementation of the Dodd-Frank Act, which continues to require significant time and has resulted in delays in the rulemaking schedule. In contrast, Europe has seen more in the way of new initiatives, including the publication of the European Commission’s Green Paper on a future EU-wide corporate governance framework and the U.K. government’s significant proposals intended to curb executive compensation.

As the year goes on, we expect that U.S. and European companies will continue to experience intense pressure from regulators and shareholder advocacy groups in respect of their corporate governance practices on a number of fronts. It is inevitable that the reaction to the financial crisis of 2008 and the ongoing Eurozone crisis should provoke such severe and prolonged reaction.  What remains to be seen, if, as and when global economic conditions stabilize, is whether or not these ongoing governance reforms ultimately do anything to improve the competitiveness or actual governance of individual companies or the North American or Western European economies, or whether they are simply a series of responses – ranging in nature from remedy to retribution – that may be understandable, but perhaps not efficient in the long term. 

Read the “Global Overview” chapter >

For the past two proxy seasons, companies have criticized how proxy advisory services have selected company peer groups in order to evaluate “pay for performance” for purposes of making say-on-pay voting recommendations. Recently, Glass Lewis announced changes in their peer group selection methodology that will affect annual meetings held after July 1, 2012.

On July 12, 2012, Glass Lewis hosted a “proxy talk” during which they outlined enhancements to their proprietary pay-for-performance model. The most significant development is the change to peer groups. Since 2003, Glass Lewis has been using a process that is based on GICS codes, industry group and geographical region, but they will now use a “market-based” peer group approach developed with Equilar. Akin to social networking, Equilar starts with each subject company’s self-disclosed peers (direct peers). They also examine (a) the peers disclosed by the direct peers (second-degree peers), (b) the companies that use the subject company as a peer (incoming peers) and (c) the peers disclosed by incoming peers. The focus is on the direction of peer relationships and the similarity of peer groups, with peers ranked based on the strength of the connection, to ultimately identify up to 30 companies as the peer group for purposes of the say-on-pay analysis. The Glass Lewis report will display differences between the company’s self-disclosed peers and the Equilar-derived peer group.

Other enhancements include changes in performance metrics that Glass Lewis will consider (which includes total shareholder return, change in operating cash flow, EPS growth, return on equity and return on assets). In addition, there will be a slightly longer outlook of three-year weighted average of total compensation for CEO and Top 5 executives, instead of the prior test of one year. Glass Lewis’ dreaded letter grades will no longer be subject to a forced “curve” distribution, but will be assigned based on the relative level of compensation and performance against peers.

There is also a qualitative element to the analysis which Glass Lewis continues to emphasize, with the details largely similar to ISS in terms of the focus on the mix of pay, targets and metrics and best practices. Glass Lewis does tend to criticize companies for perceived poor or lack of disclosure.

Glass Lewis recommended against 16% of companies it reviewed in 2012 so far. While Glass Lewis does not offer any consulting services, companies can subscribe to Equilar to obtain the peer group information.

In related news, ISS, which also uses a GICS code-based peer group selection system (albeit different from Glass Lewis), announced that they will be changing their process for the upcoming proxy season, with effect for companies with annual meetings after February 1, 2013. We understand that this will be covered in ISS’s policy survey, which is expected to come out shortly.

In the midst of the focus on executive compensation litigation, a recent Delaware opinion serves as a reminder that stockholder approval of at least some portion of director compensation may be beneficial in subsequent litigation, particularly if the approval results in the application of the “business judgment rule.” However, as described below, uncertainty remains about the level of detail concerning director compensation that is necessary in a stockholder-approved plan to warrant the application of that rule. Companies and their boards will want to balance the desire to increase the likelihood that compensation decisions will be protected by the business judgment rule with the understandable preference to preserve flexibility in establishing director compensation. Director compensation remains an item to consider for a company (whether an existing public company or an IPO-ing company) that is seeking approval of a new or amended equity compensation plan.

On June 29, 2012, Vice Chancellor Glasscock of the Delaware Court of Chancery handed down a decision in Seinfeld v. Slager, a stockholder derivative suit focusing on executive and director compensation. The Court dismissed all claims against the defendants except for a claim that certain director equity awards constituted corporate waste.

The director equity awards challenged were granted under the company’s broad-based equity compensation plan, which was a typical stockholder-approved plan with a plan-wide limit on the number of shares available for grant, as well as an annual cap on awards that could be granted to any participant (including directors). The plaintiff argued that, because the director defendants awarded themselves the compensation under the plan, they were interested in the transaction and thus Delaware’s heightened “entire fairness” standard applied. Defendants, in turn, argued that because (a) the compensation plan was approved by the company’s stockholders, and (b) the plaintiff did not allege that the awards violated the terms of the stockholder-approved plan, the business judgment rule applied.

Vice Chancellor Glasscock distinguished the earlier In re 3COM Corp. Shareholders Litigation, which had accorded business judgment rule treatment to director awards granted under a stockholder-approved plan with specific annual limits for categories of director service, by finding that, in 3COM, there were “sufficiently defined terms,” whereas, in the present case, there were “no effective limits on the total amount of pay that can be awarded.”

Interestingly, Vice Chancellor Glasscock elaborated, “The sufficiency of definition that anoints a stockholder-approved option or bonus plan with business judgment rule protection exists on a continuum. Though the stockholders approved this plan, there must be some meaningful limit imposed by the stockholders on the Board for the plan to be consecrated by 3COM and receive the blessing of the business judgment rule . . . . A stockholder-approved carte blanche to the directors is insufficient. The more definite a plan, the more likely that a board’s compensation decision will be labeled disinterested and qualify for protection under the business judgment rule.”

While it remains to be seen how the plaintiff’s claim will be decided on the merits, Vice Chancellor Glasscock’s decision underscores the long-standing corporate law principle that self-dealing/interested transactions generally are subject to the heightened entire fairness review.

As to whether and how to implement changes in equity compensation plans going forward, the potential litigation benefits will need to be weighed against the need for flexibility to react to such factors as changes in the market for director compensation. For example, the articulated “continuum” approach to stockholder approval of director compensation in Seinfeld raises the possibility that approval of specific annual grants (as in 3COM) may not be necessary, but makes it clear that more specificity is better in terms of defending subsequent litigation.

As an aside, and in favor of the defendants, Vice Chancellor Glasscock also reaffirmed a point related to executive compensation that is worth noting here. Citing to Vice Chancellor Noble’s recent opinion in Freedman v. Adams, Vice Chancellor Glasscock reiterated that there is no general fiduciary duty to minimize taxes. In other words, a board may have reason to pay compensation that is not deductible as a result of Section 162(m) of the Internal Revenue Code, which restricts compensation deductions for payments made to a company’s CEO and other executives under specified circumstances.

Following closely on the heels of its announcement of a package of proposals  intended to curb executive remuneration, the U.K. Government recently published a consultation paper focusing on the content of remuneration reports of UK-incorporated quoted companies that would disclose the compensation of directors, including executive directors.  While much of the consultation paper simply echoes the announcement, which we summarized in our memo, it is fairly detailed and merits a close read.  Here are selected highlights:

• Remuneration reports would have two parts:
  • A policy report setting out all elements of a company’s remuneration policy and key factors that were taken into account in setting the policy. This part of the report will only be required when there is a shareholder vote on the policy.
  • An implementation report on how the policy was implemented in the past financial year, setting out actual payments to directors and details on the link between company performance and pay.

• The policy report would cover the following six elements:
  • Tabular disclosure of the key elements of pay and supporting information, including how each supports the achievement of the company’s strategy, the maximum potential value and performance metrics (the consultation paper helpfully provides an example in an annex at the end). This table would be accompanied by a narrative explanation of whether the remuneration policy for directors differs from the policy for other employees and, if so, an explanation of why.
  • Information on employment contracts.
  • Scenarios for what directors would get paid for performance that is above, on or below target, presented in graphical form.
  • Information on the percentage change in profits, dividends and overall spending on pay.
  • The principles on which exit payments would be made, including how they would be calculated, whether the company would distinguish between different kinds of departures or the circumstances of any exits and how performance would be taken into account.
  • Material factors that have been taken into account when setting the pay policy, specifically employee pay and shareholder views.
    • While the U.K. Government did consider requiring the disclosure of a CEO-median employee pay ratio, it concluded that this information would not be meaningful and, instead, proposed that the policy report set out information including the percentage increase in pay of the workforce and the percentage increase in pay of the CEO.
    • The policy report would also set out how shareholder views were taken into account in setting remuneration policy.

• The implementation report would cover the following nine elements:
  • Single total figure of remuneration for each director, presented in a specific tabular format disclosing: salary, benefits, pension, bonus, long-term incentives and total.
  • Performance against metrics for long-term incentives, including the following details:
    • What the performance conditions were and the relative importance of each.
    • Within each performance condition, the targets originally set and the potential level of award achievable.
    • For each performance condition, how the company performed against the targets set for that condition.
    • Where the remuneration committee had discretion, how it exercised that discretion.
    • The resulting level of award.

For those elements of pay that were awarded in relation to the financial period being reported on and were subject to deferral, the implementation report would also set out the percentage deferred and whether it was deferred in cash or shares.

• Total pension entitlements (for defined benefit plans).
• Exit payments made in the previous year, with further detail including:
  • The level of compensation received broken down into the key elements.
  • An explanation of how each element was calculated.
  • An explanation of how the decisions made relate to the policy on exit payments.
• Variable pay awarded in the previous year, including the following details for awards made in the current year under long-term incentive plans:
  • Scheme – the type of long-term award (e.g., shares, matching shares, options).
  • Basis of award – calculation of face value (e.g., X times base salary).
  • Face value.
  • Vesting maximum if above face value.
  • Percentage of the award that would vest at threshold performance.
  • Date performance period ends.
  • Summary of performance criteria if not set out elsewhere.
• Total shareholdings of directors.
• Chart comparing company performance and CEO pay.
• Information about who has advised the remuneration committee.
• Shareholder context, meaning:
  • How shareholders voted on both the binding vote and the advisory vote at the previous year’s annual shareholders meeting, set out as a percentage of votes cast.
  • Percentage of shareholder base that abstained.
  • Reasons for significant dissent where known.
  • Action taken by the remuneration committee in response.

• In addition, specified sections of the remuneration report, including the single total figure for remuneration, would be required to be audited.

• The remuneration report would be prefaced by a statement to the shareholders from the Chairman of the Remuneration Committee summarizing the key messages on remuneration and the context in which decisions have been taken.  The proposal declined to prescribe a form for this letter.

• Consistent with the current regime, the proposal would apply to all UK-incorporated quoted companies and would apply to the remuneration of all directors, with the intent that it would be most relevant for executive directors.  The U.K. Government intends to work with the UK Listing Authority to consider whether the requirements of the Listing Rules need to be reviewed.

• The consultation closes on September 26, 2012 and the proposed provisions would take effect for companies whose reporting years end after October 2013.

• These proposed regulations would replace, and not supplement, the existing disclosure requirements of remuneration reports.  Specifically, they would revoke and replace Schedule 8 of the Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (S.I. 2008/410).

Today, the SEC rules on the independence of compensation committees and advisers were published in the Federal Register. As we described in our memo, the listing exchanges have 90 days to propose implementation, and then a year from today to finalize the standards with approval from the SEC.

Since those are the outside dates, the listing exchanges can act much sooner. Depending in part on the comments received on the proposed standards, final standards may be adopted in time to apply to the 2013 annual meeting. We hope that the transition period for compensation committee independence standards will accommodate the fact that many boards evaluate director independence months before proxy statements are issued with related independence disclosure. Companies and boards will need sufficient time to modify their processes to evaluate additional independence factors required, or possibly even change the composition of their compensation committee.

In terms of compensation adviser independence, since there is no public disclosure required, the rules may not be affected by the proxy season (and proxy statement) timing. The importance in this case is for the listing exchanges to provide sufficient transition periods for companies to gather the necessary information and the compensation committee to examine the required factors. Companies will also need to consider whether their governance documents, including committee charters, should be modified to reflect the new rules.

As a reference, in a rule filing on April 2003, NYSE allowed companies 18 months following SEC approval to comply with the requirement to have a majority of independent directors (classified boards had 30 months if the affected director was not up for election). By the time the SEC approved those and other governance rules for NYSE and Nasdaq in November 2003, the implementation schedule had been revised to apply to the following year's annual meeting.

Yesterday marked an active day on the corporate governance front. First, the U.K. Government announced “a far reaching package of reform to strengthen the hand of shareholders to challenge excessive pay.” The hallmark of this package is a binding shareholder vote on prospective compensation and exit payments. Other elements include a continued shareholder advisory say-on-pay vote, as well as enhanced disclosure regarding actual amounts of remuneration paid during the prior year.

Second, the SEC finalized its rule requiring listing standards for compensation committees and their advisers, as required by the Dodd-Frank Act. The final rules largely adopt the SEC’s proposed approach, which in turn closely follows the original statutory language. However, there are a few changes, such as narrowing the disclosure requirement regarding compensation consultants, which many had complained as overly extensive. In any event, there is much more to come, as the exchanges must now propose listing standards on several key elements within 90 days of the SEC rule’s publication in the Federal Register, and it is conceivable that they may expand beyond the limited statutory language. There may also be practical implications for companies in terms of possible committee charter amendments and procedures for the committee to consider adviser independence and consultant conflicts.

We will be summarizing both developments in further detail, but wanted to alert our readers in the interest of time.

The U.S. Chamber of Commerce recently sent a letter to the SEC asking the regulator to "monitor the activities" of Glass Lewis, questioning whether the proxy advisory firm's recent vote recommendations for the 2012 Canadian Pacific Railway meeting was influenced by its parent company, the Ontario Teachers' Pension Board. The letter pointed out that the Ontario Teachers' opposition to the board of directors of Canadian Pacific Railway was followed by Glass Lewis issuing a recommendation that shareholders vote for the alternative slate of directors. The Chamber questions the "tangible conflicts of interest in the operation of proxy advisory firms."

Glass Lewis issued a press release refuting the Chamber's assertions. In a fairly defensive statement, Glass Lewis' first response, although not pertinent to the issue, is that it does not offer consulting services to public companies or their directors. Glass Lewis noted that it fully disclosed the potential conflict on the front cover of the relevant research report that Ontario Teachers has a stake in Canadian Pacific (although the excerpt of the cover did not indicate Ontario Teachers' position) and that the timing of the report was driven by meetings with the company and dissidents. In addition, Glass Lewis also emphasized that it recommended for seven of the company's nominees while Ontario Teachers voted against all of them, and highlighted two incidents where the firm's recommendations differed from Ontario Teachers' votes in the last two years. 

With proxy season in full swing, we wanted to provide an update on this year’s say-on-pay findings to date and compare them to results from last year at this time, almost to the day.  As of the end of last week (May 18, 2012), 639 large accelerated filers reported the voting results from their shareholder meetings. Note that these results do not account for any companies that adopted a triennial or biennial say-on-pay vote, nor do they include smaller companies.

Percentage Approval	Large Accelerated Filers by Say-on-pay Vote   (as of May 18, 2012)	Large Accelerated Filers by Say-on-pay Vote (as of May 20, 2011)
90-100%	454	540
80-89%	85	126
70-79%	40	65
60-69%	22	40
50-59%	23	14
40-49%	8	9
30-39%	4	7
20-29%	3	1
0-19%	0	0
Total	639	802

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Approval for say-on-pay votes has remained high so far this season, as the average say-on-pay results for all large accelerated filers is 89%.  The findings to date reveal that less than 16% of large accelerated filers reported say-on-pay results below the 80% approval level (compared to less than 17% by this time last year), and less than 10% reported results below the 70% approval level (compared to less than 9% by this time last year).  Companies that garnered less than 70% approval last year received extra scrutiny from ISS this proxy season.

So far this year, a total of 15 large accelerated filers have lost their say-on-pay votes (compared to 17 by this time last year) - 14 of them received “against” recommendations from ISS.  To date, large accelerated filers with “against” recommendations that lost their say-on-pay votes this season have averaged 39% approval, while the large accelerated filer with a “for” recommendation that lost its say-on-pay vote received 41% approval. 

Large accelerated filers that received a “for” recommendation from ISS are averaging 92% approval this season. 

A total of 27 large accelerated filers reported losing their say-on-pay votes during the 2011 proxy season, of which all except one that have had their meetings to date (14) have reported shareholder approval in 2012.

This proxy season there has been a lot of focus on companies filing additional soliciting materials to supplement proxy disclosure, with a particular focus on executive compensation in light of the say-on-pay vote. Exxon Mobil has taken a particularly interesting approach turning a two-dimensional paper communication into something more dynamic by inviting interested persons to a company-sponsored webcast on executive compensation.

The webcast represents an additional proactive step Exxon has taken. On the same day it filed its proxy statement, Exxon took the unusual step of also filing a colorful presentation filled with data, graphs and photos to explain how its pay-for-performance approach focuses on the long-term nature of its capital-intensive business. In supplemental information filed more recently, Exxon took issue with specific aspects of the ISS analysis, including the peer group selected, which Exxon asserted failed to adjust for its size and complexity, since the company's revenue is more than 4X larger by revenue and 3.5X larger by market capitalization than the median of the peer group. 

On the webcast, which included a presentation, Exxon representatives discussed the company's business environment, the scale and scope of the company and its focus on the long-term nature of its business strategy. The company explained that together, these form the basis for customized compensation decisions, including a lengthy "hold-to-retirement" policy and a unique approach on the deferral of 50% of annual bonuses, a measure rarely seen outside of financial institutions. The company's focus on executive training, retention and succession was emphasized, including the fact that the company achieves its retention goals without change in control or severance agreements with senior executives. The company also discussed the shareholder engagement it undertook as a result of last year's say-on-pay vote. In response to questions during the webcast, the company noted how its programs focus on performance assessments that take a more holistic approach rather than concentrating on formulas that inspire executives to reach for only certain specific goals. The company received several questions about specific aspects of its pay decisions, the reasons for the webcast and the proxy advisory firms' recommendations.

The U.K.’s implementation of “say on pay” in 2002 is widely considered the harbinger of mandatory “say on pay” in the United States. So far, in both countries, the shareholder advisory vote on executive compensation has been non-binding on companies and their boards. Now, the U.K. appears to be moving toward a binding regime. Earlier this spring, the U.K. government’s Department of Business Innovation & Skills (BIS) published a consultation paper setting out a range of measures, including:

• An annual binding vote on future remuneration policy;
  
  
• An increase in the level of support required on votes on future remuneration policy (up to 75% of votes cast);
  
  
• An annual advisory vote on how the company’s pay policy was implemented in the previous year (same as the status quo); and
  
  
• A binding vote on “exit payments” of more than one year’s salary – with “exit payments” including not only cash severance payments, but also the vesting of equity compensation, continuation of benefits, etc.

How This Differs from Current Practice

Currently, the U.K.’s “say on pay” vote is limited to a shareholder advisory vote on the compensation of the executive directors (by approving the directors’ remuneration report). The vote is retrospective in that it relates to the prior year’s compensation.  Under the proposal, the retrospective vote would remain advisory; however, there would also be a binding vote on future pay, where an affirmative vote would require a supermajority. Companies would be required to propose, at the start of the year, a pay policy for the upcoming year, including potential payouts and the performance measures that would be used. This proposal would then be put before shareholders. If, for some reason, the binding vote were lost, the company would be required to fall back to the last policy to be approved or hold another shareholders meeting so that shareholders could vote on a revised proposal.

To facilitate this binding vote on future remuneration, the U.K. government intends to publish draft regulations later this year, which will prescribe the content of remuneration reports. The regulations are likely to state that the section of the report that discloses the company’s future remuneration should include the following elements:

• The composition and potential level of pay for each individual executive director;
  
  
• How proposed pay structures reflect and support company strategy and key performance indicators;
  
  
• What the performance criteria are, how performance will be assessed and how this will translate into total level of reward for each individual under different scenarios (e.g., on-target and stretch performance);
  
  
• How and why the company has used benchmarks and other comparison data to inform pay levels and structures;
  
  
• How employee pay and views have been taken into account; and
  
  
• How shareholders’ views have been sought and taken into account, including the results of the previous year’s votes on remuneration.

In addition, there would also be a binding vote related to any severance arrangements for an executive director exceeding the equivalent of one year’s base salary. A company proposing to pay a higher amount would be required to provide detailed information explaining the proposed amount, how it was calculated and why it is deserved. This proposal would then be put to shareholders. If the vote were lost, the company would not be able to pay the exiting executive more than the basic limit. Existing arrangements would be required to be amended prior to legislative effectiveness (as noted below, currently slated for October 1, 2013).

What to Expect Next

Already, this spring has been a tumultuous one for U.K. public companies. Three major companies – including, most recently, Aviva, Britain’s largest insurer – have witnessed the departures or imminent departures of their CEOs, in connection with compensation arrangements that drew shareholder ire. And, just before their annual shareholders meeting, Barclays announced that a portion of the bonuses for the CEO and Finance Director would be subject to performance criteria. An unanswered question is whether these developments will serve to embolden shareholder activists, or whether they are Exhibit A that shareholders already have the ability to exert their will in compensatory matters.

As a formal matter, the consultation period closed on April 27, 2012, and our understanding is that a number of market players, including trade and business organizations, have commented on the proposals. The consultation paper notes that the government will consider the comments received and confirm the exact measures it proposes to take forward in primary legislation later this year, subject to parliamentary time being available. 

Subject to the parliamentary process, the government expects legislation on new shareholder voting rights and revised reporting requirements to come into force in spring 2013. These provisions would take effect for companies whose reporting years end after October 1, 2013, and for executive directors whose contracts are terminated after that date; thus, this would impact shareholders meetings held after October 1, 2013.

It is contemplated that, in the first instance, these changes will be adopted via amendments to the U.K. Companies Act (analogous to the general corporation law of many U.S. states). Thus, they would apply to all U.K. public companies (the consultation paper notes that there are over 1,000 U.K.-incorporated companies listed on the London Stock Exchange’s Main Market as of January 31, 2012, plus another 100 or so U.K.-incorporated companies listed on the NYSE, Nasdaq or in a European Economic Area state).

However, given the perceived anti-competitive effect that this could have on U.K.-incorporated companies (who might even seek to redomicile elsewhere), it remains to be seen if any changes along these lines will be implemented more broadly through other means, such as through the requirements of the UK Listing Authority or the index inclusion rules.

In 2011, companies included in their proxy ballots a choice for shareholders to advise on whether they preferred to cast advisory votes on executive compensation every 1, 2 or 3 years, the so-called "say-when-on-pay" or frequency vote. Item 5.07(d) of Form 8-K required issuers that did not otherwise announce their decisions earlier to file a second, amended Form 8-K. That deadline was months later, either 150 calendar days after the meeting or 60 days before the shareholder proposal deadline, whichever came first. The SEC Staff realized this year in reported news accounts that possibly hundreds of companies did not file the amended Form 8-K. 

Failure to file this Form 8-K can lead to the loss of Form S-3 eligibility, but the SEC Staff appears willing to consider granting a waiver to those companies that have implemented the frequency that the majority of shareholders supported, which was the case for all but a handful of companies. To obtain a waiver (which the Staff prefers to characterize as a "non-objection"), a company with an existing shelf registration or one that is about to file a shelf registration must file the amended Form 8-K and make a request by writing a letter and uploading it to the new SEC site. 

A company will work directly with Office of the Chief Counsel on the exact content of the letter, but in general the information may include:

• Whether the company has an existing Form S-3 registration statement or is planning to file one
  
• A request for the waiver, including any requests to use an existing Form S-3 registration statement or the ability file a new one
  
• Background on the frequency vote conducted and the board's decision as to the frequency selected
  
• The reasons for the failure to file the Form 8-K on a timely basis
  
• Whether the company received a shareholder proposal on the frequency of the advisory vote on executive compensation for the 2012 meeting
  
• Whether the company has previously failed to make any required Exchange Act filings on a timely basis
  
• Processes and procedures implemented to ensure timely Exchange Act filings in the future

The Staff will respond orally and will not confirm in writing. 

In year two of say-on-pay, we find that companies continue to file additional materials to solicit for favorable votes. These additional materials are generally in the form of a brief letter to shareholders highlighting aspects of executive compensation.  Most are in the form of descriptive narratives, although a few companies use graphs and charts and even PowerPoints. While a few are filed early on following the proxy statement, the majority appear to be in response to negative recommendations on say-on-pay from proxy advisory firms. 

Proxy disclosure this season has been thorough and detailed, which would suggest that additional materials are not technically necessary. However, even with lengthy disclosure on executive compensation, companies have many reasons to want to file additional materials. They may wish to highlight key aspects of compensation without worrying about including all the different aspects necessary for compliance with SEC rules, or the proxy advisory firms' reports have narrowed the main issues that become important to discuss. Some materials provide companies with a set of talking points or script for conversations with shareholders, and others believe that investors benefit from having a clear set of reasons in summary form as ammunition to reject the proxy advisory firms' recommendations.

A threshold question is whether to directly address the criticisms from the proxy advisory firms' reports. Most companies do usually focus at least on ISS pay-for-performance analysis (a favorite statement this season has been that the ISS peer group methodology is deeply flawed). This is not a surprise, since that analysis appears to be the primary source of most of the negative recommendations in the first place. 

So far, we have not seen many companies actually modify existing compensation in any way, along the lines that Disney and GE did last year. Recently however, NCR Corp. initially filed materials that advocated for the company's say-on-pay vote, explained its compensation decisions and rebutted ISS, but about a week later, the company indicated that after discussions with shareholders, it decided to add performance conditions to the CEO's existing special retention award that were initially granted as time-based restricted stock units.  This reportedly changed ISS' recommendations, and the company's vote was ultimately about 80% favorable.  

Glass Lewis released a brief overview that it calls a "Primer for Issuers." Glass Lewis reiterates that it does not engage in discussions with companies during the proxy solicitation period because of concerns about the possibility of receiving material, nonpublic information. However, it will sometimes host a Proxy Talk conference call during which a company's management or board can speak directly to Glass Lewis' clients.

Board Matters. It is not always clear when a director will run afoul of Glass Lewis' voting recommendations. The Issuer FAQ provides some information about related person transactions, noting that a director who controls more than 20% of voting stock would be deemed an affiliate. Different types of relationships receive varying levels of scrutiny assessed against different financial thresholds. The condensed proxy voting guidelines are truly "abridged" and only provide the most general of discussions on different voting matters.

Pay-for-Performance Analysis. Some information in this section also raises more questions than provides answers. The Glass Lewis model examines six indicators (stock price change, change in book value per share, EPS growth, total return, return on equity and return on assets) and the total compensation of executives against four different peer groups (industry peers, sector peers of similar size, companies of similar market capitalization and companies in the same geographic regions). Each peer group is assigned a weight based principally on the market capitalization of the company. In the Issuer FAQs, Glass Lewis notes that it uses market-based data to calculate shareholder returns from FactSet and, like ISS, finds peers from the Global Industrial Classification System (GICS).

In the end, the model calculates an executive compensation percentile and a performance percentile against peers. A final numeric score is then calculated for each company based on these weighted-average percentile scores, which are then placed on a forced curve, producing the infamous Glass Lewis letter-grade on compensation.  20% of companies receive As and 10% receive Fs.  The remaining distribution is not disclosed. 

Say-on-Pay Analysis.  The above pay-for-performance discussion makes up only the quantitative aspect of the Glass Lewis say-on-pay analysis.  Here issuers will find more lists and charts and general descriptions of items examined to come up with the say-on-pay recommendations.  With more negative recommendations on say-on-pay when compared to ISS, one thing to note that makes Glass Lewis quite different is its focus on proxy disclosure, particularly with respect to performance metrics.

In a recent study trying to determine whether and how any of this matters, The Conference Board, NASDAQ, and the Rock Center for Corporate Governance at Stanford University surveyed 110 companies.  More than 70% reported that their compensation programs were influenced by the guidance received from proxy advisory firms or by the policies of these firms.  The study found that a negative recommendation from ISS, on average, influences between 13.6% to 20.6% percent of say-on-pay votes.

The impact is further detailed in a different study that examined the reports issued for the S&P 1500, concluding that a negative recommendation from ISS is associated with 24.7% (12.9% for Glass Lewis) more votes against say-on-pay. When both advisors make negative recommendations, voting dissent is higher by 37.9%.  According to this study, not all "Against" recommendations have the same impact.  The impact is greater when ISS identifies a problem in pay-for-performance and change-in-control agreements, and when it identifies a problem in more than one category.  In the case of Glass Lewis, the impact is higher for companies with the worst letter-grade ratings. 

Yesterday, the SEC sued two former executives of Arthrocare Corporation, a manufacturer of medical devices, to recover bonuses and stock profits they had received after the company had filed false financial statements. In doing so, the SEC continued its policy of seeking to apply Section 304 of Sarbanes-Oxley to executives who have not been personally charged with the fraudulent financial statements.

Under Section 304, if “an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct,” then its CEO and CFO is required to reimburse the issuer for certain compensation received or profits made from the sale of the issuer’s stock during the 12-month period after the fraudulent financial statement was filed. While the SEC had previously settled charges against two other Arthrocare executives who were charged with fraudulently overstating the company’s revenues and earnings, it did not charge the CEO or CFO with any personal misconduct in its current complaint.

In a previously litigated case, SEC v. Jenkins, the District Court of Arizona held that disgorgement of compensation and profit pursuant to Section 304 of Sarbanes-Oxley does not require personal misconduct.

In its press release, Robert Khuzami, the Director of the SEC’s Division of Enforcement, stated that clawbacks under Sarbanes-Oxley are “yet another reason for CEOs and CFOs to be vigilant in preventing misconduct and requiring that companies comply with financial reporting obligations.”

At the Walt Disney Company’s annual meeting of shareholders today, shareholders approved Disney’s controversial executive compensation plan and voted to reelect Disney’s slate of directors, despite negative recommendations by the ISS.  ISS had recommended against voting for the members of Disney’s Governance and Nominating Committee because of the decision to appoint its Chief Executive Officer, Bob Iger, as Chairman of the Board at the annual meeting, thereby reversing “a commitment to independent board leadership without conducting outreach to shareholders beforehand.” Disney had not combined the roles of CEO and Chairman since 2004.   ISS also recommended against Disney’s say-on-pay vote.

Disney had vigorously opposed the negative ISS recommendations. In recent SEC filings, Disney asserted that its action of combining the CEO and Chairman roles was part of a well thought-out succession and transition plan for its CEO who is expected to retire in 2016. Disney also stated that it expected to appoint an independent lead director with duties and responsibilities “that, ironically, exceed in scope those recommended by ISS.” Disney found that ISS’s recommendation on its compensation plan are “based on both flawed premises and methodology.”  Disney disputed ISS’s choice of peer group and also compared its total shareholder return to that of the S&P 500 and found that it was four times greater during Mr. Iger’s tenure as CEO.   

Disney’s executive compensation plan was reportedly approved by 56.6% of the shares cast while 42.8% opposed.  This is down from last year when 76.8% shares supported the compensation plan and 22.7% opposed it.  Although Disney might deem this a “win”, it will be interesting to see if this relatively low approval rate will result in greater scrutiny of its compensation plan by shareholders and proxy advisory services next year.

Among the new proxy disclosure requirements under the Dodd-Frank Act is the mandate that issuers disclose in their CD&A “[w]hether, and, if so, how the registrant has considered the results of the most recent shareholder advisory vote on executive compensation… in determining compensation policies and, if so, how that consideration has affected the registrant’s executive compensation decisions and policies.”  Thus far, the vast majority of the 110 large accelerated filers who filed proxy statements in the 2012 season through February 29, 2012 have addressed this new requirement in their CD&As.  Generally, the disclosure has been fairly predictable: those that received lower shareholder approval ratings on say on pay in 2011 have provided lengthier disclosure, often addressing changes made to their compensation programs, while those that received stronger shareholder support have simply stated that they have considered the results and decided to continue their previous compensation practices in light of the support.

However, 14 large accelerated filers have failed to disclose the effect of the 2011 say on pay vote results in their CD&As.  Of these, 9 did not mention the say on pay vote in their CD&A at all.  Five companies reported last year’s vote results but did not go on to discuss whether or how the company considered the result.

Interestingly, the failure to disclose the effect of last year’s say on pay vote has not negatively affected either ISS recommendations regarding this year’s say on pay proposals or say on pay results in 2012.  Of the 14 companies discussed above, the 9 that have received a recommendation on their 2012 say on pay proposal from ISS have all received a “for” recommendation.  Of the 14 companies discussed above, the 6 that have reported their 2012 say on pay results as of February 29, 2012 have all received above 90% shareholder support.  The lack of focus on the new disclosure by ISS and shareholders may be because all of these companies received at or above 89% shareholder support in 2011.  Query whether the SEC will be as forgiving with respect to companies that do not address the new disclosure requirement.

• Just in time before most proxy statements are issued, the SEC staff has issued a CDI on how say-on-pay resolutions should be described on proxy cards and voting instruction forms, with specific examples given of resolutions that would be considered compliant.  The four examples (To approve the company’s executive compensation; Advisory approval of the company’s executive compensation; Advisory resolution to approve executive compensation; and Advisory vote to approve named executive officer compensation) all contain the notion of "approval" in casting the vote.   The Staff indicated it was concerned that some resolutions, such as "To hold an advisory vote on executive compensation," are not sufficiently clear.
• Western Union has announced that it will drop its plans to adopt a proxy access bylaw, in light of its decision to declassify its board and "its ongoing assessment of whether proxy access should be included in the Company’s corporate governance structure."
• CalPERS, other pension funds and investors submitted a letter to the SEC asking that the Commission focus on certain priorities in the next 12 months.  The list includes proxy access, the remaining executive compensation provisions required under the Dodd-Frank Act, International Financial Reporting Standards (IFRS) and corporate disclosure on sustainability issues, such as environmental matters and board diversity. 
• As noted on TheCorporateCounsel.net, Apache and John Chevedden have reached a settlement in the Southern District of Texas, permitting Apache to exclude Chevedden's shareholder proposal, which Apache had disputed with respect to Chevedden's proof of ownership.  Chevedden's appeal in the Fifth Circuit with respect to a similar prior case (KBR v. Apache), is pending. 
• The NY Post reports that a whistleblower has filed a complaint with the SEC alleging that an employee in the Boston office of ISS has been providing proxy solicitors with shareholder voting data in exchange for cash and gifts. 

The Oregon district court provided a ray of hope for companies fearing the possibility of shareholder say on pay litigation when it handed down its January 11, 2012 decision granting Umpqua’s motion to dismiss a shareholder derivative suit alleging directors’ breach of duty and officers’ unjust enrichment after an increase in executive compensation.  In the decision, Magistrate Judge Acosta rejected the shareholders’ arguments that demand was futile because the directors were not independent or disinterested.

In Umpqua, plaintiff-shareholders argued that, where directors were likely to be subject to liability for the challenged actions, they could not be disinterested.  The court rejected that reasoning in this context, saying that an adverse say on pay vote coupled with the award of increased compensation did not reach the necessary threshold of substantial likelihood of liability necessary to show that demand would be futile under Delaware law.  (See our October 17, 2011 blog post on the success of companies in dismissing shareholder say on pay suits under Delaware and New York law).  That reasoning had been successful in defeating dismissal under Ohio law in Cincinnati Bell, a case filed by the same firm representing the plaintiffs in Umpqua.  The Oregon court disagreed, stating that accepting the reasoning “that presuit demand is itself suggestive of impending liability [and] is sufficient to create the type of self-interest that triggers the demand futility exception. . . would permit every derivative action plaintiff to argue that demand is futile. . . because no board would be able to act objectively in evaluating presuit demand.”  This would essentially negate the purpose of the demand requirement.

Despite the positive nature of the Umpqua decision for potential defendant-companies and the fact that, as the Umpqua decision points out, the holding in Cincinnati Bell has recently been called into question by jurisdictional defects, Cincinnati Bell Inc.’s December 20, 2011 decision to settle one of the say on pay shareholder suits may continue to fuel the plaintiffs’ bar’s desire to bring further suits.  For example, suit was filed against Navigant Consulting, Inc. on January 19, 2012 in the Northern District of Illinois alleging breach of fiduciary duty on the part of the board and executive officers for increasing executive compensation during a period of decreasing shareholder value.

It remains to be seen if court decisions such as that in Umpqua will quell the lawsuits.

NOTE: Umpqua was dismissed without prejudice.

Contact Kyoko Takahashi Lin. Contact Gillian Emmett Moldowan.

In December, ISS issued a whitepaper providing further guidance on its new pay-for-performance review framework first introduced in its 2012 proxy voting guidelines update (effective for meetings on or after February 1, 2012).  As described in our memo New ISS Policies Overhaul Say-on-Pay Analysis (November 29, 2011), the revised pay-for-performance methodology includes both a three-part quantitative analysis and a qualitative analysis.  The quantitative analysis is made up of two relative measures (“Relative Degree of Alignment,” comparing CEO pay and TSR performance against a comparison group over 1- and 3-year periods, and “Multiple of Median,” comparing the prior year’s CEO pay to the median pay of a comparison group for the same period) and one absolute measure (“Pay-TSR Alignment,” comparing trends in CEO annual pay and the value of an investment in the company over the prior 5-year period).

The whitepaper provides extensive detail on ISS’s pay-for-performance evaluation methodology, which continues to analyze pay based on award opportunity (and not realized pay) with a focus on Total Compensation as reflected in a company’s Summary Compensation Table.  Of particular interest, the whitepaper provides insight into (1) how ISS will construct a company’s relative alignment comparison group and (2) how the results of a company’s quantitative analysis will determine whether ISS considers the company to be at risk of having a pay-for-performance disconnect.

Comparison Group.  Comparison groups will consist of 14 to 24 companies selected from a database of more than 4000 companies (the Russell 3000 index, together with publicly traded peers disclosed by Russell 3000 companies in their proxy statements).  Comparison groups will be constructed twice per year, and will be selected from a group of companies within the same 2-digit GICS category, between 0.45 times and 2.1 times annual revenues (assets for financial companies) and with market capitalizations between 0.2 times and 5 times.  In constructing a comparison group, ISS will start with companies within the same 6-digit GICS category and those closest in revenue and market capitalization.  Approximately 25 unidentified “super-mega” non-financial companies (over $50 billion in revenue and at least $30 billion market capitalization) will make up their own comparison group.

Impact of Quantitative Analysis. The quantitative analysis is intended to identify companies with a likely pay-for-performance disconnect by identifying companies that are (1) high concern with respect to a single evaluation measure or (2) medium concern with respect to two or three evaluation measures.  The whitepaper includes the following table showing where results would trigger concern:

Measure	Medium Concern		High concern
Relative Degree of Alignment	-30	~25th percentile	-50	~10th percentile
Multiple of Median	2.33x	~92nd percentile	3.33x	~97th percentile
Pay-TSR Alignment	-30%	~10th percentile	-45%	~5th percentile

ISS’s new approach to evaluating pay-for-performance alignment is complex and may be difficult for companies to model on their own.  Despite this challenge, there are a number of actions companies can take to ready themselves for the second year of say-on-pay as described in our Say-on-Pay Year Two: a Planning Primer (December 13, 2011) memo.

Contact Kyoko Takahashi Lin. Contact Gillian Emmett Moldowan.

Proxy season 2012 has begun and we’re beginning to see disclosure on the impact of last year’s say on pay voting results.  As of December 16, 2011, 14 large accelerated filer companies have filed proxy statements for the 2012 season.  These proxy statements disclose whether, and to what extent, the companies considered the results of their 2011 management say on pay proposal and how that affected their compensation decisions and practices.  Unsurprisingly, the ten companies with high shareholder approval ratings (83% and higher) have provided simple and unremarkable disclosure.  These companies generally acknowledge their high ratings and cite them as support for continuing their compensation practices.

In contrast, disclosure varied among the four companies with lower shareholder approval ratings.  Mueller Water Products, Inc., who received approximately 78% approval from its shareholders in 2011, kept its disclosure short, indicating that the results were taken into account in determining the amounts of annual cash incentive awards for 2011 and in setting bonus targets for executive officers for 2012.  Johnson Controls, Inc., Jacobs Engineering Group, Inc., and Monsanto, Co., who had 60%, 45%, and 65% approval ratings respectively, all provided lengthy disclosure regarding how say on pay results were considered, and two companies disclosed changes in their compensation practices. 

Johnson Controls and Jacob Engineering both stated that feedback from investors was a factor in their decisions to modify their practices, with Johnson Controls changing annual and long-term incentive performance plan targets and Jacobs Engineering changing the form of awards and adding a performance condition to its long-term equity based incentive program.  In contrast, Monsanto did not alter its compensation practices in light of its results from say on pay.  Monsanto said that discussions with shareholders suggested no common reason for the negative votes and hypothesized that the results stemmed from poor fiscal performance in 2010.  Monsanto said it believes its compensation practices are sound and, based on improved performance in 2011, it thinks it will have improved say on pay results in 2012.

It appears that companies with solid support for their compensation practices are not providing extensive disclosure on the impact of say on pay results, while those who did not fare so well are taking steps to demonstrate they take say on pay seriously—even if they aren’t changing their compensation practices.  This bifurcated approach aligns with what we are hearing in discussions with other companies regarding disclosure for the 2012 proxy season.

Contact . Contact .

During its 2012 North American Proxy Season review, proxy advisory services firm Glass Lewis looked back to the 2011 proxy season and also gave insights as to what we can expect from them in 2012.  Highlights included:

Say-on-Pay.  Glass Lewis recommended against 17.5% of say-on-pay proposals in 2011.  They use a proprietary model to evaluate companies and come up with "A" to "F" grades.  10% of companies that they reviewed received "F"s in 2011, with the average say-on-pay results at those companies at 73%.  While, like ISS, they cite pay for performance issues as the primary reasons for causing negative recommendations, Glass Lewis also tends to cast an unusual focus on CD&A disclosure that sometimes surprises companies.  According to Glass Lewis, they find it problematic when companies disclose performance measures but not the rationale for the selection or the weighting of the measures, or when they perceive inadequate discussion of a compensation committee's exercise of discretion.  Glass Lewis grades CD&A disclosure as "poor, fair and good," and 5% of companies received "poor" citations in 2011.  They mentioned Amazon as an example of a company that, in their view, both performs and has appropriate executive compensation, but has poor CD&A disclosure.  In terms of evaluating company responses to prior year say-on-pay votes, Glass Lewis will examine those companies that received at least 75% negative votes for whether to recommend against either the chairman of the compensation committee or the entire committee, depending on companies' engagement efforts with shareholders and then the level of responses. 

Shareholder Proposals, Including Proxy Access.  Glass Lewis data shows that there were 443 shareholder proposals in 2011, a decrease from 591 in 2012, mainly attributable to the absence of compensation proposals in light of mandatory say-on-pay.  This year's most popular proposal, given the election year, will likely be on political contributions and related topics.  As for proxy access shareholder proposals, similar to ISS, Glass Lewis will review those on a case-by-case basis before making recommendations, including the percentage ownership requested and holding period requirement.  Their list of factors that they will consider is much longer than the ISS policy, including an analysis of the company's shareholder base in both percentage of ownership and type of shareholders, responsiveness of board and management to shareholders as evidenced by "progressive shareholder rights policies" such as annual elections and majority voting, and company performance and steps taken to improve bad performance. 

Exclusive Forum Provisions.  Glass Lewis discussed the selection of Delaware as an exclusive forum for shareholder derivative suits by 80 companies as of November, adopted either after seeking shareholder approval or by board action alone.  We recently blogged about ISS policies on this matter.  Like ISS, Glass Lewis generally recommends against an exclusive forum provision and a company will need to demonstrate that it has a long history of suffering from frivolous lawsuits to justify the proposal.  But Glass Lewis also takes it a step further and will recommend against the chairman of the governance committee if the company adopts exclusive forum provisions either without shareholder approval or pursuant to a bundled bylaw or charter amendment (where exclusive forum is coupled with other changes).  If a company adopts an exclusive forum provision before a company's IPO, Glass Lewis will recommend against the chairman of the governance committee or the board chairman if there is not a governance committee chairman. 

Talk to Us Now.  Glass Lewis reiterated that they do not engage with companies during the proxy season, long a frustrating policy for companies after they receive negative Glass Lewis reports, but they are available for discussions during the off-season.  At times during the proxy season, they will sponsor "proxy talks" involving a specific company and invited clients. 

Contact .

Although the SEC staff has publicly stated that the clawback provision is the most complex of the remaining Dodd-Frank governance rulemaking, the most controversial provision appears to be the requirement to disclose the ratio between the CEO total compensation and the employee median.  Given the specific and prescriptive nature of the legislation, interested parties have been struggling for some time to come up with a workable solution, while some continue to argue for outright repeal.   

In August, the AFL-CIO suggested that the SEC could permit issuers to comply through the use of statistical sampling, with SEC guidance on how to construct the sample methodology, such as sample size and specific confidence levels, as well as allowing issuers to identify the median employee based solely on cash compensation.  Certain SEC staff members have publicly declared the idea "interesting" and worth considering as they develop proposed rules.  The SEC website still indicates that proposed rules are planned before the end of 2011. 

Now the Center for Executive Compensation, which represents the senior HR representatives of more than 325 of the largest US corporations, has responded with its own letter to the SEC.  After conducting a survey of its members, the Center concluded that statistical sampling would be extremely difficult for most global companies to implement, primarily due to the wide variability in pay practices and recordkeeping.  More than three-quarters of respondents have over 10,000 employees globally, with significant populations located in more than 10 countries.  Almost half said that manual calculations would be the predominant approach and that it would take at least three months to calculate the ratio, so that proxy deadlines may not be met. 

The primary concerns stem from the complexity of data aggregation given the fact that most companies, especially large multinationals, do not maintain a centralized list of employees that is linked to their compensation information.  Rather, since information about each employee is maintained in the separate country and business unit, statistical sampling would not avoid the need to develop a list that first identified all employees and then identified and calculated all elements of compensation needed for sampling purposes.  Some of the specific issuer responses noted that sampling would require examining local payrolls in over 30 countries or as many as 100 different payroll systems, and countless vendors.  Other concerns raised included the implications of currency values, tax impacts and privacy laws.  Issuers also questioned whether total cash compensation is an appropriate proxy for total compensation for non-US employees, as "in kind" contributions make up a substantial part of compensation in certain parts of the world for tax and cultural reasons. 

"Issuers appreciate the SEC staff's efforts to find a flexible approach for a very challenging requirement, but unfortunately statistical sampling would neither eliminate, nor reduce the significant difficulties associated with gathering the data necessary to accurately identify the median employee based on compensation.  For large multinational companies with multiple operating units like J&J, we can already see that this data gathering exercise will present major administrative burdens.  What we need is a practical solution that does not place additional strains on companies' resources in these tough economic times," commented Doug Chia, Corporate Secretary at Johnson & Johnson, which has 117,000 employees working in over 250 operating companies worldwide.

The Center concludes its letter by recommending that the SEC consider the use of estimates similar to median employee pay that are already publicly available, such as to employee earnings maintained by the Department of Labor's Bureau of Labor Statistics, which can be customized for a company's primary industries. 

Contact . Contact .

Engagement with shareholders plays an increasingly important role in strengthening issuers’ corporate governance practices.  With proxy season around the corner, we turn to Donna Anderson, a vice president of T. Rowe Price Associates, Inc., and global corporate governance analyst in the U.S. Equity Division of T. Rowe Price., for her perspective on company efforts.  In her current role, Donna leads the policy-formation process for proxy voting, shepherds the firm’s engagement efforts with portfolio companies, and is co-chair of the Proxy Committee.  She joined the firm in 2007, has 15 years of investment experience, and was recently named one of the "People to Watch" in the NACD Directorship 100. 

Davis Polk:  Part of the difficulty companies sometimes have with investor engagement is finding the right person to talk to, since institutions operate under different structures.  We understand that at T. Rowe Price, proxy voting responsibility is assigned to each fund manager, with recommendations from the industry analyst and the governance analyst.  What role do you play in voting decisions, and who should companies interact with in the first instance when they have an issue they want to discuss?

Donna Anderson:  We encourage companies to contact us however they wish. Typically, dialogue begins with a call from the IR department to our industry analyst or from the corporate secretary’s office to me.  Either way, we make every effort to have these discussions jointly. We believe it’s important to incorporate the investment context and the governance perspective when it comes to our voting decisions.

I would not want to leave you with the impression that our fund managers are equally engaged in every proxy voting decision. We do not expect them to be familiar with every corporate governance issue in every country where they invest. This is why we’ve deployed internal resources in this area, to support our managers’ ability to make these decisions. Generally speaking, our fund managers tend to follow the standard T. Rowe Price guidelines when it comes to the more arcane areas of corporate governance (certain shareholder proposals, takeover defenses, bylaw changes, forum selection provisions, etc.).  By contrast, they tend to be quite engaged and opinionated in the areas of director elections, compensation, equity plans, M&A, contested elections, and the like.

Davis Polk:  What are some of the issuer engagement efforts that you find to be useful, and what in particular would you advise companies to focus on, or even to avoid? 

Donna Anderson:  Our approach is an open-door policy.  If a company wishes to speak with us about corporate governance matters, we will gladly take the meeting.  The objective of this type of engagement should be establishing a two-way dialogue about substantive issues.  Once a relationship has been established, some companies find there’s no need to meet on a regular schedule (once or twice a year).  Other companies prefer regular, periodic contact as a way of collecting up-to-date feedback from their shareholders.  We are flexible about the method, but I would say that incorporating some level of proactive outreach to shareholders into a company’s governance program is an investment that pays off when the company encounters the inevitable setback.  It is frustrating for us to receive those panicked phone calls 48 hours before a shareholder meeting when the votes are flooding in and the company finally realizes its shareholders have serious concerns.

Another tactic I’m not sure is useful is placing the burden of engagement on shareholders. We receive a surprising number of form letters every year saying, in essence, “We at XYZ Corp. care about corporate governance. If you have anything you’d like to discuss, give us a call.”  We would not characterize this as proactive outreach. While we would like to have the time to respond to open-ended requests, the companies offering specific agenda items for discussion are the ones we put at the top of the priority list.

Sometimes an issue doesn’t arise until the midst of proxy voting season, and we understand that. We are always willing to have shorter, targeted discussions about particular voting issues. In this regard, we found this year’s supplemental proxy disclosures to be quite helpful. We did read them, and we thought they were effective and efficient vehicles for communication.

Davis Polk:  Tell us what issuer engagement was like during the 2011 proxy season, with say-on-pay being the primary focus as we were all learning in this first year.  Did you find companies prepared and ready to discuss issues or did you find that engagement was mostly reactionary?  What are you expecting now from companies with respect to their say-on-pay votes?  Are you currently inundated with requests for discussions?   

Donna Anderson:  I know some institutional shareholders are inundated, but that has not been our experience. We can tell from the call volumes that many calendar-year-end companies are drafting next year’s proxies now, but we do not experience nearly the level of inbound calls that some larger asset managers do.

This year, I found companies were well prepared for compensation-related discussions, by and large. We heard from companies who knew (or suspected) they would have a rough time getting through their first say-on-pay votes, and we heard from companies with very modest, well-constructed plans who simply wanted to know how their shareholders felt about their CD&A disclosures. For the more complex compensation discussions, we find it helpful when someone from the company’s HR team is on the line, but we’re not as comfortable speaking with external compensation consultants.

Davis Polk:  Recognizing that ISS recommended against the say-on-pay votes for 11% of the companies they covered while the rate of failed votes was much lower, at less than 2%, it appears that institutional investors approached the vote using their own independent analysis.  How does T. Rowe use proxy advisory services?  Should companies facing negative recommendations from proxy advisory services address those issues head-on with their investors, and if so, how should they engage in those discussions? 

Donna Anderson:  I’ve studied this year’s results, and there is no question in my mind that shareholders exhibited a lot of independent thinking on say-on-pay this year. It’s not just the small number of failed votes relative to ISS recommendations. There were also a couple of dozen companies that saw support levels for their pay votes in the 50’s and 60’s even with favorable ISS recommendations. I think each say-on-pay outcome reflects a unique concoction of past pay decisions, stock performance, shareholder characteristics, company size, proxy advisor recommendations, company outreach, and the quality of the compensation disclosure.

For our general voting guidelines, T. Rowe Price employed a scorecard approach to say-on-pay votes. Our view is, we shouldn’t be voting against pay plans when we only have one or two concerns. Our “no” votes should reflect a persistent pattern of concerns that we believe have not been adequately addressed. Our scorecard for this year included a 25% weight on our proxy advisors’ recommendations. We found their recommendations to be helpful in the many instances where our quantitative screening process identified situations that needed a more qualitative review. There were many occasions (on both positive and negative recommendations) where we agreed with the ISS or Glass Lewis analysis. In other instances, we thought they placed too much weight on short-term considerations (year-over-year changes in pay, for example) or one-off pay practices such as single triggers.

From a company’s perspective, I understand the impulse to react aggressively to a negative vote recommendation. I hope that, after this year, companies will see the proxy advisor recommendation as just one factor in the mix. Every company should be able to gain at least some new insight from an expert outsider’s review of their pay program, shouldn’t they? Why not react to their analysis in a more constructive, open-minded manner?  Also, companies should not assume all their shareholders follow ISS’s guidance. It’s not a great use of time, especially during proxy season, for a company to launch into a 10-minute monologue on all the reasons ISS has it wrong, only to find out that the shareholder subscribes to a different advisor or has a customized approach to pay. My advice to companies in this situation would be to remain calm, issue an 8-K if you feel the facts have been misinterpreted, initiate an outreach effort to your largest shareholders, and find out what their say-on-pay triggers are before you spend time on rebuttal.

Contact .

Section 951(b)(2) of Dodd-Frank requires companies to hold a non-binding shareholder vote on executive severance packages (golden parachutes) in connection with M&A transactions that are presented for shareholder approval.  Shareholder votes on golden parachutes have been required since April 25, 2011.  Pearl Meyer & Partners recently completed a study on the outcomes of such shareholder votes held between April 25, 2011 and September 26, 2011. 

According to the Pearl Meyer study, during this period, 37 companies included golden parachute disclosure and votes in their merger proxies, 24 of which to date have publicly disclosed the results of the golden parachute vote.  Each golden parachute vote received support of a majority of shareholders, with the median vote equal to 91% approval.  Interestingly, Pearl Meyer noted that the median support for the related merger transactions was 99%.  The study shows that shareholders are generally voting in favor of golden parachutes where the shareholders approve of the related merger transaction, but at slightly lower rates.

Pearl Meyer also noted that ISS issued reports on 32 of the 37 transactions.  Four of ISS’s reports contained a negative recommendation for the golden parachute votes.  Of the golden parachute votes that did not receive ISS support, according to the Form 8-Ks filed reporting the results of such votes, a majority of shareholders still approved each golden parachute vote (albeit by a percentage somewhat below the median – approval votes ranged from 57% to 95%).  Based on this early data, it appears that while ISS may have the ability to sway shareholder votes to some extent, the shareholders’ votes on golden parachutes are closely linked with shareholders’ views regarding the related merger transaction.  The “say on golden parachutes” vote therefore may not greatly affect a company’s decision(s) with respect to the golden parachute payments offered to executives and officers.

Contact .

On October 19, we posted about the Federal Reserve’s recently released report detailing its horizontal review of incentive compensation practices at 25 large banking organizations.  The report notes that the Fed intends to implement the Pillar 3 compensation disclosure requirements adopted in July by the Basel Committee on Banking Supervision.  The required disclosures are quite extensive (e.g., compared to the disclosures currently required for U.S. public companies).  As the disclosures will be public, banks may be criticized for their compensation practices.  On the plus side, banks will have a window into their peers’ practices.

The Pillar 3 requirements are limited to disclosure and do not mandate particular forms or amounts of compensation.  But if the impact of other disclosure regimes is any guide, the requirements may cause banks to modify their compensation practices.  (Separately, the Fed, jointly with six other federal agencies, has proposed a rule under Section 956 of Dodd-Frank that would subject financial institutions to substantive compensation requirements—see our March 3 memo).

The Basel Committee expects banks to comply with the Pillar 3 requirements from January 1, 2012.  But as the Fed’s report does not specify when it intends to propose rules implementing the requirements, it is not clear when the requirements will apply to Fed-regulated banks.  Nor is it clear how closely the Fed’s rules will adhere to the letter of Pillar 3 or whether the Fed will propose its rules jointly with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation (as it has for rules implementing previous Basel regulations).

Pillar 3 requires 18 qualitative and 11 quantitative disclosures, with the quantitative disclosures covering, and broken down between, senior management and other material risk takers.  Here are a few examples:

Qualitative:

• The types of employees considered senior managers and material risk takers, including the number of employees in each group.

• How the bank ensures that risk and compliance employees are compensated independently of the businesses they oversee.

• The measures the bank will implement to adjust remuneration if performance metrics are weak, including the bank’s criteria for determining “weak” performance metrics.

• The bank’s policy on deferral and vesting of variable compensation and, if the fraction of variable compensation that is deferred differs across employees or groups of employees, the factors that determine the fraction and their relative importance. 

Quantitative:

• The numbers and total amounts of guaranteed bonuses, sign-on awards and severance payments granted in the fiscal year.

• For deferred compensation, the total amount outstanding (with a breakdown by cash, equity, equity-based and other forms) and the total amount paid out in the fiscal year.

• For compensation generally, a breakdown by fixed/variable, deferred/non-deferred and form (cash, equity, equity-based and other forms).

• Information about employees’ exposure to compensation adjustments, both implicit (e.g., fluctuations in the value of shares or performance units) and explicit (e.g., malus, clawbacks or similar reversals or downward revaluations of awards).  Such information must include the total amount of outstanding compensation exposed to such adjustments and the total amount of reductions during the fiscal year, with the reductions broken out by those due to implicit versus explicit adjustments.

Banks are expected to provide the disclosures on one site or in one document.  But Pillar 3 provides the Fed with discretion to permit banks to cross-reference to a different site or document if equivalent disclosure has already been made under an accounting or listing requirement relating to the same time period (e.g., proxy statement disclosure under Item 402 of Regulation S-K).  The Fed also would have discretion to exempt banks fully or partly from the requirements, depending on the banks’ risk profile, and to exempt certain types of compensation as immaterial, proprietary or confidential.

Contact Barbara Nims.

The Federal Reserve recently released a report detailing its horizontal review of incentive compensation practices at 25 large banking organizations.  The findings and recommendations are expressed in highly general terms, and set forth the Fed’s views on what financial institutions are and should be doing to identify practices effective in balancing incentive compensation arrangements and risk and formulate next steps in developing these practices.  Because the interagency rule on incentive compensation in the financial sector may provide a roadmap for future regulation in this area extending beyond financial institutions, the insight offered by the report may be helpful in structuring incentive compensation policies at any company. 

Based on the report, the Fed would like to see companies implement the following practices when using risk adjustments and deferred compensation to achieve balance between risk and financial reward in compensation arrangements:

• Well-developed and robust compensation policies that clearly identify the weight given to risks taken during the performance year, and improved monitoring of these policies to ensure the effective and consistent use of risk adjustments (this is particularly important for incentive-based deferred compensation plans because, to have a significant impact on risk-taking behavior, plans need to provide employees with a clear understanding of the risk-taking decisions that impact plan payouts);

• Where adjustments to the size of annual bonus pools are used as a risk adjustment mechanism, adjustments in connection with individual incentive compensation awards if individual employees in a single pool have varied levels of impact on risk; and

• Deferral practices that are broader than traditional clawback arrangements – although clawbacks are considered useful in creating balanced risk-taking incentives by discouraging specific types of behavior, the Fed considers their focus (typically, malfeasance, violations of policies, and a material restatement of financial results) too narrow to impact most risk-related decisions.

In the report the Fed makes clear that it expects boards to actively oversee the development and operation of incentive compensation policies and be attentive to risk taking incentives created by the incentive compensation process.  The Fed also expects directors to monitor carefully the effectiveness of incentive compensation arrangements in balancing risk-taking incentives, for example, through reviewing periodic reports that monitor incentive compensation awards and payments relative to risk outcomes.  Note that the Fed’s expectations for board responsibility and oversight are not limited to incentive compensation of senior executives, but extend to incentive arrangements throughout the employee ranks.  This could result in a significant expansion of the board and/or compensation committee process at many companies.

Contact . Contact .

On October 4, 2011, we blogged about the dismissal of a series of lawsuits filed in New York by Goldman Sachs shareholders.  We noted that a similar shareholder suit against Goldman Sachs was pending in the Delaware Chancery Court.  Last week, that suit was dismissed. 

With respect to executive compensation issues, the shareholders in the Delaware case claimed that Goldman’s directors breached their fiduciary duties by (1) failing to properly analyze and rationally set compensation levels for Goldman’s employees and (2) committing waste by “approving a compensation ratio to Goldman employees in an amount so disproportionally large to the contribution of management, as opposed to capital as to be unconscionable.” 

Ruling on Goldman’s motion to dismiss for failure to make a pre-suit demand upon the board and for failure to state a claim, the Delaware Chancery Court found that a pre-suit demand was not excused because the plaintiffs failed to plead demand futility with sufficient particularity.  In other words, the plaintiffs failed to plead particularized factual allegations that raised a reasonable doubt as to whether (1) Goldman’s board lacked independence because of its financial ties to Goldman, (2) the board’s compensation structure was the product of a valid exercise of business judgment and (3) the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.

Taking the New York and Delaware results together, it is clear that for these types of compensation lawsuits, at least based on Delaware law, it is not easy to plead demand futility with sufficient particularity to survive at the motion to dismiss stage.  It will be interesting to see for how much longer the plaintiffs’ bar will continue trying.  Note that the one say-on-pay-based derivative suit (against Cincinnati Bell) so far that has survived a motion to dismiss, and excused pre-suit demand, applied Ohio substantive law.   

Contact .     

As revealed in court documents filed last week, a series of lawsuits filed in New York by shareholders who claimed that bonuses paid to Goldman Sachs employees resulted in corporate waste were dismissed on September 21, 2011.  Security Police & Fire Professionals of America Retirement Fund and Judith A. Miller sued the investment bank in December 2009, accusing directors and executives of breaching their fiduciary duties by reserving half of the company’s net revenue for employee compensation.  Shareholders Ken Brown and Central Laborers Pension Fund filed similar suits the following month, and the two actions were consolidated. 

The consolidated case was subsequently dismissed by mutual agreement; however, in connection with dismissal, the plaintiffs requested attorneys’ fees.  To determine whether the award of fees was appropriate, the Court focused on whether the lawsuit at the outset was capable of surviving a motion to dismiss. 

On this issue, the Court found that the case was not “meritorious when filed” because the plaintiffs failed to make a pre-suit demand.  Demand was not excused because the plaintiffs’ complaints failed to create a reasonable doubt that: (1) the directors were disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.  Plaintiffs’ request for attorney fees and expenses, therefore, was denied.  The court’s decision is available here.

Another similar case against Goldman Sachs alleging breach of fiduciary duty and unjust enrichment of management is currently pending in the Delaware Chancery Court, and it will be interesting to see if it results in a similar outcome.  The Amended Shareholder Derivative Complaint can be found here. 

Comparing this case with the Cincinnati Bell say-on-pay lawsuit recently surviving a motion to dismiss, it is difficult to generalize about the factors leading to, or correlated with, the differing outcomes, or to predict how easy (or difficult) it will be to get these types of actions dismissed.

Contact .

Section 953(b) of Dodd-Frank requires companies to disclose the internal pay ratio between the total annual compensation of their CEO and the median total annual compensation of their employees.  Effectiveness of the requirement has been delayed until the SEC promulgates implementing rules.  Meanwhile, companies have complained that the calculations required to comply with the disclosure requirement are burdensome and unfeasible, and proposals for Section 953(b)’s repeal have been introduced in Congress. 

Against this background, it is somewhat surprising that shareholder proposals seeking disclosure of the internal pay ratio decreased in 2011, and average shareholder support for this disclosure has remained low (although it increased slightly in 2011).  According to an executive compensation bulletin published by Towers Watson in June 2011, shareholder proposals with respect to internal pay ratio disclosure dropped from 9 in 2010 to 3 in 2011 (through mid-June), while average shareholder support increased from 6.2% to 9.1%.

One such example of a failed shareholder proposal is the 2011 proposal by the International Brotherhood of DuPont Workers calling for the board of directors of E. I. du Pont De Nemours to compare the “compensation packages for senior executives with that provided to the lowest paid employees.”  The proposal received just 5.8% in shareholder support.

Some companies already address concerns regarding internal pay equity.  Examples of such “proactive” companies include Whole Foods Market, which places a cap (expressed as a multiple of the company’s average wage) on executive cash compensation, NorthWestern Corporation, which voluntarily disclosed in its 2011 proxy that its targeted compensation for its CEO in 2010, excluding benefits, was 18 times the median pay of all its employees, and Goldman Sachs, which released supplemental proxy materials dedicated exclusively to its compensation practices.

A possible reason for this lack of activism may be that shareholders as a whole are less concerned with internal pay ratio disclosure than with other areas of compensation policy, such as linking pay to performance and requiring executives to retain a significant percentage of their equity.

As we wait to see where the SEC and Congress will come out on mandatory internal pay ratio disclosure, it is difficult to predict where we will end up, but one thing looks certain – shareholder proposals are not currently leading the charge. 

Contact .

As previously posted on June 24, several derivative lawsuits have been filed against companies that have failed their "say-on-pay" votes. The lawsuits seek a recovery for alleged excessive executive compensation. Earlier this month, Dex One Corporation became the eighth company sued. The Dex One lawsuit, filed in the Eastern District of North Carolina, claims that officers and directors breached their fiduciary duty to the company by awarding large increases in compensation to the management team while the company was in bankruptcy, followed by a share price decline of more than 95 percent. 

Since our last post on this topic, several companies with say-on-pay lawsuits have updated their disclosure. Cincinnati Bell indicated that two additional derivative lawsuits were filed naming the company's directors and named executive officers as defendants, and Hercules Offshore also disclosed the existence of a second lawsuit. As was the case with the two lawsuits against Occidental that followed on the heels of its first say-on-pay litigation, these additional suits are substantially similar to the initial complaints.  No further settlements have been announced. 

Even companies with majority support for say-on-pay have been subject to derivative claims alleging excessive executive compensation. One slight difference between those and the say-on-pay litigation is that those complaints generally have a broader focus than alleged pay-for-performance disconnects for executives, and may even include general pay practices across the entire company.

As the total number of say-on-pay lawsuits increases, we note the frequency with which the same plaintiff firms have appeared. Five firms (Barrack, Rodos & Bacine, Landskroner; Grieco & Madden, LLC; Robbins Geller Rudman & Dowd LLP; Strauss & Troy and The Weiser Law Firm, P.C.) have each filed two of the derivative lawsuits.

Contact . Contact

Earlier this week, the SEC announced a settlement with the former CFO of Beazer Homes USA to clawback incentive compensation and profits from the sale of Beazer stock of more than $1.4 million pursuant to the Sarbanes-Oxley Act.  Neither the CFO nor Beazer’s CEO, who reached a similar settlement with the SEC earlier this year for almost $6.5 million, was charged with personal misconduct.  Notably, the SEC blames Beazer’s chief accounting officer as the main perpetrator of the fraudulent actions that led to accounting restatements, but in accordance with the Sarbanes-Oxley Act, the SEC could not seek recoupment from any officers other than the CEO and CFO.  The SEC complaint against the chief accounting officer only included traditional cease-and-desist and disgorgement relief.

Section 304 of the Sarbanes-Oxley Act authorizes the SEC to seek recoupment of certain incentive compensation if an issuer must prepare an accounting restatement due to material noncompliance of the issuer with financial reporting requirements “as a result of misconduct.”  The SEC actions against Beazer’s CEO and CFO were criticized for taking an expansive reading of “misconduct” under the statute.  In contrast, the new rules the SEC is expected to promulgate in the coming months to implement the clawback requirements under Dodd-Frank will subject current and former officers to clawbacks, without reference to misconduct by anyone.  Under Dodd-Frank, companies must develop and implement policies with respect to (1) disclosure of incentive-based compensation that is based on publicly reported financial information and (2) clawback of incentive-based compensation from current or former executive officers following a restatement triggered by material noncompliance with any financial reporting requirements under securities laws.  The amount subject to the clawback is the amount in excess of what would have been paid under the restated results during the 3-year period preceding the date on which a company is required to prepare the restatement.

In a number of respects as noted below, the requirements of Dodd-Frank are broader than those of SOX.  Due to its expansive nature, in particular the absence of any misconduct as a trigger, there will likely be more clawback actions under Dodd-Frank than we have seen so far under SOX.  The Dodd-Frank provisions raise a number of interpretative questions, including whether SEC actions against officers will make it difficult for companies not to seek compensation reimbursements under Dodd-Frank if available.

Dodd-Frank	SOX
Requires clawbacks without regard to whether any misconduct has occurred	Requires misconduct, but according to the Beazer action, the misconduct does not need to be by the individual charged with clawback
3-year look-back	12-month look-back
Applies to current and former executive officers	Applies only to CEO and CFO
Enforceable by the issuer, as well as the SEC	Enforceable only by the SEC

 

For more information on open issues regarding the clawback under Dodd-Frank and its impact on foreign private issuers, see Compensation Clawback under Dodd Frank: Impact on Foreign Issuers from our Tokyo Office Blog.

The SEC news release regarding the clawback of compensation from Beazer Homes’ former CFO, as well as the related SEC complaint, can be found here.

Contact Ning Chiu. Contact Gillian Emmett Moldowan.

Some shareholders are using lawsuits as a new tactic to fight what they perceive as an escalation in executive compensation.  Shareholders are likely to find these suits difficult to push through the courts on their merits, but the suits can cost subject companies time and money, not to mention reputational harm brought on by negative media attention.

Last year, we saw shareholder derivative suits filed on behalf of KeyCorp (in Ohio state court) and Occidental Petroleum (in California state court) in connection with failed say-on-pay votes during the 2010 proxy season.  KeyCorp agreed, according to Reuters, to pay $1.75 million in attorneys’ fees and expenses to settle related suits and Occidental Petroleum, faced with three suits, settled one for an undisclosed amount and had two dismissed.  Both KeyCorp and Occidental announced significant changes to their executive compensation practices following the shareholder suits.

Similar lawsuits have been filed during the 2011 proxy season.  Earlier this month, a shareholder derivative suit Hercules Offshore, Inc. against the company’s directors, named executive officers and compensation consultant.  This suit represents the fourth shareholder derivative suit following a failed say-on-pay vote during the 2011 proxy season.  Suits have been filed on behalf of Umpqua Holdings (in Oregon), Jacobs Engineering Group (in California) and Beazer Homes USA (in Georgia) – all of which held meetings early in the proxy season.

In the suits on behalf of all six companies, the plaintiffs assert a disconnect between pay and performance, because of weakening corporate financial performance and increasing executive compensation.  However, unlike the suits filed in 2010, in which the plaintiffs claimed a multi-year history of excessive compensation at the respective companies, the suits filed this year focus on 2010 compensation relative to company performance.

The suits each claim that the directors breached their fiduciary duties, generally arguing that approving an increase in executive compensation not in line with the company’s disclosed pay-for-performance policy was an invalid exercise of the directors’ business judgment.  The plaintiffs argue that the failed say-on-pay votes rebut the presumption that the directors’ acted in the best interests of the company.  The validity of this argument is questionable in the case of the 2011 suits in light of the specific Dodd-Frank provision that the say-on-pay votes mandated by the Act do not create or imply any change to or addition to the fiduciary duties of directors.

Even so, if the cases get beyond a motion to dismiss, the outcome may be affected by the record (recall the Disney case from a few years ago).  Companies should consider what the background documents will show (including any compensation committee minutes) and be conscious of reviewing the record as closely as in, say, M&A matters.

Contact Kyoko Takahashi Lin. Contact Gillian Emmett Moldowan.

The Dodd-Frank frequency vote is of course "nonbinding", but companies that have "lost" the vote for triennial frequency have almost without exception decided that the better part of valor is to follow the shareholders' expressed will for an annual vote. With more than 60% of large accelerated filers having announced their decisions, only two companies have bucked the trend. Annaly Capital Management just filed an amended Form 8-K declaring that its board has determined that future say-on-pay votes will be submitted to shareholders every three years, even though annual say-on-pay received majority approval. Annaly Capital Management is the first large accelerated filer to follow the example previously set by American Reprogaphics Company, a small company, to conduct triennial votes. The vote wasn't close in either case; each company had received 70% or more shareholder support for an annual vote.

While signifying that it won't conduct another say-on-pay vote for three years, Annaly Capital Management indicated that the board will "continue to evaluate this decision annually." The company's annual meeting also resulted in one director receiving more "against" votes than "for" votes, it appears due to the director's failure to attend more than 75% of board and committee meetings. The company stated, also in the amended Form 8-K, that after considering the director's qualifications and past attendance history, the board determined that it would not be in the company's best interest to request the director's resignation. The company has a classified board, but interestingly, the Form 8-K declared that the director will serve until the company's next annual meeting, at which time the board expects the director to be re-nominated.

The story doesn't end there - will ISS recommend withhold votes for the board next year for not following the shareholders' will?

Contact . Contact .

May is high season for annual shareholder meetings for U.S. public companies, so we wanted to update the findings that we shared in our last memo on the subject.  As of the end of last week, 802 large accelerated filers reported the voting results from their shareholder meetings.

Regarding approval of “say-on-pay”, so far:

Large Accelerated Filers by Say-on-Pay Vote (as of May 20, 2011)
90-100% Approval	540
80-89% Approval	126
70-79% Approval	65
60-69% Approval	40
50-59% Approval	14
40-49% Approval	9
30-39% Approval	7
20-29% Approval	1
0-19% Approval	0
Total	802

 

 

 

 

 

 

 

 

 

 

 

 

 

In other words, less than 17% of large accelerated filers reported say-on-pay results below the 80% approval level, and less than 9% reported results below the 70% approval level.

A total of 16 large accelerated filers have lost their say-on-pay votes, and all of them received “against” recommendations from ISS.  To date, large accelerated filers with “against” recommendations have averaged 64% approval, while those with “for” recommendations have averaged 92% approval.  We believe the total number of public companies, including large accelerated filers, that have lost their say-on-pay votes is 26.

On the “say-when-on-pay” front, shareholders at 729 large accelerated filers voted in favor of an annual frequency (i.e., almost 91% of all large accelerated filers).  Less than a quarter of all large accelerated filers that recommended a triennial frequency have had their recommendation endorsed by shareholders, and, in the great bulk of these cases, the vote was supported by a controlling or at least very substantial insider shareholder.

Contact Kyoko Takahashi Lin.

Questions have come up about whether companies can declare how frequently they intend to hold say-on-pay votes in the Form 8-K announcing annual meeting results within four business days after the meetings, or whether they must wait and make the disclosure in an amended Form 8-K.  While this seems to demand a simple "why not" response, the confusion stems from the fact that careful readers of the rules noted that the Form 8-K itself only provides for disclosing future frequency in an amended 8-K, to be filed no later than 150 days after the end of the meeting and 60 days before the 14a-8 shareholder proposal deadlines. 

The instructions do not appear to be exclusive, and if a board has made a decision there seems to be no reason to later prepare an amendment and make two filings.  In fact, at least half of the companies that have announced annual meeting results so far have gone ahead and declared their future intentions with respect to the frequency of say-on-pay, in particular where (a) the board recommended annual and (b) votes were overwhelmingly in favor of annual. 

Contact .

It has been frustrating for companies who want to benefit from the substantial cost-savings provided by the SEC notice and access rules to discover that they must also comply with the Department of Labor (DOL) ERISA rules regarding electronic communications to employees, if for example the employee shareholders hold company stock through a 401(k) plan that is registered on a Form S-8.  As a practical matter, using notice and access for employee benefit plan participants has proved prohibitively difficult.  The ERISA rules permit electronic delivery of documents only to participants who have the ability to access them at their regular place of work, and who have access to the company's electronic information system as an integral part of their duties.  Even for those participants, administrators must try to ensure actual receipt of the documents and provide notice about the documents' significance.  For participants who do not meet this test (e.g., former employees and current employees who do not work at computers) an affirmative consent, with specific content requirements, is required.

The DOL recently published a request for information (RIF) soliciting "views, suggestions and comments" from interested parties on the use of electronic media by employee benefit plans to furnish information to participants.  The rules have not been updated since 2002, a lifetime ago in terms of technological changes.  The deadline is June 6th.  This may be an opportunity to alert the DOL of the important need to finally align the ERISA rules with notice and access.  One suggestion might be to permit plans to send plan participants and beneficiaries a paper notice/election stating that, unless a participant affirmatively elects otherwise, electronic access will be the default mode of access for certain items (such as proxy statements and cards).  For other items, such as plan benefit statements, the notice could provide that the default will be a paper mailing, unless a participant affirmatively elects electronic access in lieu of paper.  This notice/election could also be provided to new participants when they join a plan.

Contact .  Contact . 

Companies considering new equity plans should take note that Fidelity (a large shareholder of just about every public company) has adopted a new voting policy for equity plans.  As of March 2011 its policy focuses on burn rate rather than dilution.  Fidelity will vote “no” on a plan if:

 

(A) the company’s three-year burn rate on equity awards is greater than:

 

- 1.5% for Russell 1000 companies;

- 2.5% for companies not in the Russell 1000;

- 3.5% for companies with a market cap below $300M; and

 

(B) the burn rate is not otherwise acceptable to Fidelity based on circumstances specific to the company or plan.

 

Note that this test is based strictly on company size and, unlike the ISS test, takes no account of industry practice.  (ISS applies a limit equal to the greater of 2% or one standard deviation from the average burn rate for the company’s industry group). Fidelity's new policy will tend to particularly impact companies in the tech sector and in other industries with high share usage rates.  If a company fails the Fidelity test, Fidelity may contact the company and try to get the company to commit to reduce its future burn rate or make other changes in exchange for Fidelity’s support.  Our sense is that Fidelity may be getting push-back from companies in a number of industries, so it would not be surprising if Fidelity reconsiders its approach.

 

Contact .

 

When the SEC decided to eliminate the ability of brokers to vote on a discretionary basis without specific client instruction for director elections in July 2009, many predicted that it would seriously affect the ability of directors to obtain majority support.  The concern proved to be a false alarm.  As a result, when the Dodd-Frank Act required the elimination of broker discretionary voting for executive compensation matters, including say-on-pay, there wasn't nearly the same chatter. 

But it turns out that given the closeness of many of the failed say-on-pay votes, the reported broker non-votes would have made a real difference.  We calculated that 7 of the 21 companies reporting failed votes so far would have passed, in some cases by a decent margin, if the non-votes had actually been counted as "for" say-on-pay, which is not an unreasonable assumption given these discretionary votes generally favored management.  For one company, there were more broker non-votes reported than "for" votes. 

Currently for most companies the only proxy item that brokers can continue to vote on without client direction is auditor ratification.  In addition, many are not aware that the NYSE usually permits brokers to vote at their discretion on most management proposals to amend charters, including to declassify boards, eliminate supermajority provisions or allow special meetings of shareholders.  Since NYSE Rule 452 governing discretionary voting has a specific list of "cannot vote" items, items not on the list, and not viewed as contested, can be marked as a broker-may-vote matter by the NYSE.

Contact .

Although it often looks like proxy season 2011 is a one-topic event, say-on-pay is just one item on proxy cards.  Recent data reminds us that say-on-pay may even be the least controversial item.  ISS reports that as of May 9, shareholder proposals calling for declassifying boards (annual election of directors) won as much as 95% and 81% approval rates at MEMC Electronic Materials and Alcoa, respectively.  Average support so far for nine proposals is 69%, up from 61% last year.  Shareholder proposals on majority voting are also faring well, averaging 57% support at 14 companies, including 78% at SkyWest.

Recognizing the increased probability of getting these types of results, companies that receive such proposals often go ahead and implement without putting the shareholder proposals on the ballot.  Companies seeking management proposals to amend governance documents for declassification and majority voting have won more than 96% approval this year. 

Contact Ning Chiu.

When shareholders mark "abstain" on a ballot, what does it mean?  Does the meaning differ depending on whether it's to elect a director, vote on say-on-pay or a shareholder proposal?  The effect of abstentions in determining the pass/fail rate for an item depends on state law and corporate governance documents, but should they be excluded if we're trying to examine different companies' results for comparability?

 

You may be aware that it is ISS policy to ignore abstentions when reporting the results of shareholder proposals, citing Rule 14a-8(i)(12).  The approval rate of shareholder proposals determined by ISS feeds into their policy of recommending against boards for failure to implement proposals that receive majority support two out of three years in a row.  If abstentions were counted, it would decrease the level of support for these proposals.  Given the close votes received on written consent and special meeting proposals in recent years at some companies, whether or not abstentions are counted sometimes matter.

 

We're not aware that such a policy exists yet for say-on-pay.  In his RiskMetrics Insights blog, Ted Allen reports results that includes abstentions, as duly noted in the articles.  As a management proposal, abstentions have the opposite effect on say-on-pay than for shareholder proposals, by decreasing the level of support.  In both cases, the companies come out looking worse.

 

Thus far, abstentions have played a minor role in say-on-pay results, averaging about 1.9% of votes.  However, abstentions played the deciding role in causing Motorola to report a failed vote in 2010, a similar fate faced by Hemispherx BioPharma and Cooper Industries this year.  Hemispherx had nearly 16% in abstentions.  In the U.K., investors often "abstain" against say-on-pay in the first instance to express a milder form of dissatisfaction with executive compensation.

 

Contact Ning Chiu.

We released today a memo summarizing the say-on-pay results so far this proxy season, including eleven companies who have failed to get majority support and a number of others where the vote was close enough to suggest meaningful shareholder concerns.  My anecdotal experience so far this season suggests a couple of supplemental points:

• With every public company required for the first time this year to comply with say-on-pay, ISS is clearly swamped, and it's showing in terms of quality control: we've seen an unusual level of cases in which ISS made factual mistakes in its report, and even a couple of situations in which ISS missed issues that in other years would likely have concerned them.

• If you do face a negative ISS recommendation you will wish you had planned for it, because the recommendations generally come with only about two weeks to go before the meeting, which will not allow much time to plan and execute a communications campaign.  You can't predict in advance how ISS will react, but in the vast majority of cases you can determine whether you are at risk of a negative recommendation.  If you're at risk you should have a communications plan on the shelf and ready to execute, unless you're feeling lucky. 

Contact Bill Kelly.

 

The SEC has just extended the deadline for comments in response to its proposed rules directing the national securities exchanges to adopt listing standards regarding the independence of compensation committees and advisers, as required by Dodd-Frank . The original deadline was today, and we had submitted our comments yesterday in anticipation, but commenters now have until May 19, 2011.

Our comments generally applaud the SEC for giving the exchanges the flexibility to develop applicable independence considerations. We’ve also made suggestions for technical changes and clarifications, such as that the independence rules for compensation committee members should not apply to committees that are responsible for broad-based plans (e.g., 401(k) plans), that the independence rules for consultants and advisers should not apply to in-house or outside counsel retained by management and that IPOing companies should be permitted a transition period, as they currently have under existing listing standards.

The SEC will consider the comments that it receives and will then propose its final rules. Ultimately, it will be up to the exchanges to determine how to implement those rules, subject to SEC approval. Exchanges must have their final listing standards within one year after the SEC publishes its final rules in the Federal Register.

Contact Kyoko Takahashi Lin.
 

There continue to be multiple areas of legislative activity to repeal or amend certain provisions of Dodd-Frank, including draft legislation to require employees to communicate internally before making whistleblower claims to the SEC. In March House Republicans announced a bill to eliminate the provision to disclose the ratio between the CEO’s compensation and the median annual total of all employees. Recently the AFL-CIO denounced this attempt to “water-down” Dodd-Frank, expressing their belief that this disclosure would have a “profound impact.” on executive compensation. According to their data, the average total compensation for S&P 500 CEOs is now about 343 times that of the average American worker, up from 42 times in 1980.

Contact Ning Chiu.

We’re up to nine failed say-on-pay votes so far for the year. We’ll provide a client communication shortly on the latest state of play in the say-on-pay world, including the reasons reported for the negative votes, and interesting additional soliciting materials filed by companies facing negative ISS recommendations. But we still have a long way to go before we can get the full picture. While the last week in April saw 300 annual meetings held, there will be over 400 alone in the first two weeks of May and 650 in the third week of that month.

Contact Ning Chiu.

Last week House Republicans announced that they are drafting five bills to eliminate or change parts of the Dodd-Frank Act.  One of the five is the elimination of the provision to disclose the ratio between the CEO’s compensation and the median annual total of all employees.  Could this possibly come to fruition?  Unlikely given the hurdles of getting any kind action out of Congress lately, but it’s a space to watch.  The latest SEC timeline aims for proposing and adopting final rules on the pay ratio disclosure in the August-December timeframe.  

Contact Ning Chiu. 

Notable recent support for triennial say-on-pay include Viacom, with insiders controlling about 80%, and Franklin Resources, which barely squeaks in 57% support for triennial even though insiders own approximately 35%.  The tide is starting to turn as more companies recognize that triennial is a long shot without some kind of insider block.  Our data shows 416 large accelerated filers and 188 S&P 500 companies had filed their proxy statements, with 59% of large accelerated filers and 64% of the S&P 500 now recommending for annual say-on-pay.

Contact Ning Chiu.

We’ve all engaged in the “what-if” scenarios of close votes on the say-on-pay frequency vote, faced by Green Mountain Coffee Roasters.  The company recommended triennial say-on-pay frequency and received 49.37% for annual and 49.99% triennial.  Talk about close.  Instead of keeping us in suspense as they are legally permitted to do, the company has announced that they will adopt annual frequency and hold another vote next year.  Would more a .01% support that pushed triennial into majority support made a difference to the board? 

Contact Ning Chiu.

While ISS voting recommendation reports for companies are not “public”, sometimes additional soliciting materials filed by a company are informative.  On March 2nd, Disney filed its first communication indicating that the ISS recommendation to vote against its say-on-pay proposal is based on the disclosure of excise tax gross-ups that was granted in January 2010, and the compensation committee has since then adopted a policy that prohibits excise tax gross-ups in any future agreements (including any material amendments).  It’s tough to battle ISS recommendations, as on March 18th, Disney filed another communication indicating that the company has amended four employment agreements to remove excise tax gross-ups entirely. 

Contact Ning Chiu.