Board Matters

We spoke with Agenda for its recent article, "Large Companies Have Strictest Director Independence Standards" (subscription required), which explored the Conference Board's 2013 Director Compensation and Board Practices report.  The report showed that one-fifth of companies in the financial services sector and one-fifth to one-quarter of companies in other industries have director independence policies that go beyond what the applicable securities exchanges require.  In addition, the largest companies are more likely to maintain more stringent independence standards.

The article provides examples of different types of restrictive standards that some companies are following, such as a longer look-back period for examining certain relationships, or a lower threshold amount for the receipt of direct compensation.  We also mentioned that there may be limits to the amount of charitable contributions donated to nonprofit organizations with which directors have affiliations, which is not prohibited under the securities exchanges' director independence rules.

The Conference Board report reached a similar conclusion as to the prevalence of other governance practices among large companies, such as the tendency to have higher representation of independent directors overall.

On December 13, the SEC declined to permit Disney to exclude a proxy access shareholder proposal submitted by Legal and General Assurance (Pensions Management), in conjunction with its client, Hermes Equity Ownership.

The proposal requested that Disney’s board adopt a bylaw that would allow a holder of 3% of its stock for at least three years to nominate up to 20% of the directors. The ownership requirements of the proposal closely resembled those of the SEC’s vacated proxy access rule and was substantially similar to two other proposals that were approved by a majority of shareholders at Chesapeake Energy and Nabors Corp. at their 2012 annual meetings.  

Disney sought to exclude the proposal as vague and indefinite under Rule 14a-8(i)(3), arguing that the proposal’s requirement that the nominating party provide Disney with information required by SEC “rules” about the nominating party and the board nominee was vague and misleading because it did not describe the substantive provisions of such rules. Disney also argued that the proposal was subject to multiple interpretations and its references to both SEC rules and to “any federal regulations” was vague and misleading.

In response, counsel to the shareholder proponent argued that the proposal “is a garden-variety ‘proxy access’ proposal” whose “central aspect” is the request of proxy access for owners of 3% of the stock for three years for up to 20% of the board. As such, the proponent argued that the language cited by Disney as vague and misleading was a secondary element of the proposal. The shareholder also disputed the claim that the wording was vague and subject to multiple interpretations. Disney then submitted a second letter to the SEC refuting the claims in the proponent’s response.

The SEC did not agree with Disney’s views, including its argument that the proposal’s reference to the SEC’s “rules” made it vague and indefinite and therefore subject to exclusion subject to Rule 14a-8(i)(3). In contrast, in the 2012 proxy season, the SEC had found that proxy access proposals which referenced “SEC Rule 14a-8(b) eligibility requirements,” without specifically describing such requirements, were subject to exclusion as vague and indefinite. In those letters, the SEC reasoned that the specific eligibility requirements were a central provision of the proxy access proposal in question.

A copy of the correspondence can be found here.

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.

A Summary of Governance Resources

Our memos on two governance events last week – the release of Staff Legal Bulletin 14G giving additional guidance on citing procedural deficiencies for shareholder proposals and a summary of the ISS draft policy survey – can be found here. It seems that proxy season is clearly getting underway, so this may be the last chance to find time to catch up on a trove of recent studies and research:

Board practices.  The Spencer Stuart 2012 US Board Index has a wealth of useful data for benchmarking against the practices of S&P 500 boards, reporting for example that the CEO is the only inside director at nearly 60% of those companies. With respect to board leadership, 43% have separated the chairman and CEO roles, though only 23% have independent chairmen. Given the increased demands on board service, more than half of sitting CEOs do not serve on any outside boards, resulting in the leaders of major business divisions and functions making up 22% of new directors. Nominees are needed to replace, among others, directors who reach the mandatory retirement ages that have been adopted at 73% of companies (85% using 72 or older as the age cut-off). Director composition is a key focus since 83% of the large-caps conduct annual elections.  

Directors’ concerns.  Even at companies with combined CEO/chair positions, half of their boards are discussing splitting the roles at the next CEO succession, according to PwC’s annual board survey of over 800 directors. Compensation committees have increased their workloads, with 64% of directors responding that their practices have changed due to the say-on-pay votes and 86% indicating that compensation consultants are “very influential.” With increased concerns about executive pay, it is not surprising that 62% of directors reported that they have directly communicated with institutional investors (although 33% believe directors should not have such dialogues at all) and 53% have spoken to proxy advisory firms.  

Director Elections.   While more companies failed say-on-pay this year, support for directors remain fairly strong. Only 175 directors at Russell 3000 companies received a majority of negative support (either withholds or against votes) in the last 3 years, according to research conducted by the Investor Responsibility Research Center (IRRC) Institute and GMI Ratings. Their findings concluded that 80% of majority withholds occurred at smaller companies, which were more likely to have straight plurality voting for electing directors (the overwhelming type of standard at 91% of the companies reviewed). The combination of small companies that likely receive less public scrutiny coupled with plurality voting standards may largely explain why only 5% of all directors who received less than majority support left their boards as a result. Interestingly, while there are good arguments that the middle ground between majority and plurality voting standards, the “plurality plus resignation” approach, is substantially the same as majority voting, it turns out that half of the directors at companies that have adopted majority voting stepped down after receiving majority against votes, and only 8% of those directors at companies with only “plurality-plus” did the same. 

Shareholder proposals.  Finally, as we approach the shareholder proposal season, the 2012 Proxy Monitor report examined the shareholder proposal activities at Fortune 200 companies from 2012 meetings and found that a small group of shareholders continue to sponsor the majority of shareholder proposals (36% from labor and pension funds; 31% from three individual investors and their relatives and affiliates; and 22% from activists with socially responsible agendas), with a plurality of the proposals focused on corporate political contributions and lobbying. We will likely see a similar trend for 2013 meetings. 

As we discussed here, the PCAOB recently approved Auditing Standard No. 16, Communications with Audit Committees. While the bulk of the new standard concerns communications that the auditors are required to provide to the audit committee, one notable provision relates to inquiries required to be made of the audit committee by the independent auditor. Under the new standard, auditors are required to inquire whether the audit committee “is aware of matters relevant to the audit, including, but not limited to, violations or possible violations of laws or regulations.” This expands the inquiries of the audit committee required by previous auditing standards, which required the auditor to inquire of the audit committee regarding the matters important to the identification and assessment of risks of material misstatement and fraud risks.

As at least one comment letter on the proposed standard noted, the new standard could jeopardize attorney-client and work product privileges. In its adopting release, the PCAOB acknowledged the criticisms of the comment letter regarding the risk of loss of privileges, but declined to exclude the language. The PCAOB stated that it did not remove the language because “limiting the scope of information that the audit committee might provide to the auditor could severely affect the auditor’s ability to conduct an effective audit…Due to the audit committee’s oversight responsibilities, it is appropriate for the auditor to ask the audit committee for information relevant to the audit, including matters related to violations or possible violations of laws or regulations.” The final standard did exclude language from an interim proposal which would have required the auditor to inquire of the audit committee about matters that “might be” relevant to the audit, somewhat narrowing the scope of inquiry.  However, the risk of loss of privileges remains an issue. The PCAOB did not provide guidance to companies regarding mitigating such risk.

If approved by the SEC, Auditing Standard No. 16 will be effective for audits of financial statements for fiscal years beginning on or after December 15, 2012.

Yesterday, the Public Company Accounting Oversight Board (PCAOB) approved Auditing Standard No. 16, Communications with Audit Committees, which supersedes its previous standards regarding communications with audit committees. The new standard seeks to improve communications between the auditor and the audit committee about significant audit and financial statement matters by requiring the auditor to communicate certain matters regarding the audit and financial statements to the audit committee in a timely manner and prior to the issuance of the audit. This is in contrast to the PCAOB’s previous interim auditing standard (AU Sec. 380), which did not require any communication with the audit committee prior to the issuance of the auditor’s report. The PCAOB stated that the new standard would foster “[e]ffective two-way communication between the auditor and the audit committee.”

Some of the information that the auditor would be required to communicate to the audit committee under the new standard includes:

• Overview of overall audit strategy, including timing of audit and significant risks
  
• Auditor’s evaluation of quality of company’s financial reporting
  
• Results of the audit, including critical accounting policies and significant unusual transactions
  
• Difficult or contentious matters for which the auditor consulted outside the engagement team
  
• Management consultation with other accountants
  
• Uncorrected or corrected misstatements
  
• Auditor’s evaluation of going concern
  
• Material written communications
  
• Departure from auditor’s standard report
  
• Disagreements with management
  
• Difficulties in performing the audit

The new standard also expands the inquiries required to be made of the audit committee by the auditor to include inquiries concerning its knowledge of violations or possible violations of laws or regulations.

If approved by the SEC, Auditing Standard No. 16 will be effective for audits of financial statements for fiscal years beginning on or after December 15, 2012. The applicability of the new standard to emerging growth companies is subject a separate determination by the SEC.

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 >

This is the fourth in a series of posts to discuss shareholder proposals during the 2012 proxy season.

While the number of shareholder proposals on independent board chairs increased significantly this year, shareholder support for these proposals did not show a corresponding surge. As of June 30th, there was a total of 48 proposals voted on at Russell 3000 companies, as compared to 21 at the same time last year.

This increase in number of proposals is due in part to a concerted effort this year by activist investors, including AFSCME, to target companies with combined chair and CEO positions. Not all shareholders, however, followed the lead of these activist investors. Of the 48 shareholder proposals, only 3 proposals passed. The average level of shareholder support for all independent chair proposals was 36% of votes cast, which is lower than the support received this year by other governance proposals such as declassification and majority voting.

It seems that the appointment of a lead director is not enough to prevent a company from receiving a shareholder proposal for an independent chair, as a majority of the companies receiving shareholder proposals this year had a lead director in place. All but four of the remaining companies had a presiding director. In addition, there were independent lead directors at all three companies at which the proposals passed. 

According to a Spencer Stuart 2011 Board Index, only 21% of S&P 500 companies have an independent board chair.

In response to concerns that audit firms were either declining to provide important information or downplaying the results of PCAOB inspections, the PCAOB recently issued a report about how an audit committee can enhance discussions with auditors about PCAOB inspections to support the committee’s oversight role.

By law, the PCAOB may not disclose the nonpublic portion of an inspection report or other nonpublic inspection information, or compel an audit firm to make the disclosure to an audit committee.  Because of these legal restrictions, an audit committee would not even know whether a PCAOB inspection report found deficiencies in the committee’s own company – the very audit that it oversees. The only way for an audit committee to obtain this information is by asking the auditors. 

With respect to the nonpublic portions of inspection reports, the key recommendation made by the PCAOB is that an audit committee may wish to ask the audit firm to let them know if the company’s audit is selected for review in a PCAOB inspection, and if so, for the committee to be kept informed about the areas of review and any concerns raised. More ominously, the release notes that the PCAOB “routinely” communicates inspection information to the SEC, on an issuer-specific basis, which the PCAOB would have first discussed with the audit firm. If a company’s audit is the subject of an inspection, an audit committee may also want to inquire about the possibility that the firm’s audit opinion is not sufficiently supported, whether questions have been raised about the fairness of the financial statements, the adequacy of the disclosures or the auditor’s independence.

Even if a company’s own audit was not the subject of an inspection, an audit committee may want to find out whether the report identified deficiencies in other audits that involved auditing or accounting issues similar to issues presented in the company’s audit, and if so, whether and how the firm has become comfortable that the same or similar deficiencies either did not occur in the audit of the company’s financial statements or have been remedied.

The PCAOB’s clear intent that audit committees take seriously their inspection reports is evident even as they describe how the audit committee should understand the public portions of the inspection reports and the audit firms’ responses to those findings.  If a public inspection report describes a deficiency, it means that the inspection staff believes that the audit firm did not have a sufficient basis for forming an audit opinion and concluding there were no material misstatements. The PCAOB indicates that audit committees should “view with skepticism” audit firms’ responses that assert that criticisms by the PCAOB consist of nothing more than documentation deficiencies or differences in judgments, since the PCAOB has already considered and rejected those explanations. If an audit firm determines that the deficiencies have been addressed in accordance with PCAOB standards, the audit committee should seek additional detail due to the broad nature of such a response.

In terms of issues related to a firm’s quality control, an audit committee may wish to ask about changes the firm has been making to its policies and procedures to address those deficiencies, since they may implicate the company’s own audit or in order to reduce such a possibility. In addition, the audit committee may want to be kept appraised of the status of the remediation process and ongoing discussions with the PCAOB. 

This is the third in a series of posts to discuss shareholder proposals during the 2012 proxy season.

The number of shareholder proposals relating to shareholder ability to call special meetings continued to decline: to 17 this year, down from 30 last year and 45 in 2010. 

This decline is due, in part, to the number of management proposals on the same topic. Management proposals relating to special meetings typically require a higher percentage (20%-25%) of share ownership to call a special meeting than do those proposed by shareholders, which generally require 10% ownership. Companies often submit management proposals to provide a basis for excluding a shareholder proposal with a lower ownership requirement under Rule 14a-8(i)(9). There have been 18 management proposals to date this year.

Close to one-third of the shareholder proposals on special meetings passed; the average level of shareholder support of votes cast was 44%. The common factor at all the companies where the shareholder proposal passed was that the shareholders of the companies in question did not have any right to call a special meeting. (At some, although not all, of the companies where the shareholder proposals failed, the shareholders of the company already had a right to call special meetings, although at a higher percentage than that sought in the shareholder proposal.) 

The SEC also permitted a number of these shareholder proposals to be excluded based on Rule 14a-8(i)(3), which allows exclusion of shareholder proposals that are “vague and indefinite.” Those proposals called for an ownership threshold of 10% “or the lowest percentage of outstanding common stock permitted by state law,” which language was found to be vague and indefinite. Interestingly, this was the same language in the proposals at most companies that chose the alternate route of seeking no-action relief  based on introducing a management proposal.

Cognitive bias leads to faulty decisionmaking, warned Vice Chancellor J. Travis Laster at the National Conference of the Society of Corporate Secretaries and Governance Professionals. In his address, he used an example of a Delaware case to demonstrate the collective desire to develop information to support a preconceived goal rather than reach independent conclusions, the fallacy of groupthink that avoids hard questions, the tendency to prefer data that confirms a prior belief and the likelihood of taking immense risks to avoid losses, noting that the Court looks for the presence of those biases in examining cases. We also heard from the leaders of two influential proxy advisers, ISS and Glass Lewis, that each firm will change to new methodologies in the coming proxy season for constructing the all-important peer group against which they assess CEO compensation and form say-on-pay recommendations, making predictability an ever elusive goal for now.

Such were the examples of the range of discussions focused on effective corporate governance, from thoughtful debates on the relationship between companies and their shareholders to practical advice on the nuts and bolts for board functions, all centered around the conference theme – The Shape of Things to Come. Over 800 attendees gathered to hear from an impressive roster of experts, including investors, regulators, academics, consultants and counsel, and also to learn from each other given the unique opportunity to gather with other like-minded professionals whose primary role is to support boards. Since one regret is that it was not possible to attend all the sessions and take advantage of everything being offered, the following is a somewhat random selection of highlights arranged around the theme of anticipating what may be in store in the near future:

Regulators.  In his speech, Commissioner Troy Parades underscored SEC efforts toward rigorous rulemaking, including quality cost-benefit analysis based on solid economics. He stressed the need for pragmatic regulation that avoids being overly burdensome for companies in terms of compliance, but also informs investors without engulfing them in too much unnecessary information. SEC staff from the Division of Corporation Finance were present to discuss their hard work writing rules as mandated by first Dodd-Frank, and now the JOBS Act. Rules with deadlines have clear priority, but otherwise both sets of legislation are being tackled simultaneously. The staff specifically declined to address the timing for when we will see proposals on the remaining executive compensation rules under Dodd-Frank, affectionately known as the “gang of four” (pay-for-performance, hedging policy, clawback and internal pay ratio). During this past proxy season, 332 Rule 14a-8 no-action letter requests were processed, a 5% increase from last year, with average response periods of 38 days. The SEC whistleblower program is receiving about 8 complaints a day, with a significant number of those reports also being made to companies at the same time. The staff is keenly aware of the anti-retaliation provisions and may even ask companies for personnel files to confirm the absence of negative actions toward employees who came forward.

Active, or Activist, Investors.  In his keynote, Ralph Whitworth, founder of Relational Investors and a board member at Hewlett-Packard, stressed the importance of not letting the emphasis on board collegiality suppress directors from asking tough questions.  He captured it succinctly with a statement about the need for a director to be likeable, without having others believe that the director wants to be liked. There was active and vigorous debate at another session on whether the Section 13D 10-day reporting period should be shortened, during which a representative from Pershing Square argued that all shareholders benefit from the increased liquidity and stock price brought on by activist actions, and claimed that the available data shows that it is quite rare that investors who are required to file 13Ds ultimately accumulate more than a 10% ownership stake. 

Shareholder Engagement.  BlackRock’s willingness to devote 20 people to their engagement effort on a global basis is due in part to its inability to merely walk away from a vast majority of its investments that are made on an indexed basis. The firm talks to companies privately when they perceive issues, and expect directors to be available for discussions when there are significant say-on-pay problems. They recommend that off-season engagement focus primarily on the effectiveness of company boards, with executive pay being only a part, but not the key point, of the discussion. Engagement this year has increased exponentially, CalSTRS indicated, while the AFL-CIO announced that over half of the shareholder proposals it submits are withdrawn after negotiations with companies. One example of the divide between companies and proponents appears in the wide ranging views of which information should be captured when companies decide to adopt a policy to disclose political spending. 

Board Dynamics and Elections.  The need for directors to be willing to challenge what they are being told, even at the cost of being perceived as disruptive, was discussed in more than one session. The recent emphasis on individual director qualifications raised the concern that other directors may place over-reliance on board members who are labeled as having functional expertise, obscuring the need for all directors to have a general understanding of the company. Director elections (and as a byproduct, proxy access) continue to be a hot topic. While only a few directors receive a majority lack of support, those tend to be at companies that have plurality voting and thereby able to fully ignore shareholder sentiment. Some investors have developed a short list of problem directors and will vote against those directors at every company where the directors serve. 

Executive Compensation.  Speculation abounds over the rising number of companies that are disclosing realizable, or realized, pay, with some 40% of large-caps including this element in their proxy statements. But others lamented the lack of a cohesive and recognized method that would allow for comparability. Over 100 companies filed supplemental materials this season.  While most investors thought they were somewhat helpful, they generally do not change investor voting and in some situations triggered criticism when new information was presented that was not found in proxy statements. There was widespread agreement among investors that those filings, and subsequent investor discussions, should avoid being merely, or even largely, an attack on the proxy advisory firms’ recommendations. 

These brief highlights represent only a small portion of the active dialogue and discourse that made the conference a valuable resource as governance matters continues to gain prominence and affect both the workings and reputations of companies, in particular, as Chancellor Laster indicated, the underlying state law itself has changed very little while there has been enormous shift in the reality of the power balance between shareholders and companies. These are suitable times to have author Bethany McLean, known for her writing on Enron and the financial crisis, provide the closing address. She explored the causes of one financial scandal after another, questioning whether company leadership were willing to engage in candid assessments of their organizations’ risks and problems. 

Doug Chia, the Chairman of this 66th national conference and Assistant General Counsel and Corporate Secretary at Johnson & Johnson, reiterated his support for providing a forum where complex governance issues can be aired and understood, “We wanted to give governance professionals who support management and boards an opportunity to hear from and discuss the perspectives of the numerous constituents who influence the debate on effective corporate governance, and also a chance to engage with and learn from each other.“

This is the second in a series of posts to discuss shareholder proposals during the 2012 proxy season.

Not surprisingly, shareholder proposals on majority voting for uncontested director elections continued to garner support this year, averaging 62.5% of votes cast at 33 companies as of early July, up slightly from 59.2% in 2011.

Of this total, 18 of the proposals voted on were at S&P 500 companies. Half of those  passed with average support of 57.5% of shares cast. Two companies – PACCAR and CF Industries – had notably high shareholder support: 97.1% and 91.7%, respectively. Management had supported the proposal at PACCAR but opposed it at CF Industries. 

At its annual shareholder meeting this year, Apple announced its intention to adopt a majority voting standard, as proposed in a shareholder proposal in its proxy statement. This followed a year of Apple’s refusal to adopt a majority vote standard, despite 73% of its shareholders having supported such a proposal in a non-binding vote in 2011. CalPERS had submitted the majority vote proposals at Apple in both 2011 and 2012.

In looking at these results, it seems that while majority voting is often referred to in the same breath as other governance stalwarts such as board declassification (which we recently discussed), shareholder support for such proposals is not nearly as high. Indeed, this season management proposals for majority voting passed at 9 companies, but failed at two companies. Nevertheless, the trend of adoption of majority voting standards, especially at large cap companies, continues apace; according to ISS, 79% of S&P 500 companies had adopted majority voting by 2011, up from 59% in 2009.

The Business Roundtable has updated its Principles of Corporate Governance, last revised in 2010.  It would be easy to dismiss the Principles as 32 pages of platitudes and conventional wisdom, but it’s actually worth a look.  The Business Roundtable is far from a thought leader, but at the same time it is not as reflexively retrograde as some other business organizations that come to mind.  The Principles may not be bold, but it is rooted in a humility—we may not know all of the answers, and different situations may call for different approaches—that is welcome in a field more often characterized by rigidity and bluster.

You can think of the Principles as providing a useful, albeit lagging, indicator of what large U.S. public companies actually do, or at least aspire to do, in corporate governance.  Put it this way: if your company is not following a practice that the Principles recommends, it should be as a result of a conscious decision at the board level.   

The general approach of the Principles is to be prescriptive as to matters that are thought to be noncontroversial (and that in many cases are already required by law or stock exchange rule), to be equivocal as to areas where the authors believe a consensus has not definitively emerged, and to be silent as to truly controversial areas.  Thus:

• Prescriptive: Items in the 2012 update that are in the “every public company should” category include: having an independent chair or lead director; having a “substantial majority” of the board be independent; having a majority vote policy under which directors who fail to receive a majority must offer their resignation; establishing a risk oversight structure (although not usually a dedicated committee); annual succession planning sessions; board oversight of political activities; and board prioritization of dialogue with “long-term” shareholders.
• Equivocal: Plenty of things that companies should “consider,” including separating the CEO and chair, using restricted stock rather than stock options for board compensation, adopting a disclosure policy with respect to political activities, board retirement age policies, and adopting a three audit committee membership limit (no reference to overboarding rules generally).
• Unaddressed: Annual election of directors, proxy access, one share/one vote, shareholder rights to act by consent or call special meetings, and audit firm rotation.

You might consider including the Principles in your next board packet.

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.

This is the first in a series of posts to discuss shareholder proposals during the 2012 proxy season.

The march towards board declassification showed no signs of slowing down in the 2012 proxy season. Of the 45 precatory shareholder declassification proposals that had gone to a vote as of mid-June, 40 of such proposals passed with an average support of 89% of the votes cast. This shows an increase in support of shareholder declassification proposals over the previous proxy season, in which  declassification proposals passed with average support of 77% of votes cast. For the proposals that failed, the average support was 43.7% (excluding a failed proposal at Hospitality Properties Trust, which garnered the support of 90% of votes cast but failed to get the requisite 75% of outstanding shares.) 

The number of shareholder declassification proposals might have been even higher had an additional 44 companies receiving such shareholder proposals not negotiated agreements to offer management proposals to declassify their boards, according to a report by the Harvard Law School Shareholder Rights Project (SRP). All the management proposals regarding declassification received resounding support of votes cast, but some nevertheless failed at companies, such as Alcoa and Charles Schwab, which require votes of more than 80% of the outstanding shares.

According to the ISS, only one-third of all S&P 500 companies have staggered boards, as compared with over half of the mid-cap and small-cap companies. Notwithstanding this gap, the activist focus continues to be on the large-cap companies. Approximately three-quarters of the shareholder declassification proposals this season were filed at large-cap companies, many of them proposed by institutional investors who were advised by the SRP. 

The Nasdaq Stock Market has proposed to broaden the exception (in Rules 5605(c)(2)(B), 5605(d)(3) and 5605(e)(3)) that allows one non-independent director to serve on a company’s audit, compensation or nomination committee under “exceptional and limited circumstances” for a maximum of two years if the board determines that it is in the best interests of the company and its shareholders. Under the existing rules, a company may not use the exception if the director is currently an officer or employee of the company or has a family member who is an officer or employee of the company. 

The proposed rules would continue to prohibit the use of the exception for family members of executive employees but would not prohibit the use of the exception if the director is a family member of a non-executive employee. The proposal attempts to harmonize the exception with the director independence rules generally, which do not disqualify a director from being considered independent based on a familial relationship with a non-executive officer. As before, a listed company that relies on the exception must comply with the relevant disclosure requirements. 

The SEC is soliciting comments on the proposal. Comments are due within 21 days from the date the proposal is published in the federal register (which is expected shortly).

Read the proposed rule change.

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.

After receiving comments and hosting a roundtable, the PCAOB has reproposed for comment an auditing standard on Communications with Audit Committees by making modifications to its original proposal from March 29, 2010.  Both proposals update existing AU 380.  Comments are due by February 29, 2012, with the new standard anticipated to be effective for audits of fiscal years ending on or after December 15, 2012.

Overall, the proposal as it currently stands covers almost all of the existing topics under AU 380, and in addition contains specific enhancements or new requirements, such as:

• providing the audit engagement letter to the audit committee and determining that the committee has acknowledged and agreed to the terms of the engagement;
• inquiring of the audit committee about matters that might be relevant to the audit, including knowledge of violations or possible violations of laws or regulations or complaints or concerns raised regarding financial reporting matters;
• discussing with the audit committee an overview of the audit strategy, including significant risks identified during the auditor's risk assessment procedures, whether specialists will be needed and the extent to which the auditor plans to use the work of the company's internal audit function or other parties;
• with respect to critical accounting estimates, describing the process that management used to develop those estimates and changes to the process as well as any assumptions used by management that the auditor believes have a high degree of subjectivity;
• informing the audit committee about difficult or contentious matters that triggered consultation outside the engagement team and that the auditor believes are relevant to the audit committee's oversight of the financial reporting process;
• discussing significant transactions that are outside the normal course of business for the company or otherwise appear to be unusual due to their timing, size or nature; and
• communicating matters from the audit that are significant to the oversight of the company's financial reporting process, including concerns regarding accounting or auditing matters that have come to the auditor's attention. 

In addition, the auditor must inform the audit committee of certain matters related to an evaluation of the company's ability to continue as a going concern, and when the auditor expects to modify its opinion or include explanatory language in the auditor's report.   The audit committee communications, which will be required to be conducted prior to the issuance of the report, may continue to be handled either orally or in writing, so long as they are noted in the auditor's work papers.   

Contact . Contact ner.

In what would appear to be the first filing of proxy access proposals by an institutional investor, Norges Bank Investment Management (NBIM), manager of the Norwegian Government Pension Fund, has recently filed proxy access shareholder proposals at six U.S. companies. The Norwegian Government Pension Fund held approximately $98 billion in U.S. equities and $63 billion in U.S. bonds as of the end of November.

According to its press release, NBIM filed shareholder proposals at Wells Fargo, Charles Schwab, Western Union, Staples, Pioneer Natural Resources and CME Group, asking each of the companies to establish procedures for shareholders to nominate candidates to the company’s boards of directors.  The NBIM proposal would require that shareholders own a minimum of 1% of the company’s stock for at least one year in order to nominate directors.  Under the proposal, up to 25 percent of the board may be nominated by shareholders. These proposals provide a lower threshold of stock ownership required for nomination than that of  the SEC’s vacated Rule 14a-11, which required ownership of 3% of a company’s shares for a period of three years in order to nominate a director.

All but one of the companies targeted by NBIM has seen a drop in its stock price over the last year.  In its press release, a spokesperson for NBIM said that it “will continue to identify companies with unsatisfactory performance.” According to an article in the Wall Street Journal today, NBIM selected the six targeted companies after a review more than 2000 of the fund’s U.S. holdings.  A spokesperson also said in the article that NBIM is “not planning [on nominating directors] now; we would much rather have a good dialogue with the board.”

Contact . Contact .

ISS has asked that we encourage interested parties to register for its free webinar to discuss its new proxy voting guidelines, which we recently summarized in a client publication.  The session focused on U.S. policies will take place on Wednesday, December 7, at 11:00 a.m. EST and will feature Martha Carter, Head of Governance Research; Carol Bowie, Head of U.S. Compensation Research; and Pat McGurn, Special Counsel. 

Having been on panels with Carol and Pat, both frequent speakers about ISS, it is always helpful to hear them discuss ISS' recent experiences and the background and application of ISS guidelines.  They may explain and further elaborate on some of the seeming complexities of the new pay for performance criteria that will be used to evaluate say-on-pay in 2012, and may provide indications of their upcoming guidance to be issued on the topic, likely in mid-December.  They may also give a sense of the latest status of proxy access proposals.  While many are critical of it, no one disputes the reality of ISS' influence on proxy voting, so this is a welcome opportunity for education as a key step toward being prepared. 

A separate discussion of the European policies will take place a day earlier, and you can find registration for that session on the same site as noted above.   

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Exclusive forum provisions in charters and bylaws, under which derivative suits and other shareholder litigation must be brought in the courts of the company's state of incorporation, drew some attention during the 2011 proxy season.  My recent piece summarizing the state of the law and the practice on this subject is here.  No consensus on this topic has yet emerged among institutional investors, and the 2011 votes were close and had mixed results.

ISS's position on these provisions in the 2011 season ignored the merits of exclusive forum requirements and instead looked to a set of largely unrelated governance "best practices":

• annual election of directors
• majority voting for directors in uncontested elections
• 10% shareholders having the right to call special meetings
• the absence of a poison pill unless approved by shareholders

Only companies that had adopted all four of these practices would receive an ISS recommendation in support of an exclusive forum provision.

ISS has revisited this policy in connection with its overall policy review for the 2012 season and, as often seems to be the case with ISS, has taken a step or two forward and a step back.  Instead of the checklist approach used in 2011, ISS says that this issue will now receive "case-by-case" analysis, taking into consideration most of the same factors that were in the checklist.  The weighting of these factors is unclear.

A step forward is the deletion of the 10% shareholder special meeting requirement from the list of best practices.  ISS acknowledges that "this governance feature is less relevant to exclusive venue than it is to other proposals".  (The same could of course be said about the other items on the list, but never mind.)

The step backward is the addition of a new factor that ISS says it will consider: "[w]hether the company has been materially harmed by shareholder litigation outside its jurisdiction of incorporation, based on disclosure in the company's proxy statement."  It's hard to make sense of this one, since exclusive forum provisions are by their nature prophylactic and not retrospective.  If avoidance of potentially duplicative litigation is a legitimate goal, it hardly becomes less legitimate if the company has not yet been a victim of the practice.  This would be akin to saying that you shouldn't buy fire insurance unless your house has burned down at least once in the past.

The new guidelines make ISS's position on any particular company's proposal less predictable than before, and to that extent further complicate the decision tree for companies considering whether to adopt an exclusive forum provision and, if so, whether to submit it for shareholder approval.  We may need to see another proxy season's results before this becomes more clear.

Contact Bill Kelly.

The latest Spencer Stuart Board Index (November 2011) finds that three-fourths of S&P 500 companies require annual election for directors and 79% have some form of majority voting.  41% of boards, almost double the percentage from 10 years ago, now split the roles of chairman and CEO, with 21% of those having truly independent chairs.  18 companies disclose a formal policy requiring separation of the two positions. 

The Index highlights that this year saw the smallest increase of new directors being added in a decade, and nearly a quarter of those members are first-timers on public company boards.  Less than a quarter of directors are active CEOs, as more than half of active CEOs do not serve on an outside board. 

The survey provides a useful benchmark for companies evaluating their governance guidelines, finding that 81% have policies requiring board resignation upon a change in circumstances and 74% now restrict the number of other corporate directorships for their board members. 73% of these companies establish a mandatory retirement age, with 55% of the policies set at age 72.  Only 4% mandate term limits for their boards.

Boards met an average of 8.2 times while audit committees met an average of 8.7 times.  Nearly 70% of companies have more than three standing committees (most often an executive or finance committee).  Only 37% of companies pay meeting fees, a 20% decline from 2006.  Healthcare and energy companies provide more director compensation than other industries, while the West Coast leads other regions in having the highest director compensation at an average of $295,356. 

The five- and ten-year trends in the Index are an interesting study on evolving notions of corporate governance "best practices" and the comparative board data gives some company-specific details for additional benchmarking.

Contact .

Considering that there continues to be growing pressure on larger companies to update their corporate governance provisions in response to both government regulations and pressure from shareholders and advisory groups, we thought this would be a good time to review the corporate governance practices at the time of the IPO to see which of these practices were being adopted by IPO companies.  We surveyed corporate governance at the time of the IPO for the largest 50 U.S. company IPOs from January 2009 through August 2011. Our survey separates the data for “controlled companies” (as defined in NYSE and NASDAQ listing standards) and noncontrolled companies.

Click here to access the survey results excluding controlled companies.  

Click here for the survey results for controlled companies only.

Our survey shows that the pressure to update corporate governance practices at the larger companies has had only limited effect on companies at the IPO stage and that IPO companies still have much latitude when designing their governance structures.  For instance, we found that only 6% of IPO companies had majority voting for directors (versus 70% of S&P 500 companies according to a 2011 ISS Survey) and 78% had classified boards (versus 39% for S&P 500 companies).

As would be expected, some of the corporate governance practices at the
“controlled companies” we surveyed were significantly different from those found at the noncontrolled companies.  For example, 82% of controlled companies were listed on the NYSE, while only 52% of the noncontrolled companies we surveyed were. Also, the average level of director independence at the controlled companies was 39% versus 74% at the noncontrolled companies.

As compared to our 2009 IPO survey, we found some small movement towards  practices more commonly found at seasoned issuers.  We have also added a new section, “Exclusive Forum Provisions,” reflecting the new trend of public companies incorporating provisions in either their charter or bylaws requiring certain litigation against the company to be brought exclusively in the company’s state of incorporation.  

Overall, it remains the case that the IPO companies still have considerably more freedom than seasoned issuers when designing their corporate governance structures.

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MSCI, the parent company of ISS, recently announced that Gary Retelny, a member of MSCI’s Executive Committee and its Corporate Secretary, has been appointed President of ISS.  As ISS is clearly an influential force in corporate governance developments, we asked Mr. Retelny about his new position.

Davis Polk: What are your primary goals and expectations for ISS as we approach the 2012 proxy season?

Gary Retelny: With only a few days “on the job” as ISS’ President, I still have a lot of listening and learning to do before I can articulate specific goals.  I hope to meet frequently with all our constituencies and provide a variety of forums for meaningful dialogue and of course, debate.  I can tell you generally though that as we look toward the 2012 proxy season, I will be working to ensure that ISS’ policies and related research continue to be increasingly transparent, fair and impartial.  I would note that we will soon be releasing the results of our 2011-2012 policy survey and in October will release draft policy updates and invite comments on the draft.  I urge interested parties to participate in the comment process.

Additionally, I’m enthusiastic about ISS’ potential growth prospects as both investors and companies demonstrate a need for a broader set of products and services to inform and support their decision-making.  By accelerating our product development cycle, I am confident that we’ll not only meet these needs but will become an engine for innovation and continued thought leadership in our field.  ISS has been a market leader for more than 25 years – we intend to build upon an already strong foundation.

Davis Polk: How do you think your experience as corporate secretary of MSCI will affect your leadership of ISS?

Gary Retelny: As Corporate Secretary, I work very closely with our entire board of directors, various board committees and of course our chairman and lead director.  I have worked closely with our board and the chairwoman of our Nominating & Corporate Governance Board Committee on our governance policies.  I believe this has given me an opportunity to be exposed to and consider from a number of perspectives the kinds of governance issues confronting many boards today.  It has helped make me sensitive to the challenges boards increasingly face.  I also see firsthand the value that comes from constructive dialogue between companies and their constituencies, in particular shareholders.

I expect to leverage my experience as a corporate secretary to help ISS address complex corporate governance policy issues in a reasoned and practical way and to foster more effective ISS engagement with all market constituents. 

Davis Polk: What do you think are the most important governance challenges facing U.S. public companies today?

Gary Retelny: That’s a difficult question to answer specifically because every company is different.  The logjam in Washington related to Dodd-Frank and the reversal on proxy access, make the regulatory waters difficult for all market constituents to navigate.  Putting the regulatory landscape aside, I think that companies that foster dialogue among their directors, their management and their shareholders are in a better position to address governance challenges in a balanced and thoughtful way.  Clearly, we want to continue to foster transparency and dialogue as key areas of focus.

Davis Polk: What advice do you have for U.S. public companies regarding their interest in communicating with ISS about its policies and recommendations?

Gary Retelny: First, I would encourage companies to participate in ISS’ policy development process, which is quite transparent and inclusive of investors and issuers alike.  There are a number of forums and client conferences that we host for communication.  As mentioned above, the process is under way now and has an open comment period coming up in October.   Second, I would encourage companies to engage with both their major shareholders and with ISS sooner rather than later when they know that there is going to be a contentious proxy issue.  In some cases it also may be useful to have directors participate in this engagement.  Finally, I would remind everyone that a difference of opinion over governance guidelines or practices does not equate to a wrong outcome.  Remember that we offer our clients standard benchmark policies, specialty policies and completely custom policies, which can differ significantly from each other.  In all cases, however, it is important that ISS understand a company’s position on a governance issue and the rationale behind it.  It is ISS’ responsibility to provide informed analyses and vote recommendations to its institutional clients.

On a personal note, I expect also to be an active channel myself for dialogue and at times, for debate.

Contact Ning Chiu.

The 2011 Corporate Board of Directors Survey from Stanford's Rock Center and Heidrick & Struggles suggests that active CEOs may not make the best board members.  We asked Professor David Larcker, corporate governance expert at Stanford, to discuss those and other findings.

Davis Polk: Active CEOs are generally considered prized board candidates due to their leadership experiences.  Do your survey results dispute that view?

Prof. Larcker: I don’t think our survey disputes it so much as qualifies it.  What we see in the survey results is that there are advantages and disadvantages to different types of directors, including active CEOs.  When identifying new candidates for the board, the nominating and governance committee needs to balance the leadership and knowledge aspects with concerns about whether an individual really has the time to devote to being an engaged board member.  The survey responses suggest that, when all of these factors are taken together, active CEOs might be roughly equivalent to the quality of other board members.

Davis Polk: The survey also focuses on concerns with board turnover.  Is board turnover at appropriate levels?  What can boards do to better manage turnover?

Prof. Larcker: About half of respondents to the survey think that turnover is too low.  It is certainly possible that there is a “sweet spot” regarding board service, or when it is time to bring in new people and new ideas.  There is not going to be a uniform answer to this question.  It will vary based on the specific company and the individuals involved.  That said, if an underperforming director is identified, the lead independent director or the chairman needs to think carefully about how to manage that person off the board.  We find that it is very difficult to get rid of an underperforming director who has stayed on the board too long.  An operational succession plan for board members would go a long way to matching the composition of the board to the strategic needs of the company. 

Davis Polk: What do you think accounts for the findings that nearly 20% of lead independent directors are being chosen by the CEO or Chairman, and only 47% are elected by the independent directors? 

Prof. Larcker: The lead director is somewhat of a new position on the board. This person provides balance for a company when the CEO and chairman positions are held by a single person.  Since the lead director is the spokesperson for the outside directors, it seems appropriate that these directors select who represents them.  We find it odd that the lead director would be appointed by the CEO.  However, some input from the CEO is certainly useful when picking the lead director.

Contact Ning Chiu.

The SEC staff issued a surprising CDI recently.  Seems that the biographies of directors who are not standing for re-election are required to be disclosed under both Item 401(a) and Item 401(e) of Regulation S-K, if not technically in the proxy statement, then in the Form 10-K.  Why investors would be interested in the bios of directors who won’t be continuing is a bit of a mystery.  And for those of you who have asked – Item 401(a) only applies to your current directors.  If they resigned before your published your proxy statement, you don’t have to worry about their biographies.

Contact Ning Chiu.

The Delaware Supreme Court today struck down the bylaw amendment that would have accelerated the expiration of one of Airgas’ class of directors.  The Court ultimately cited “practice and understanding” to conclude that directors of staggered boards should serve three full-year terms and that a bylaw requiring the company to hold its next annual meeting just four months after its prior meeting is invalid.  I expect this opinion will give considerable comfort to companies with staggered boards by allaying concerns that the lower court’s decision (upholding the bylaw) weakened their defenses.  That being said, companies with the opportunity to do so (which may only be pre-IPO companies and spin-offs) ought to consider providing in their charters that their board has unilateral power to set the date of annual meetings.  Here’s the Davis Polk memo on the decision.

 

Contact Phillip Mills.

 

Delaware’s Vice Chancellor Laster recently issued a decision in which he proposed that a board should get “business judgment review” of a going private transaction involving a controlling stockholder when the transaction is subject to BOTH a “majority-of-the-minority” tender or vote condition AND blessed by a qualified special committee.  This is a well litigated issue as a result of which Delaware courts have distinguished between the standards of review applicable to these types of transactions depending on whether the transaction is structured as a one-step merger or a two-step tender offer (applying entire fairness to one-steps but not to two-steps that contain certain procedural protections like a majority-of-the-minority tender condition).  This case attempts to harmonize the discrepancy by advocating a unified standard but the proposal will need the future blessing of the Delaware Supreme Court to be effective, given the existing law.  I expect it will remain an important judgment call for parties to decide whether to introduce the added risk of dual approvals (special committee and minority shareholders) in the hope of getting business judgment review; or to follow the traditional path of shifting the burden of proof in entire fairness to the plaintiffs through a well run special committee process.  Here’s the Davis Polk note.

Contact Phillip Mills.