ON Securities : Securities Lawyer & Attorney for Corporate Governance & Executive Compensation Matters

As an increasing number of companies have been hit (or threatened) by shareholder derivative lawsuits prior to their annual meeting, the number of articles, posts and other materials discussing these cases has also increased. A few of these articles, discussed below, should be on the reading list for anyone who might be faced with defending one of these actions.

The annual meeting lawsuits are filed after the mailing of the proxy statement, seeking to enjoin the shareholder vote or votes based on purported incomplete or misleading disclosures and claimed breaches of the directors’ fiduciary duties. I have called these cases the second generation of “Sue-on-Pay” lawsuits, because they focus mainly on the Say-on-Pay vote and, often, a separate shareholder vote to increase the share authorization of an equity plan. [A third type of claim, not compensation-related, sometimes relates to a shareholder vote to increase the share authorization under the corporation’s charter.]

Most of these lawsuits have been filed by the Faruqi & Faruqi law firm; a review of that firm’s web site shows that since the beginning of 2013, they have announced investigations relating to at least 20 companies’ annual meetings, a step often followed by the commencement of a derivative lawsuit. These cases have become more widely known as a result of a recent Wall Street Journal article, “Anxiety Stalks Proxy Season” by Emily Chasan.

A recent post by David Katz of the Wachtell, Lipton law firm, “The New Wave of Proxy Disclosure Litigation,” offers some very specific and helpful tips on advance preparation for the possibility of an annual meeting lawsuit. Katz first focuses on crafting proxy disclosures that are more likely to withstand challenge, and on advising the board of directors on the possible risk of litigation. Then he provides some tactical advice about steps that might help the company move quickly in the event of litigation:

Companies that are sued in this context and decide to vigorously contest the allegations frequently have been successful. One tactic that has been helpful in some cases is to procure affidavits from significant institutional shareholders to counter the allegations. Such an affidavit can be very persuasive to a court; moreover, in our experience, institutional shareholders generally are not supportive of this type of litigation. Having an institutional shareholder submit a declaration gives the lawyer defending the company the ability to draw a sharp contrast between the interests of shareholders and the interests of plaintiffs’ lawyers who file these lawsuits on behalf of small individual shareholders who often serve that function in multiple cases. Companies that engage regularly with their significant institutional shareholders are more likely to be able to leverage these relationships to procure support when confronted with these lawsuits. Companies have also successfully engaged experts in areas such as disclosure practices to effectively resist preliminary injunction motions. Prior planning is important to be able to marshal the resources necessary to defend against these lawsuits.

Another good post counsels that companies in the process of drafting their proxy statements should be cautious before trying to tailor their disclosures to avoid litigation. In “Changing Your Proxy Disclosures May Not Be the Right Way to Fend Off Annual Meeting Litigation”, Steve Seelig of Towers Watson goes through a laundry list of the types of proxy statement disclosures frequently sought by plaintiffs in these cases and analyzes in very specific terms whether it makes sense to address them in advance. For example:

Equity Plan and Share Authorization Votes . . . [W]e view the request for information on dilutive impact and estimates of run rates to be reasonable and relatively easy to fulfill.  With this information, shareholders can see the current state and forecasts of future dilution, but we would only disclose forecasts based on historical patterns. . . . We are less enthusiastic about providing share usage projections developed for the compensation committee as these often contain hypotheticals that do not come to pass. . . .

Finally, the Society of Corporate Secretaries & Governance Professionals has made available the materials from a January webinar on “Protecting Your Company from Proxy Disclosure Litigation” (PDF). A panel of in-house counsel, outside counsel and a Society representative present a laundry list of steps that can serve as a checklist for a public company that wants to be as prepared as possible.

Or, if you don’t want to do advance planning, you can just file your proxy statement and collectively try to look invisible – maybe look into this company’s claims that it has created an invisibility cloak using its “Quantum Stealth” technology. Hey, buddy, does that cloak come in size “Corporate”?

The Cheat Sheet is Back!

We have posted the latest version of the ON Securities Cheat Sheet (PDF), including the updated status of all of the governance and compensation developments under the Dodd-Frank Act. After several months with very few changes, in January the SEC approved the changes in the listing standards of Nasdaq and the New York Stock Exchange relating to compensation committees and their independence. The Cheat Sheet covers, in one place, the specific requirements of the new listing requirements, the effective dates, and which new provisions cover smaller reporting companies. Check it out.

Thanks to my colleagues Alan Gilbert and Leah Fleck for their help in bringing the Cheat Sheet up to date.

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On December 21, 2012, the SEC issued new rules requiring broker-dealers to search for holders of securities with whom they have lost contact. The new rules also require broker-dealers and other “paying agents” to provide notice to persons who have not negotiated checks received on account of securities they beneficially own. The new rules may make it easier as a practical matter for states to lay claim to “unclaimed property” held by broker-dealers and paying agents. In addition, the rules may make it more attractive (i.e., profitable) for states to focus their unclaimed property collection efforts on securities and securities-related property in general. As described below, this could drive up compliance costs for public companies and their service providers.

New SEC Rules. Broker-dealers will be required to comply with the revised “lost securityholder” rules (Rule 17Ad-17) in the next year or so. Similar to existing transfer agent requirements, broker-dealers will be now obligated to conduct at least two database searches (using at least one database service) for “lost securityholders” - securityholders whose mail is returned as undeliverable. The first search must be conducted between three and 12 months of a person first becoming a “lost securityholder,” and the second search must be conducted between six and 12 months after the first search. Exclusions will apply for a securityholder (i) for whom the broker-dealer (or transfer agent) has documentation indicating the securityholder is deceased, (ii) whose aggregate value of assets is less than $25, or (iii) who is not a natural person.

Also, “paying agents” (including certain issuers, broker-dealers, transfer agents, and other entities) will be required to notify each “unresponsive payee” within seven months of the date on which an unnegotiated check is sent. An “unresponsive payee” is someone to whom a check is sent by the paying agent and the check is not negotiated (i.e., cashed) before the earlier of the paying agent’s sending the next regularly scheduled check or the lapse of six months after the sending of the unnegotiated check. Here too, an exclusion applies if the value of the unnegotiated check is less than $25.

Effects on State Unclaimed Property Laws. Although the new SEC paying agent rules in particular contain a statement that those rules “shall have no effect on state escheatment laws,” the rules may nonetheless affect the collection of unclaimed property in significant ways. For example, the new and revised rules will make it easier for state inspectors to find and obtain evidence of a lack of “dominion and control” by securityholders over their investment property, a finding that can trigger unclaimed property proceedings. Furthermore, some state laws require a second finding, that the owner of property be “lost,” prior to the commencement of what is commonly referred to as the “dormancy period” (generally three to seven years for securities). In sum, the new and revised SEC rules will make lost or inactive accounts more easily indentifiable by state investigators, and the rules may offer additional evidence for state investigators to assert that the owner is “lost”, if relevant.

Unclaimed Property on the States’ Radar. While unclaimed property and escheat law is complex, the importance of escheatment and unclaimed property is not lost upon state legislators attempting to balance state books. As indicated in this comprehensive academic review of unclaimed property laws in the Michigan Law Review in 2011 (PDF), only approximately 30% of unclaimed property is eventually reclaimed by a rightful owner or heir. And state efforts have been effective. The Delaware Office of Economic and Advisory Council estimated Delaware’s 2012 revenue from unclaimed property at $475 million, a figure that approaches 50% of all revenue raised from personal income taxes in that state. According to the Minnesota Department of Commerce website, in 2011, Minnesota received nearly $57 million in unclaimed property.

The significance of revenue derived from unclaimed property is a major reason why states will continue to pursue the property aggressively. For example, as Broc Romanek recently reported in TheCorporateCounsel.net Blog, many states have shortened the statutorily defined “dormancy period” after which they can take possession of such property, and embarked upon various “voluntary reporting” programs practically designed to speed the process by which the state takes possession of property.

Comment. As described above, the SEC rules may help states track down unclaimed property and provide them with additional evidence. Therefore, the biggest beneficiaries of these new rules may in fact be the states and their balance sheets. Quite a nice holiday gift for the states. A thank-you note to the SEC may be in order. Broker-dealers, paying agents and ultimately issuers may not be so grateful if their compliance costs are increased by the SEC rules and the states’ increased activity.
 

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Recent news reports make it clear that now is a good time for public company compliance officers to review their company’s procedures for approval of insiders’ Rule 10b5-1 trading plans. If you are not looking at your practices in this area, it’s possible that a regulatory authority or media reporter will soon be taking a close look.

Rule 10b5-1, adopted in 2000, provides insiders with an affirmative defense to charges of insider trading if the trades are made pursuant to a so-called 10b5-1 trading plan. The plan must be entered into at a time when the insider has no material nonpublic information about the company and must either provide specific instructions about the trades or must turn the decision making over to a third party who does not possess material non-public information. Since its adoption, the rule has facilitated countless trades by public company officers and directors.

Recently, the Wall Street Journal has led the charge in scrutinizing insiders’ transactions in their companies’ stock, either within 10b5-1 plans or outside of such plans:

On November 28, 2012, in Executives’ Good Luck in Trading Own Stock (subscription required), the Journal’s reporters Susan Pulliam and Rob Barry detailed numerous examples of executives making sales, generally under Rule 10b5-1 plans, shortly before corporate announcements of negative news. These trades thus permitted the insiders to take advantage of higher sale prices than would have been the case had they sold after the news was made public.

On December 11, in Insider-Trading Probe Widens, the Journal reported that the November 28 article had triggered a criminal investigation by the Manhattan U.S. Attorney’s office of trades by seven executives, and an SEC investigation of another. On December 12, in Big Sales by Big Lots Brass, the Journal gave more detail on the some of the trades. One of the problematic practices cited: insiders making trades outside of Rule 10b5-1 plans fairly close in time to trades within the plan. While there is no requirement that all trades be made under the Rule (which is only a safe harbor), frequent trades outside the plan can raise questions about whether the insider is acting in good faith.

On December 14, in Trading Plans Under Fire, the Journal reported that Congress is investigating whether Rule 10b5-1 provides adequate protections against insider trading, a development that could put pressure on the SEC to increase scrutiny on insider trades even further.

All of this attention means that companies should focus on making sure that their own insider trading policies are adequately enforced and prevent, not only illegal activity, but even the appearance of impropriety. In connection with 10b5-1 trading plans, companies should focus on the following areas:

• Consider adopting or expanding a cooling off period between adoption or amendment of the 10b5-1 plan and the commencement of trading. This can make it easier to prove that the plan was actually adopted or amended before the insider learned of any material nonpublic information. In a September 2010 survey reported by thecorporatecounsel.net Blog, respondents reported that their companies used the following cooling-off periods: two weeks or less-13%; one month-23%; two months-6%; a waiting period until the next open window-12%; none-37%. Such a cooling off period has become a best practice, even though it would not have prevented all of the problems outlined in the recent Journal articles.
• Consider encouraging insiders to sell shares only pursuant to a 10b5-1 plan. In the 2010 survey cited above, 31% of the respondents said that their companies "strongly encouraged" insiders to sell only under a Rule 10b5-1 plan, and another 4% said their companies actually require that trades be made only under such a plan.
• Examine other aspects of your process for approving 10b5-1 plans and amendments and make sure they are up to date and adequately enforced and documented. For example, make sure it is possible to document that all 10b5-1 plans and amendments were actually adopted or amended at a time when the insider was not in possession of material non-public information.
• Avoid multiple trading plans by the same insider at the same time, which can permit the insider to exercise discretion by terminating one or more of the plans. This was the manipulative technique used by former Countrywide Financial CEO Angelo Mozilo, resulting in a record settlement of $67.5 million with the SEC in 2010.

Maslon’s Holiday E-Card – Send it On!

I wanted to share with all of you our Maslon Holiday E-Card with the theme, “Send it On.” Maslon attorneys and friends of the firm have shared “Words of Wisdom” from others that have guided each of us.

We invite you to participate by taking a couple of minutes to share words of wisdom that have meaning for each of you. You can help us reach our goal of 200 or more submissions. For each submission, Maslon is making a donation to Bolder Options, an innovative charity focused on promoting healthy development of youth through mentoring.

We wish you all a very happy holiday season.

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Over the past few years, there has been an increasing focus on public company insider hedging and pledging activities. Institutional shareholders and proxy advisory firms have been pressuring public companies to disclose their policies on hedging and pledging. Under the Dodd Frank Act, enacted in 2010, Congress charged the SEC with adopting rules regarding disclosure of this activity in SEC filings.  However, the SEC has not yet proposed or adopted rules implementing this mandate.  The SEC has eliminated its expected rulemaking timetable for this and certain other Dodd-Frank provisions and, instead, the SEC’s website now indicates that the rulemaking is “pending action.”

Taking matters into its own hands, the shareholder advisory firm Institutional Shareholder Services (ISS) specifically addressed hedging and pledging activity its 2013 U.S. corporate governance policy updates, which were posted on November 16, 2012. Among other policy updates, ISS added a footnote to its policy on voting for director nominees in uncontested elections in circumstances where there are perceived governance failures. Currently, ISS will recommend that shareholders vote “against” or “withhold” votes from directors (individually, committee members, or the entire board) due to, among other things, “[m]aterial failures of governance, stewardship, risk oversight, or fiduciary responsibilities at the company”. The new footnote cites hedging and significant pledging of company stock as examples of activities that will be considered failures of risk oversight. Other cited examples of risk oversight failures include bribery; large or serial fines or sanctions from regulatory bodies, and significant adverse legal judgments or settlements.

By identifying the existence of hedging and significant pledging as a risk oversight and corporate failure, ISS will attempt to hold directors accountable for permitting that practice to exist. “Against” or “withhold” recommendations may not be limited solely to individuals that actually engage in hedging or pledging activity.

As rationale for this update, ISS states that director and executive stock ownership, whether resulting from equity compensation grants or open market purchases, should serve to align executives' or directors' interests with the interests of shareholders. ISS asserts that hedging severs the alignment of these interests and, therefore, any amount of hedging will be considered a problematic practice warranting a negative voting recommendation.

Pledging is treated differently. As noted by the Society of Corporate Secretaries & Governance Professionals in a comment letter on the proposals (PDF), ISS’ initial proposal was to consider pledging by executives as a problematic practice in all cases. In its comments, the Society argued that “an across the board policy was inappropriate, and that it could affect many smaller, founder-led companies where company stock constitutes the majority of an executive's (or other director's) net worth and such pledging has been used judiciously for an appropriate reason such as purchasing a home.” In response to these and other comments, ISS revised its policy to state that only “significant” pledging will be considered a problematic practice warranting a negative voting recommendation. What constitutes “significant” pledging will be determined on a case-by-case basis.  In making voting recommendations for election of directors of companies who currently have executives or directors with pledged company stock, ISS will take the following factors (in additional to “other relevant factors”) into consideration:

• Whether the company has an anti-pledging policy that prohibits future pledging activity;
• The magnitude of aggregate pledged shares in relation to the total shares outstanding, market value or trading volume;
• The company’s progress or lack of progress in reducing the magnitude of aggregate pledged shares over time; and
• Whether shares subject to stock ownership and holding requirements include pledged company stock.

ISS’ 2013 policy updates will be in effect for shareholder meetings on or after February 1, 2013.

Comment. Companies who currently have executives or directors with pledged company stock will likely include disclosures regarding these matters in the proxy statements for their meetings even in the absence of SEC rules mandating such disclosure. I would also expect to see companies without insider hedging or pledging activity call that out in their filings.  As Dave Lynn pointed out in his September 2012 InsideCounsel article, policies governing hedging and pledging activity are often included in a company’s insider trading policy, and companies will no doubt be reviewing their existing policies to assess the potential impact of ISS’ new policy recommendations.

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Call it “Sue-on-Pay – The Sequel.” 

In 2011, several public companies faced lawsuits after losing their Say-on-Pay shareholder advisory votes on executive compensation mandated by the Dodd-Frank Act. As reported in this prior post, a few of these first generation “Sue-on-Pay” lawsuits resulted in settlements, while many since that time have been dismissed. However, in early 2012, a new round of compensation-related lawsuits began, and these lawsuits use a new tactic that presents real dangers. Companies need to use caution in preparing proxy materials for annual meetings, especially in certain cases as described below.

The plaintiffs in this new round of cases have sued over 20 companies prior to their annual meeting, seeking to enjoin shareholder votes based on purported incomplete or misleading disclosures. See “‘Say on Pay’ and Executive Compensation Litigation: Plaintiffs’ New Racket”, posted on the D&O Diary blog by securities litigation attorneys Bruce Vanyo, Richard Zelichov and Christina Costley of the Katten firm. The cases focus on two types of shareholder vote: (1) the Say-on-Pay vote and also, very often, (2) a separate shareholder vote to increase the share authorization of an equity plan (a “share authorization vote”). The attempt to delay vital corporate activities through litigation is similar to the tactic that has been used successfully over the past several years by plaintiffs’ lawyers in merger and acquisition-related litigation. If the litigation threatens the timing of the important events, the defendant company will often be willing to agree to a settlement to end the litigation so life can go on. For a new comprehensive discussion of the impact of the M&A litigation, see “The Trial Lawyers’ New Merger Tax” (download) issued by the U.S. Chamber Institute for Legal Reform.

Vanyo, et al. report that several companies have settled the compensation-related cases in 2012, notably Brocade Communications Systems, Inc. In that case brought in California state court, plaintiffs claimed various disclosure deficiencies in the proxy statement, including failure to include projections of future stock grants under the plan and planned share repurchases, as well as the failure to include the board’s peer group analysis of share usage under the plan. The court issued an order enjoining the share authorization vote. In the ensuing settlement, the company had to delay for a week the portion of the annual meeting involving the share authorization vote. The company was forced to file a supplemental proxy statement in which it disclosed, among other things, the board’s internal projections regarding future stock grants. As is often the case in these types of settlements, the only cash payment was up to $625,000 in fees to plaintiffs’ counsel.

Comment. Reportedly, some of these second-generation Sue-on-Pay lawsuits have been brought solely in connection with the disclosure in the Say-on-Pay advisory vote. However, in Brocade and the other cases where plaintiffs have reportedly been successful in obtaining injunctions and/or achieving settlements, the common denominator is that the company was also seeking an increased share authorization for an equity plan. Although I don’t have access to the courts’ rulings or the settlement documents in all of these cases, I believe plaintiffs can present these share authorization vote cases in a more compelling way:

• For many companies’ proxy statements in the past few years, the share authorization vote disclosures have been given less thought and scrutiny than the compensation discussion and analysis section that sets the stage for the Say-on-Pay vote. Often, the share authorization disclosure describes the equity plan in detail but gives little or no background on how the requested amount of the share authorization was chosen, the company’s share usage or the board’s intentions in connection with share usage going forward. Therefore, it is fairly straightforward for plaintiffs to pick apart these disclosures and point out alleged deficiencies.
• The applicable SEC disclosure rule for share authorization votes (Item 10 of Schedule 14A) includes disclosure requirements that relate to some of the deficiencies claimed by counsel in Brocade. (In contrast, the rules for Say-on-Pay votes themselves include no substantive disclosure requirements, but rather refer to the other compensation disclosures, which are usually more polished.) For example, Schedule 14A requires that the proxy statement disclose the number of options to be received under the plan, “if determinable,” by executive officers as a group and other specified persons and groups. In practice, companies generally don’t include these disclosures, because the amounts are not considered to be determinable prior to the compensation committees’ actual decisions to make the awards. Even though the Brocade plaintiffs apparently did not base their argument on this point, a future plaintiff might be able to convince a court that the proxy disclosure rules were not followed adequately.

Therefore, it is reasonable to assume that plaintiffs will have better luck getting traction with cases that involve a share authorization vote than in cases that involve only a Say-on-Pay vote. In fact, there is some anecdotal evidence that lawsuits that relate solely to a Say-on-Pay vote may be defended more readily by the company with less likelihood of a delay in the annual meeting. For example, we have learned of two recent court cases involving annual meetings where there the only compensation-related item on the agenda was the Say-on-Pay vote - there was no share authorization vote. In both cases, plaintiffs’ motion for a TRO was denied by the court in time to hold the annual meeting as originally scheduled. This blog post by Cornerstone Research describes one of the cases, involving Symantec.

I would add that companies that intend to seek share increases in the share authorizations for their equity plans should be especially cautious. The proxy disclosures on this topic should be as complete as possible. If the board has considered analyses of share usage or projections of future grants, the company might consider including summaries of this information in the proxy statement. Further, practitioners should take a fresh look at Item 10 of Schedule 14A and err on the side of more disclosure.

For a company that is uncertain about whether to seek an increased share authorization in 2013, my advice would be to delay that vote until 2014 if possible. By that time, the litigation may have died down, or strategies to defeat such lawsuits may be clearer.  

A Few Enhancements on the Way!

I'm delighted to announce that two of my partners in Maslon’s Business & Securities Group, Alan Gilbert and Paul Chestovich, will join me to write some of the posts for ON Securities going forward. Alan and Paul have each written guest posts in the past. Maslon attorney Leah Fleck provided research for this post and will continue to provide editorial assistance. I will continue to be the Blog’s Editor.

In the near future, we will also seek feedback from readers about the Blog, including subject areas you would like to see covered. Also, if any readers would like to write a guest post or contribute to the Blog in some other way, please send me an e-mail.

As always, I would like to thank our readers for their support and feedback over the past three and a half years!
 

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Last week, the SEC adopted final rules (PDF) under Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (PDF), requiring reporting companies to disclose their use of so-called “conflict minerals” that originated in the Democratic Republic of the Congo (DRC) or a nearby country. These minerals, which include tantalum, tin, gold and tungsten, are used in computers, cell phones, cameras, automotive and aerospace components, medical devices, jewelry and many other products. The rules were controversial, passing by a 3-2 margin.

Companies that file reports with the SEC will be required to file a new SEC form called Form SD to disclose the use of conflict minerals that originated in the DRC. All issuers will report on a calendar year basis on May 31 of the following year, with the first report, covering 2013, due on May 31, 2014. Smaller reporting companies and foreign issuers are subject to the reporting requirement, although smaller reporting companies get a longer transition period for reporting about products where the origin is uncertain – four years vs. two years for larger companies. Companies that manufacture products with conflict minerals in the supply chain need to study the new rules and formulate an action plan to satisfy the due diligence and audit requirements. Since the first period covered by the disclosure rules starts in four months, time is of the essence.

I won’t try to summarize the entire 356 page SEC release. As usual, the SEC has provided a very useful Fact Sheet as part of its press release announcing the rule. And the release includes a handy one-page decision tree chart (PDF) that maps out the various reporting issues under the rules.

Comment. The SEC release describes that Congress, in enacting Section 1502,

“. . . intended to further the humanitarian goal of ending the extremely violent conflict in the DRC, which has been partially financed by the exploitation and trade of conflict minerals originating in the DRC. . . . Congress chose to use the securities laws disclosure requirements to bring greater public awareness of the source of issuers’ conflict minerals and to promote the exercise of due diligence on conflict mineral supply chains. . . .”

The disclosures are intended to reduce the use of conflict minerals that help fund the armed groups, and thus put pressure on the groups to end the conflict.

In reading the commentary and analyses on the new rules, I focused on the reactions of various groups. The rules have sparked an interesting debate about the role of disclosure requirements in shaping policy and changing corporate and governmental behavior, with both sides of the debate make valid points. However, even more fascinating, several very large electronics manufacturers, rather than fight the rules, have gone beyond mere compliance with the disclosure requirements. They have used the pendency of the rules as an opportunity to demonstrate leadership in corporate social responsibility.

Criticism and Counterpoint. Critics of the rules raise persuasive concerns about the rules’ value compared to the cost of compliance. SEC Commissioner Daniel Gallagher, who voted against adoption, released a Public Statement detailing why he could not support the rules. After deploring the violence in the DRC, Gallagher states that the benefits of the disclosure requirements in reducing the conflict cannot be quantified. On the other hand, the costs of the disclosure and audit requirements are very real, estimated by the SEC at $3 to $4 billion initially and around $200 to $600 million per year on an ongoing basis. Many commentators believe this cost is vastly underestimated. Gallagher acknowledged that Congress, not the SEC, mandated the disclosure requirement, but he could not support the final rules because the SEC did not use its discretion to exempt smaller reporting companies or create a de minimis exemption for products with incidental use of the minerals.

The statement of the other dissenting Commissioner, Troy Paredes, expressed his concern that the Commission did not determine “ . . . whether and, if so, the extent to which the final rule will in fact advance its humanitarian goal as opposed to unintentionally making matters worse.” As Professor Steven Davidoff wrote this week in a DealBook commentary, “These new rules could lead to manufacturers simply refusing to buy any of these minerals from Congo and surrounding area. This would be a de facto boycott that could harm the populace more than it would help.” Or the rules could provide a greater competitive advantage for foreign companies that do not report in the U.S.

On the other hand, the supporters of the rule respond that the SEC worked hard to craft final rules that minimize the costs to issuers and will be effective. Chairman Mary Schapiro said in her statement introducing the rules, “. . . [W]e incorporated many changes from the proposal that are designed to address concerns about the costs. I believe the rule we are considering today faithfully implements the statutory requirement as mandated by Congress in a fair and balanced manner.”

The Social Responsibility Opportunity. In reading much of the commentary on the conflict minerals rules, I was struck by the statements of a “multi-stakeholder network” that included issuers, socially responsible investor groups and non-governmental organizations. The group was really part of the process, participating in the SEC roundtable, submitting four comment letters and attending several meetings with the SEC staff. The companies in the group included major corporations: Advanced Micro Devices (AMD), Ford, General Electric, Hewlett-Packard, Microsoft, Philips and Sprint. This group submitted a letter to the SEC (PDF) supporting the disclosure rules and applauding the work of the agency.

The Co-Chair of the multi-stakeholder network was Tim Mohin, Director, Corporate Responsibility of AMD. On the day the SEC adopted the final rules, Mohin wrote a compelling piece in the Huffington Post, “How Electronics Companies Plan to Comply With the SEC’s New Conflict Minerals Rule.” He reported that an industry group not only supported the rules, but also went beyond the disclosure requirements to explore new ways to track the source of conflict minerals:

At first blush, this sounds like an impossible requirement. . . . But, after some time and thought, we, in the electronics industry -- specifically, the member companies of the Electronics Industry Citizenship Coalition (EICC) and the Global e-Sustainability Initiative (GeSI) -- are confident we have found a way. And, more importantly as this rule ripples through the economy, we are willing to share our ideas with others. . . .

Mohin describes some of the nuts and bolts of their process for identifying smelters and the subset of “conflict free smelters” and continues:

. . . While the conflict free smelter list stands at just 13 so far, we anticipate that many more will be added as implementation of the rule progresses. . . . [Also,] [w]hile the law itself does not require any of these steps, the electronics industry has worked on a couple of programs aimed at avoiding a minerals embargo of the region [and thus harming legitimate mining enterprises]. AMD and several other companies joined the U.S. State Department to found the Public-Private Alliance (PPA) for Responsible Minerals Trade. This a joint initiative among governments, companies, and civil society aims to demonstrate that it's possible to secure legitimate, conflict-free minerals from this region. . . .

By partnering across the electronics industry and applying the spirit of innovation that created the tech revolution, we went from "it can't be done," to "we think we have a solution," to "we need to go beyond the law to make sure that our solution actually helps the people of the DRC."

In this case, a group of  companies, rather than challenging the validity of the rules, put their minds and resources into efforts to go beyond mere compliance. Consistent with the corporate social responsibility movement, their approach tries to address the problem in sophisticated ways, and they want to share their wisdom with other companies. And maybe, if their approach really works, their use of “conflict free” suppliers could actually help their sales – something like “dolphin-free” tuna. At the very least, it’s a commendable effort.

I’d really like to hear what readers think about the approach described by Mohin, and about the disclosure rules in general. Send me an e-mail, which I will keep confidential, and I can summarize the thoughts on an anonymous basis in a follow-up post.

Honored to Be Recognized for Pro Bono Work

I was honored to be recognized recently as Maslon’s 2012 Pro Bono Attorney of the Year. As Chair of our Pro Bono Committee for the past five years, I have been very proud of our firm’s commitment to the community. Also, as a Board member of the non-profit group LegalCORPS, it has been enjoyable to help LegalCORPS develop new ways to deliver business law pro bono services to low-income businesses and non-profits in Minnesota. I am currently working on an exciting project, in partnership with the in-house attorneys at a large company, to expand LegalCORPS’ reach in a novel way. After the launch of this program, I’ll share the news.
 

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This month, I participated in an executive compensation program for the Twin Cities Chapter of Financial Executives International (FEI). In “A Perspective on Executive Compensation After Dodd-Frank”, compensation consultant Eric Gonzaga of Grant Thornton LLP and I gave an update on Dodd-Frank Act requirements, including new and upcoming SEC rules, and Eric gave his perspective on the latest trends in performance-based compensation – see our presentation materials here (PDF).

Highlights of the Dodd-Frank Act update included the following:

General Update. I presented the latest version of the ON Securities Cheat Sheet, with updates on the latest compensation and governance regulations. The Cheat Sheet is always available at the right hand side of the home page of this blog. It no longer includes projected dates for proposal and adoption of the SEC rules, because (1) the SEC’s web page that lists upcoming rulemaking activities under Dodd-Frank no longer discloses projected dates and (2) the SEC kept missing/changing the dates anyway.

Say-on-Pay. There is not much new in connection with the non-binding shareholder advisory vote on executive compensation, and the vote on the frequency of the Say-on-Pay vote. The results in 2012 are very similar to those in 2011. Average shareholder support once again is over 90%, but a handful of companies continues to experience negative votes. ISS and other advisory firms continue to have significant influence, approximately 20% of the vote by some estimates.

Advisory Vote Requirements for Smaller Reporting Companies. One of the great things about speaking to the FEI gathering was that it forced me to look back at all of my Dodd-Frank materials from 2012. I realized that we are coming up on a major compliance date for Say-on-Pay and Say When on Pay: smaller reporting companies, after a two-year exemption, will finally become subject to these advisory vote requirements (PDF) for annual meetings starting on January 23, 2013. See the SEC's Small Entity Compliance Guide (PDF) for these rules. Smaller reporting companies have not previously been required to include a Compensation Discussion and Analysis (CD&A) section in their proxy statements, and this will not change as a result of Say-on-Pay. The advisory vote will cover whatever is actually disclosed in the proxy statement – generally, just the compensation tables and the description of severance benefits. Some smaller reporting companies already voluntarily include some form of CD&A in their proxy statements, including an explanation of the company’s compensation philosophy and the reasons for the levels and types of the executives’ compensation reported in the tables. Companies that are not making these disclosures should definitely consider adding some version of CD&A in 2013, as it will be helpful in achieving a positive Say-on-Pay vote.

Proxy Disclosure Trends. For larger companies that continue to be subject to Say-on-Pay votes, proxy statement disclosures have been focusing more and more on describing Pay for Performance (P4P). I pointed to the Coca-Cola proxy statement, with its color graphics, and the Exxon Mobil glossy mailing on executive compensation (with companion video) as examples of effective communication. Compensation disclosures are looking more and more like political campaign pieces.

Upcoming Disclosure Requirements. We’re still waiting for these new compensation disclosure requirements from the SEC:

• Pay vs. performance chart: will require disclosure of executive pay compared to the company’s financial performance (likely measured by Total Shareholder Return).
• Pay equity disclosure: will require a comparison of median annual compensation of employees vs. that of the CEO, a rule that will likely result in reporting burdens for public companies.

Clawbacks. We’re also waiting for proposed SEC rules on recoupment of compensation by companies listed on stock exchanges – clawbacks. As described in this prior post, the exchanges will be directed to adopt listing standards requiring a clawback policy for listed companies. The policy must require recovery of incentive compensation (including stock options) from current and former officers during the three years prior to a financial restatement, to the extent the compensation was based on erroneous financial data. I continue to believe that the clawback requirements will be the “sleeper” under Dodd-Frank, creating lots of interesting issues for listed public companies.

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On June 20, 2012, the SEC adopted final rules (PDF) under Section 952 of the Dodd-Frank Act (Section 10C of the Securities Exchange Act of 1934), covering independence standards for compensation committees of listed companies and their advisers. In themselves, the new rules are not too exciting. Consistent with Section 10C, the rules require the national securities exchanges, such as the New York Stock Exchange and Nasdaq, to adopt listing standards on these topics. The final rules raise some intriguing questions, including whether the listing standards will push public companies’ compensation committees  to engage independent counsel.

Timing. New Rule 10C-1 requires the exchanges to issue proposed rules on independence standards by September 25, 2012. Therefore, in the next few months, we will know a lot more about the approaches taken by the exchanges, and whether the exchanges’ standards will vary from each other. The exchanges must each adopt final listing standards that comply with Rule 10C-1, which must be approved by the SEC no later than June 27, 2013. 

Independence of compensation advisers. Rule 10C-1(b)(4) requires the exchanges to adopt standards requiring listed companies’ compensation committees to consider the independence of outside advisers, such as compensation consultants and legal counsel. The rule does not require that the advisers be independent, only that before engaging them, the committee consider their independence by taking six factors into consideration: (i) other services provided to the company by the advisory firm, (ii) amount of fees received by the advisory firm as a percentage of its total revenues, (iii) the advisory firm’s procedures for preventing conflicts of interest, (iv) business or personal relationships of the adviser with a member of the committee, (v) stock ownership by the adviser, and (vi) business or personal relationships of the adviser with an executive officer of the issuer. The exchanges may also require consideration of other factors.

The requirements of Rule 10C-1(b)(4) are mostly lifted directly from Section 10C(b)(2) of the Exchange Act. However, there were a few interesting changes under the Rule. First, in the final rules the SEC added the last of the six factors (relationships of the adviser to executive officers); surprisingly, that was not one of the factors listed in the Dodd-Frank Act. Second, the Instruction to Paragraph (b)(4) clarifies that the independence assessment is required for an adviser, including counsel, that “provides advice to the compensation committee.” Third, that Instruction clarifies that in-house counsel are not covered by the independence assessment requirements.

What outside law firms are covered? The new rule leaves some questions open to discussion. In what circumstances does outside legal counsel “provide advice” to the compensation committee so as to be covered by the assessment requirement? The answer is obvious where the law firm is engaged directly by the committee, in which case a partner of the law firm would be likely to attend committee meetings and would be available to answer questions of committee members. But what about a law firm that has little or no direct contact with the committee, given that the Instruction does not require that the advice be direct? Do the standards apply to outside counsel that provides compensation or governance advice to in-house counsel, who in turn incorporates that advice into her advice to the committee? What about outside counsel that provides compensation disclosure advice (or tax advice, or drafting or negotiation of agreements) to management where the work product is shared with and reviewed by the committee?

The answers may or may not be clarified by the exchanges’ listing standards. The independence assessment does not seem very relevant or important where the law firm has no direct contact with the committee, but the language of the Instruction seems broad enough to encompass this situation.

Will Committees Retain Independent Counsel? Mike Melbinger, in Melbinger’s Compensation Blog on CompensationStandards.com (subscription site) also raises the question: Will the new assessment requirement cause compensation committees to engage independent counsel? Rule 10C-1(b)(4) allows the committee to continue to engage non-independent advisers after considering the six factors in the rule. But he points out:

Committees have retained independent legal counsel in recent years, but certainly not the majority of them. Those Compensation Committees who have not retained independent legal counsel will need to grapple with questions/factors 1 and 2 [of the six factors] . . . , just as they once did for their compensation consultant. . . . We all have seen this movie before – only starring the compensation consultants instead of legal counsel, and we all know how it ends. . . . [June 25, 2012 post.]

. . . [W]hen the SEC mandates a process such as this new independence assessment, it usually wants companies to reach – or at least consider – a certain result. Thus, the issue is one of following best practices. . . . [June 26, 2012 post]

Well stated, and if a law firm providing advice directly to the committee does derive a large percentage of its revenues from the company and has a very close relationship with the executives, the committee may feel pressure to engage independent counsel. Even though the independence assessment need not be publicly disclosed, the committee may still be concerned about exposure to liability in such cases, especially given the increased incidence of compensation-related litigation in recent years.

On the other hand, I’m not sure that compensation committees will be compelled to hire independent counsel in many cases. Given the size of many law firms, it may be rare for the fees to the individual client to represent a very large percentage of the law firm’s revenues. Also, if the law firm’s role is limited or does not involve direct contact with the committee, the committee probably will not feel much pressure to engage independent counsel. Once we see the exchanges’ proposed listing standards in September, we may know more about the likelihood of such engagements.

Dodd-Frank Rulemaking Timetable Delayed

In adopting the final rules under Section 952 of the Dodd-Frank Act as described above, the SEC got in just under the wire – the SEC’s Dodd-Frank rulemaking timetable listed those rules as being scheduled for January-June 2012. Several other sets of rules were not completed in June but are still listed under that schedule:

• Propose rules regarding disclosure of pay-for-performance, pay ratios, and hedging by employees and directors (Dodd-Frank Sections 953 and 955).
• Propose rules regarding recovery of executive compensation (i.e., clawbacks) (Dodd-Frank Section 954).
• Adopt rules regarding disclosure related to “conflict minerals” and disclosures by resource extraction issuers (Dodd-Frank Sections 1502 and 1504).

Of course, the SEC now includes the following disclaimer at the beginning of the timetable: “This is an estimated timeline and may be subject to change.”

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It’s June, and the crush of annual meetings is, for the most part, finished. For most companies, this has been the second year in which a Say-on-Pay vote – an advisory shareholder vote on the company’s executive compensation – has been required under the Dodd-Frank Act. This is a good time to look at the shareholder votes to see if there has been a major change from 2011.

Semler Brossy’s latest Say-on-Pay Results report (PDF) reveals that not much has changed from last year. For the vast majority of companies, Say-on-Pay has passed with a significant margin of victory. Like last year, most companies have received greater than 90% approval.

It does appear that there will be more failed Say-on-Pay votes this year than last year. Mark Borges, in his Proxy Disclosure Blog on CompensationStandards.com (subscription site) reports that 40 companies have failed to achieve a majority of affirmative votes this year, about the same number as all last year. Therefore, there will almost certainly be more negative votes in 2012 – but it’s unlikely that there will be a huge difference.

Of course, for some companies the results will be much different this year. For example, as reported in this previous post, Citigroup failed to get a majority positive vote this year, even though it won by a large margin last year. And Chiquita Brands International slipped on a banana peel this year – Borges reported that Chiquita got less than 20% Say-on-Pay support this year, compared to an 86% positive vote last year.

The 2012 proxy season so far teaches these lessons:

Don’t get cocky. As Citigroup’s experience demonstrates, a company can take nothing for granted, even if it did great on the vote in the previous year.

Supplemental proxies don’t seem to have a major impact. According to Semler Brossy, company responses to an “against” recommendation from ISS, filed in the form of supplemental proxy statements, do not appear to have a material impact on vote results. [On the other hand, they can’t hurt.]

Sue-on-Pay is still alive. As reported in this previous post, Citigroup was sued shortly after the negative Say-on-Pay was defeated, with claims based on the negative vote. 

Engage, engage, engage. Continue to engage with major shareholders and proxy advisory firms about executive compensation issues before, during and after proxy season. The day after the 2012 annual meeting, it’s not to early to start planning for 2013.

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