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

It’s a case of “Nay-on-Pay”, as Paul Hodgson described it in his post on The Corporate Library Blog, “Hewlett-Packard latest company to feel the heat of a Say on Pay defeat.” At its annual meeting last week, Hewlett-Packard became the fourth public company this year to lose a Say-on-Pay vote, now required under the Dodd-Frank Act, with 50 percent of the shares voting against the resolution and 48 percent voting yes. The no votes have also outnumbered the yes votes at Shuffle Master, Beazer Homes USA and Jacobs Engineering Group, as reported in Ted Allen’s post on ISS’s RiskMetrics Blog, “Investors Reject H-P’s Pay Practices.”

These latter three companies are quite a bit smaller than H-P, and at least two of them had fairly obvious “red flag” issues. Shuffle Master had a CEO severance agreement with a “single-trigger” provision, as described in Allen’s post. Beazer Homes has been faced with shareholder lawsuits over its compensation practices and was the subject of a successful “clawback” proceeding, as described in this Bloomberg article by Jef Feeley and David Beasley, “Beazer Homes Directors Sued by Teamsters Funds Over Executive Compensation.”

On the other hand, the lost Say-on-Pay vote at huge H-P, ranked number 10 in the Fortune 500, is sure to get the attention of corporate America. This may be the public company equivalent of Kansas losing today to Virginia Commonwealth in the NCAA Men’s Basketball Regional Finals. H-P did not have such obvious compensation red flags, and it certainly had the resources to mount a vigorous communications campaign. However, Allen’s post cites several aspects of H-P’s compensation that could not have made large shareholders happy, and which resulted in ISS’s recommendation against the resolution:

[New CEO Leo] Apotheker's pay arrangements include substantial up-front signing awards of cash and stock, and severance provisions that would result in sizeable payouts--including automatic vesting of all his time-based equity--upon his termination without cause. Many aspects of the company's incentive programs are subject to board discretion as well, and depend on the board exercising its authority objectively--e.g., the granting of discretionary bonuses and approval of higher-than-median pay benchmarking. The company has paid substantial discretionary awards and does not disclose goals for the key metrics that drive payouts under its annual and long-term plans, even retrospectively. Without complete disclosure, shareholders cannot ascertain the rigor of the goals relative to payouts.

Allen also points out that the company had provided “generous severance payouts after the board ousted former chief executives Mark Hurd and Carly Fiorina.” The Bloomberg article also reports that ISS cited Apotheker’s participation in selecting new board members, which it deemed “inappropriate.”

H-P’s compensation committee will need to communicate with shareholders to determine the cause or causes of the lost vote and deal with them in the coming year. Likewise, other companies’ boards should try to learn lessons from the defeat at such a high profile company.
 

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Next month, the SEC is expected to adopt final rules under provisions of the Dodd-Frank Act requiring new disclosures of mineral-related activities, including the so-called “conflict minerals” disclosure requirement under Section 1502. The rules will affect companies in a broad range of industries if their products might utilize conflict minerals – gold and rare compounds mined in the Congo. These materials are used in electronic components, engine components, aerospace equipment, jewelry and other industries. Companies will be required to trace the source of raw materials in their products, or the components thereof, to determine whether conflict minerals are required and make the required disclosures, which must be audited.

The SEC issued proposed conflict minerals disclosure rules (PDF) in December 2010, and under Dodd-Frank, final rules must be adopted by April 15, 2011. The SEC has received more than 150 comment letters, summarized in a recent article by Arielle Bikard, titled “No Shortage of Opinions on the SEC's 'Conflict Minerals' Proposal,” on the Compliance Week website (subscription required):

Congress originally included the legislation in the Dodd-Frank Act to discourage companies from using conflict minerals, which warlords in the Congo use to finance their operations. . . .

Commenters generally said that compliance with such a broad rule, with so many undefined terms, will be a challenge. ‘We believe that without additional clarity in the areas of objective, criteria, and evidence, there will be significant inconsistency and lack of comparability of information in issuers' Conflict Minerals Reports,’ Deloitte & Touche wrote in a letter to the SEC. In particular, Deloitte warned, if a company can't determine the origin of the minerals, an independent private-sector outside auditor might not be able to gather enough evidence to form an opinion.

Companies were hoping that the SEC would narrow the language of the rule in the proposal, but open questions still abound, says Brian Breheny, partner at the law firm Skadden, Arps, Slate, Meagher & Flom. For example, the current language doesn't clarify whether a retailer of electronic goods has any obligation to study conflict minerals in the items it sells. Companies must also determine whether the mineral is 'necessary' to the production or to the functionality of the product. What exactly does 'necessary' mean? The proposal doesn't specify. . . .

The SEC is required to pass its final conflict-mineral disclosure rule by April 15. . . . Plenty of letter writers took issue with the rule's taking immediate effect. . . .

Regarding the last point, although the statute provides that public companies must comply with the disclosure requirements for the first fiscal year beginning after the effective date of the rules, some of the commenters are requesting that the SEC exempt companies from the requirement for the first full year after effectiveness. Assuming this does not happen, manufacturing companies in a broad range of industries should be planning to quickly conduct the due diligence necessary to meet the reporting requirements.

Proposed Disclosure Rules for Resource Extraction Issuers Will Also Be Interesting

In the Compliance Week article, Bikard also touched on the SEC’s proposed rules (PDF) on disclosure by public companies engaged in resource extraction, requiring disclosure of the payments these companies make to foreign governments. This disclosure is required by Section 13(q) of the Securities Exchange Act of 1934, added under the Dodd-Frank Act. As with conflict minerals, the SEC has received many comment letters on its proposed rules on the payments by resource extraction issuers. Bikard asked for my commentary:

Industry voices such as Exxon and the U.S. Chamber of Commerce are pushing the SEC to limit the scope of the rules in a variety of ways, says Martin Rosenbaum, partner at the law firm Maslon Edelman Borman & Brand. For example, they suggest that the ‘annual report’ required by Dodd-Frank be confidential on an individual company basis, and that only the SEC's compilation be made public, he says. They also want broad exclusions from any requirements that would be inconsistent with non-U.S. laws, and blanket exclusions for smaller companies.

On the other side are institutional investors that push for socially responsible investing, which strongly oppose limits on the reporting requirements, Rosenbaum says. They have an interest in obtaining this information for policy reasons, he continues, and they also argue that transparency on an individual company basis will benefit investors.

Expect some interesting developments in the disclosure rules under the Dodd-Frank Act in the next few months.
 

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Under the Dodd-Frank Act, public companies involved in merger and acquisition transactions must hold a non-binding shareholder advisory vote on parachute compensation related to the merger (the “Say-on-Parachutes” vote) and must include new disclosures of parachute payments in the merger proxy statement or other filing relating to the transaction. On January 25, 2011, the SEC adopted final rules implementing these requirements (PDF), effective for merger-related filings on or after April 25, 2011. Unlike the other shareholder advisory votes under the Dodd-Frank Act, there is no two-year deferral of effectiveness for smaller reporting companies.

Since the Act was enacted last year, these golden parachute provisions have been outside the spotlight – public companies have understandably focused more of their attention on the separate Say-on-Pay and Say When on Pay advisory votes, which are both required at this year’s annual meeting. However, companies need to consider whether to include the new enhanced parachute disclosures in the annual meeting proxy statement, on a voluntary basis, in order to take advantage of a possible exception from the Say-on-Parachutes vote requirement in a later merger. As described below, most companies will choose not to include the enhanced disclosures in the annual meeting proxy statement.

The new SEC rules added Item 402(t) of Regulation S-K (see Release (PDF) at page 6043), which describes the parachutes disclosure required to be included in the merger proxy statement or other transaction-related filing, such as a tender offer statement. Item 402(t) requires a new Golden Parachute Compensation table with detailed information on the various payments to each named executive officer related to the transaction.

The Item 402(t) disclosures are not required any SEC filings until there is a merger or acquisition transaction. However, if the Item 402(t) disclosures are voluntarily included in an annual meeting proxy statement that includes a Say-on-Pay vote, the company might be able to subsequently use an exception under the statute and avoid the Say-on-Parachutes vote if there is a merger. In its adopting release for the final rules governing the Say-on-Parachutes vote, the SEC states, “we would expect that some issuers may voluntarily include Item 402(t) disclosure with their other executive compensation disclosure in annual meeting proxy statements soliciting the [Say-on-Pay vote] . . . so that this exception would be available to the issuer for a potential subsequent merger or acquisition transaction.”

Is it a good idea to include the voluntary Item 402(t) disclosure to take advantage of the exception? I believe most companies will conclude that it’s not worth it:

• In its adopting release, the SEC made it clear that the exception from the vote requirement is very narrow. At the time of the merger, if there are any new or amended golden parachute arrangements since the date of the previous Say-on-Pay vote, the rules require a Say-on-Parachutes advisory vote on the new or amended arrangements. Even changes resulting from additional grants of equity or salary increases or the addition of a named executive officer would make the exception unavailable. Therefore, even if the company includes the Item 402(t) information voluntarily, it is very likely that there will be some changes to parachute compensation that will require a Say-on-Parachutes vote on the changes at the time of a merger. The merger proxy statement will be required to include two tables – one that shows all of the golden parachute compensation, and a second table disclosing only the new or revised arrangements subject to the vote.
• If the Item 402(t) disclosure is added voluntarily to the annual meeting proxy statement, this will add even more complexity to that document in a section that is already complex and often confusing.
• The addition of the voluntary Item 402(t) disclosure to the annual meeting proxy statement will call additional attention to the parachutes arrangements for purposes of the Say-on-Pay vote. In its 2011 Compensation Policy FAQs, ISS states that, if the company adds the voluntary disclosure, the information in the parachute table will “carry more weight” in ISS’s overall Say-on-Pay recommendation. Therefore, the voluntary disclosure could increase the chances of negative recommendations from proxy advisory firms on the Say-on-Pay vote.
• Boards may not view the requirement of holding the Say-on-Parachutes vote at the time of a merger or acquisition as a great additional burden. The vote is non-binding, and unlike the regular Say-on-Pay vote, the directors who made the compensation decisions subject to the shareholder vote generally will not be continuing in office after the vote. That said, of course the directors would greatly prefer a positive advisory vote, and the vote must be taken seriously.
• Depending on the structure of a future merger and acquisition deal, the Say-on-Parachutes vote may never be required anyway. Many cash mergers are structured as a friendly tender offer followed by a short-form merger. In those deals, there will be no Say-on-Parachutes vote because there is no solicitation of proxies or consents for approval of the ultimate short-form merger. However, the tender offer statement will be required to include the Item 402(t) disclosure.

For these reasons, I don’t expect to see a lot of companies elect to include the “Golden Parachutes Compensation” table required by Item 402(t) in their annual meeting proxy statements.

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In my previous post, “Whistle While You Work! SEC Proposes Whistleblower Rules under Dodd-Frank,” I reported on SEC’s proposed rules (PDF) under Section 922 of the Dodd-Frank Act, which provides a “bounty” to whistleblowers who disclose securities law violations leading to large monetary sanctions. The availability of the bounty could encourage potential whistleblowers to bypass reporting mechanisms within the company and report suspected violations directly to the SEC.

In a very interesting New York Post article last week, “SEC whistleblower call draws few tipsters”, Kaja Whitehouse reports that the expected flood of whistleblower tips to the SEC has not yet occurred:

The [SEC] has received just 168 complaints alleging corporate fraud in the first 6½ months of the program's existence, according to data the SEC provided to The Post through a Freedom of Information Act request. . . . At that rate, the SEC is receiving less than one tip a day -- hardly the flood that led the agency to delay staffing the program while it pleaded with lawmakers for more funding.

‘That's a lot less than I would have expected,’ said Steven Kohn, executive director of the National Whistleblowers Center in Washington, DC, which advocates for whistleblowers and pairs them up with lawyers. Kohn said . . . he expected the SEC . . . would receive closer to 3,000 whistleblower tips a year. . . . While the disappointing number might simply be the result of a slow start, whistleblower advocates say it may reflect the battle being fought over the SEC's final rules for governing the program, which are to be released in April. Among other concerns, the SEC has been asked to force employees to go through companies' internal whistleblower programs as a prerequisite to filing an official complaint.

Does that mean public companies should relax and stop worrying about their whistleblower procedures? Absolutely not. The complaints may come faster once the final rules are issued. And it only takes one complaint to tie up a lot of resources at a particular company.

Here is another interesting recent report on whistleblower claims by Compliance Week editor Matt Kelly, “Latest on Whistleblower Rules: Nothing Good.” Kelly reports that budget cuts at the SEC will leave the agency unable to investigate a large number of whistleblower complaints. This will increase the burden on public companies’ internal compliance programs, especially if a flood of whistleblower complaints does come.

Boards’ Recommendations on the “Say When on Pay” Vote: The Debate Continues

I got a lot of comments on my post last week about boards’ recommendations on the frequency vote required under the Dodd-Frank Act. In his subsequent post “The Debate Over Whether to Ignore Say-When-on-Pay Results So Far” on TheCorporateCounsel.net Blog, Broc Romanek said,

. . . I was a little surprised at the reactions that Mark Borges and I have received to our advice that - given the voting results so far - companies may reconsider recommending a triennial vote for say-when-on-pay (egs. Marty Rosenbaum and Amy Muecke). . . . With a statistically relevant number of results in, it's becoming pretty clear that shareholders want an annual SOP even if the company has stable management and sound pay practices. . . . [T]he fact that so many companies are ignoring the clear will of shareholders over this minor topic ("minor" in comparison to SOP itself) will likely further galvanize shareholders to more closely scrutinize pay practices. As I hear from shareholders, they feel like companies are deciding what is in the "best interests of shareholders" without taking into account what shareholders have clearly said is in their best interests. Looking at this situation from their perspective, I can see why they might get upset.

And the debate continues. Amy Muecke, in “Frequency of Say on Pay: The Statistics & Beyond,” responded that the results are still coming in, and there is evidence that some companies are successfully convincing shareholders to support triennial votes even in cases of companies with broad institutional holdings – citing Sanderson Farms as an example. And here is a commentary (PDF) released today in which Georgeson strongly supports the position that boards should make their own determination. I continue to believe that this is the correct approach, assuming as I do that most boards will take a very thoughtful approach – the board certainly should not take lightly the decision to support a triennial or biennial vote. Consider the following points, in addition to the ones I addressed in my previous post:

• Although ISS will always support an annual vote, another proxy advisory firm, Glass Lewis, has announced (PDF) that it may support a “well-crafted” argument by the board in favor of a triennial or biennial vote.
• I recently heard the comments of a representative of a company that has already been conducting biennial say-on-pay votes after previous negotiations with shareholders. That is one example of a situation in which management cannot just assume that the shareholders will vote in favor of an annual vote, although that is a possible outcome.
• Hopefully, shareholders will not take a triennial or biennial recommendation, in the first year of  the frequency vote, as an indication that the board or management is "ignoring" the voice of shareholders. Given that companies are spending more time engaging with shareholders on compensation issues, hopefully the seriousness of these discussions will convince large shareholders that management is serious about listening. I hope the shareholders will focus more on the board’s subsequent reaction to a vote favoring annual say-on-pay than on an initial triennial recommendation, as long as it is thoughtful and explained carefully.
• For a good discussion of this debate in light of the board's duty to do what it believes is in the best interests of the corporation, see this post by my partner, Paul Chestovich, in the Small Public Company Forum.
• As Broc says, it is conceivable that shareholders will take the wrong message from a triennial recommendation and will be galvanized to take action in other areas. Therefore, the board should be cognizant of that risk. Again, good communications will be important in mitigating that risk, but will not eliminate it.

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