2012 Proxy and Disclosure Planning Alert

January 2012

While most of the Dodd-Frank disclosure and reporting changes became effective for last proxy season, companies were spared this year from having to comply with the remaining pending significant proposals. In this regard, on the last day of 2011, the Securities and Exchange Commission (SEC) announced that the conflict minerals, recovery of executive incentive compensation, pay for performance, and compensation committee independence proposals, among others, would be further delayed. On the other hand, the demise of the SEC’s proxy access rule has opened the door to shareholder proposals for bylaw changes to allow shareholder director nominations to be included in a company’s proxy materials. The following discussion will provide some guidance in preparing for this season’s proxy solicitations.

Say-On-Pay: Lessons Learned

With the 2011 annual meeting season and the first year of mandatory say-on-pay (SOP) in the rearview mirror, companies should be assessing the results of the 2011 vote and feedback received from their shareholders as they prepare for 2012, unless they are among the few companies that will be holding their SOP vote triennially. Last proxy season, more than 98 percent of public companies in the Russell 3000 that held SOP votes received a favorable vote on their SOP proposal, with an average of more than 90 percent of the votes cast in favor of the proposal. Unfortunately, the positive results could lull many companies into a false sense of security, as last year’s results may be as much a product of 2010’s positive stock market performance as of shareholder satisfaction with executive pay policies. Shareholders who may have been inclined to look favorably upon SOP proposals in 2011 when the value of their investment was on the rise in 2010 may be less inclined to do so in 2012 based on 2011 stock performance. Moreover, companies with marginally positive votes or large broker non-vote counts in 2011 could easily see their positive SOP vote swing negative if shareholders who did not provide instructions to brokers in 2011 were to give instructions to vote against SOP in 2012, even if those who voted for SOP in 2011 continue to support it in 2012.

In view of these factors, a high positive vote in 2011 does not guarantee a positive vote in 2012, even if the compensation program does not change. As a result, it is important to review the lessons learned from last year’s results and consider how they may be applied in 2012. Here are our top six lessons, with a little help from some old movie favorites.

And now, witness the power of a fully operational ISS.1 Although proxy advisors such as Institutional Shareholder Services (ISS) are not the evil empire, their power over the outcome of elections increased in 2011, and as expected, their recommendations tended to move the vote significantly. While the average vote in favor of an SOP proposal was 92 percent, the favorable vote averaged only 65 percent if the company’s SOP proposal received a negative vote recommendation from ISS. Moreover, all the companies at which the SOP proposal received fewer votes for than against and on which ISS made a recommendation received a negative vote recommendation from ISS. These recommendations were primarily due to a “pay-for-performance disconnect” and, to a lesser extent, “problematic pay practices.” While it is difficult to address pay-for-performance issues after the fact, companies should consider comparing their compensation and policies to ISS guidelines to determine whether any changes should be made prior to the 2012 proxy season, particularly eliminating those practices that ISS defines as “problematic pay practices” such as tax gross-ups, certain perquisites like country club memberships and financial planning allowances, and oversized or single-trigger change-in-control arrangements. According to a recent Towers Watson survey, nearly one-third of the companies surveyed made changes to their pay programs in anticipation of the 2011 SOP vote, and 38 percent are considering changes in compensation programs for 2012.

What we’ve got here is a failure to communicate.2 Despite the general tendency of institutional shareholders to follow the voting advice of proxy advisors, engaging in dialogue with shareholders before the proxy solicitation process begins regarding the company’s compensation practices was believed to have been successful in helping to sway institutional shareholder votes. Such dialogue can take the form of one-on-one discussions, investor conferences, surveys or a combination of methods. More than half of the companies recently surveyed by Towers Watson reached out to their shareholders in advance of the SOP vote in 2011. Communication with shareholders before the annual meeting can also provide an early indication of whether the company is at risk of losing on its SOP proposal and may provide an opportunity for the company to take preemptive action in time to avoid a negative vote or cause the company to actively solicit proxies. According to the Towers Watson survey, 40 percent of companies hired a proxy solicitor to assist with communications during the proxy solicitation process.

Communication from investors is also important to allow companies to respond to shareholder concerns. ISS has indicated that in 2012, with respect to companies that received less than 70 percent approval on their 2011 SOP proposal, it will review the actions of the compensation committee on a case-by-case basis and, if the committee is found to be unresponsive to shareholder concerns regarding compensation practices, will recommend a vote against the 2012 SOP proposal and against the committee members’ reelections. All companies will need to include disclosure in their 2012 annual meeting proxy statement regarding whether and how the board of directors or compensation committee took into account the shareholder vote on compensation. Understanding investor concerns regarding compensation will be critical to companies that need to determine how to respond to a low vote or a “no” vote and to companies intent on avoiding such a result.

I do not think that word means what you think it means.3 An unprecedented number of companies that received a negative vote recommendation from ISS in 2011 filed supplemental proxy materials in an attempt to argue to shareholders during the proxy solicitation process why the ISS recommendation was wrong, primarily taking issue with the ISS conclusion that the company had a “pay-for-performance disconnect.” For ISS, the analysis of “performance” was based primarily on a review of the total compensation of the chief executive officer in light of a comparison of the company’s one- and three-year total shareholder returns with the results of a broad peer group. Anecdotally, it appears that companies’ efforts to sway votes by pointing out the shortcomings of such a narrow analysis were often successful. Moreover, these arguments spurred ISS to reevaluate what “performance” means for purposes of its 2012 voting guidelines. While still using total shareholder return as the basis, ISS has refined its analysis in several respects for 2012 and will take into account other performance factors in its qualitative analysis under certain circumstances. Still, due to the susceptibility of the market price to forces outside of management’s control, companies are likely to continue defining “performance” without reference to total shareholder return, instead using financial and operational measures relevant to the company that the compensation committee believes drive the company’s results. Companies should be prepared to address shareholder criticisms of their compensation practices or particular compensation decisions, as well as weaknesses in the ISS analysis underlying a negative vote recommendation, if it appears that shareholders may vote down the SOP proposal.

Show me the money.4 Shareholders are likely to say this or something like it to executives who receive large year-over-year increases in total compensation when stock performance has not been positive, and such increases can act as a catalyst for shareholder dissension and a negative SOP vote. Nearly all the companies that had a negative SOP vote in 2011 experienced a decrease in their stock price between December 2007 and December 2010, and many experienced a decrease during 2010. In the SOP litigation complaints, plaintiffs often focused on the total compensation column in the proxy statement’s summary compensation table to make the case that executives received large pay increases when in fact the total may have increased due to changes in a pension benefit estimate, to “catch up” compensation increases delayed from prior years due to expense-cutting efforts or to meeting operational incentive goals that did not translate into short-term stock appreciation. Boards should be sensitive to this dynamic and do what they can to avoid large year-to-year increases in total compensation or have a well-reasoned and well-documented rationale for the increase.

I want the truth! You can’t handle the truth!5 Whether shareholders can handle the truth or not, a company should use the CD&A as an opportunity to tell shareholders why it paid the compensation it paid and not merely as an exercise in compliance with the applicable SEC requirements. While rule compliance is still important, commentators believe that part of companies’ success in obtaining an overwhelmingly positive SOP vote is attributable to changes they made in their CD&A to make it more readable and more persuasive. Here are a few specific suggestions:

  • Begin the CD&A with a brief executive summary of the discussion that centers on explaining why the company paid what it paid and the link between pay and performance.
  • Go beyond the requirements, using graphs and tables where necessary, to pointedly illustrate how the company based a significant portion of compensation on performance. Explain what performance measures were used and why those particular measures were used. If a significant portion of compensation was not performance-based, explain why compensation was structured in that fashion and how it furthered the interests of the company and its shareholders.
  • Avoid broad generalizations and boilerplate that could be cherry-picked by a plaintiff’s lawyer in a suit challenging the board’s compensation decisions. Make the discussion a nuanced explanation specific to the company. In the SOP litigation to date, the complaints have drawn heavily from the CD&A section of the annual meeting proxy statement. Broad generalizations, boilerplate explanations, inconsistencies and other imprecise language are most likely to be pulled out of context and exploited to the disadvantage of the board.
  • Be concise. Avoid repetition and unnecessary detail that will only lengthen the CD&A and serve to discourage shareholders from reading it.

Round up the usual suspects.6 In view of the heightened threat of litigation, companies should remember to follow the usual governance principles of independence and process so that the board is in the best position possible to defend its compensation decisions. Actions to take in this regard include the following:

  • Be sure executive compensation decisions are being made only by a committee of independent directors with no conflicts of interest, and avoid domination of the compensation process by management.
  • Have the compensation committee hire a conflict-free consultant who reports only to the committee, and have it obtain the consultant’s written and verbal report when making compensation decisions.
  • Distribute in advance written materials relating to compensation decisions, and have the materials presented at the committee’s meeting by the consultant or management.
  • Draft minutes assuming they will be discovered in litigation. Show that the committee acted deliberately and diligently, document the committee’s rationale for its decisions, link decisions to the advice received, and avoid unnecessary detail that could be misconstrued or otherwise used against the board. Notes taken at the meeting should be destroyed once the minutes are finalized.

Private Ordering of Shareholder Director Nomination Proposals

Following the court decision striking down the SEC’s Proxy Access Rule, the SEC implemented amendments to Rule 14a-8 that permit shareholders to make proxy proposals concerning director elections, including proposals for shareholder access to management’s proxy statement. The amendments became effective on September 20, 2011.

Following the recent changes, Rule 14a-8(i)(8) no longer allows a company to exclude a shareholder proposal if it relates to a nomination or a director election or a procedure for director elections; it now permits exclusion only under very limited circumstances. The amendments to Rule 14a-8 do not create a mandatory right of proxy access, but permit private ordering on a company-by-company basis through shareholder proposals.

Under revised Rule 14a-8, beginning with the next annual meeting, any shareholder with $2,000 of stock held for at least one year may submit a proposal to the company for a change in the bylaws to require the company to include shareholder nominees for director in the company’s proxy statement and proxy card. The company must submit such a proposal to its shareholders unless it has a basis for excluding it under Rule 14a-8—for example, the proposal is impermissibly vague or misleading, contrary to state or federal law, or seeks to challenge a proponent’s evidence of ownership (see “Updated Guidance on Shareholder Proposals” below). A company could also propose its own version of proxy access for the shareholders to adopt, which may (should) result in the shareholder’s proposal being excludable (at least for this proxy season) under Rule 14a-8(i)(9), as the shareholder’s proposal would directly conflict with one of the issuer’s own proposals.

The nature of the proposal and the vote required to approve it will depend on state corporation law and the company’s governing documents. For example, because shareholders of Delaware corporations may adopt proxy access bylaws under the state’s revised corporate statutes, binding proxy access bylaw proposals can be submitted. In some states, however, only a nonbinding proposal is permitted. Unlike proposals under the overturned Proxy Access Rule, which restricted its application to the largest and oldest of shareholders, shareholder proxy access proposals under revised Rule 14a-8 are subject to no such limitations. Thus, there is broad flexibility for shareholders to fashion a favorable proposal and a strong incentive for companies to do the same.

Whether or not a company wishes to take action now, we believe that every company should evaluate its position, consider communicating with its significant shareholders and be prepared to act if it receives a proposal. Preparation could include being ready to resist a proposal by challenging the SEC’s action or by having a proxy access bylaw ready for adoption. Advance preparation should be the watchword.

Disclosure Obligations Relating to Cyber Security Risks

Not sure if you need to make disclosures relating to cybersecurity risks and cyber incidents? On October 13, 2011, the Division of Corporation Finance of the Securities and Exchange Commission issued new guidance to address the increased risks to registrants associated with cybersecurity and cyber incidents as companies become more dependent on digital technologies to operate their businesses. Not intending to be exhaustive, CF Disclosure Guidance: Topic No. 2 focused on six key disclosure areas, as detailed below.

Risk Factors. Do you need to disclose in your risk factors risks relating to cyber security and cyber incidents? The Guidance suggests the answer to this question requires the registrant to consider all prior cyber incidents, the severity and frequency of those prior incidents, the likelihood of future incidents, the quantitative and qualitative magnitude of those risks, and the adequacy of preventive actions taken to reduce cybersecurity risks, particularly in the context of the industry in which the registrant operates. Registrants may need to disclose, depending on particular facts and circumstances, a description of the following:

  • Aspects of the business or operations that give rise to material cybersecurity risks, including the potential costs and consequences
  • Outsourced functions that have material cyber security risks, including how the registrant addresses those risks
  • Cyber incidents experienced by the registrant if they are individually, or in the aggregate, material, including the costs
  • and consequences
  • Any risks related to cyber incidents that may remain undetected for an extended period of time
  • Relevant insurance coverage

Management’s Discussion and Analysis of Financial Condition (MD&A). Do the costs or other consequences associated with one or more known cyber incidents or the risk of potential cyber incidents represent a material event, trend or uncertainty that is reasonably likely to have a material effect on your results of operations, liquidity or financial condition or would cause reported financial information not to be necessarily indicative of future operating results or operating condition? If the answer is yes, disclosure of the cybersecurity risks is required in the registrant’s MD&A.

Description of Business. Are there one or more cyber incidents that materially affect your products, services, relationships with customers or suppliers, or competitive conditions? The Guidance indicates this is the key to determining whether disclosure should be provided in the registrant’s “Description of Business.” It is not enough to answer this question for the business as a whole either—according to the Guidance, a registrant should also consider the impact of the cyber incident(s) on each of its reportable segments before deciding whether to provide disclosure.

Legal Proceedings. Have you been sued as a result of a cyber incident? If the answer is yes, the registrant may need to disclose the pending proceeding in its “Legal Proceedings” disclosure, including the name of the court, the date the action was instituted, the principal parties to the litigation, a description of the factual basis alleged to underlie the litigation and the relief sought.

Financial Statement Disclosures. Have you addressed the impact of cybersecurity risks and cyber incidents on your financial statements? The Guidance provides registrants with direction relating to the impact of cybersecurity risks and cyber incidents, before, during and after a cyber incident, by pointing to certain accounting rules that may apply to the registrant’s situation. The suggested accounting rules address (1) capitalization of costs to prevent cyber incidents to the extent the costs are related to internal-use software; (2) appropriate recognition, measurement and classification of incentives provided to customers by registrants to maintain business relationships; (3) recognition of a liability if losses are probable (or at least reasonably probable) and reasonably estimable related to asserted and unasserted claims; (4) any risk or uncertainty of a reasonably probable near-term change in the estimates used in the impairment analysis related to certain assets as a result of a cyber incident; and (5) disclosure of recognized or nonrecognized subsequent events if a cyber incident is discovered after the balance sheet date but before the issuance of financial statements.

Disclosure Controls and Procedures. Do cyber incidents pose a risk to your ability to record, process, summarize and report information that is required to be disclosed in your public filings? If the answer is yes, in addition to disclosing conclusions regarding the effectiveness of disclosure controls and procedures, management should also consider whether there are any deficiencies that would render the controls and procedures ineffective.

ISS Revised Proxy Voting Policies

Institutional Shareholder Services, Inc., the leading proxy advisory firm, has published its 2012 updates to the ISS U.S. Corporate Governance Policy proxy voting guidelines. The 2012 updates include revisions to ISS’s policy on shareholder proxy access proposals, as well as its policies on pay for performance, “say-on-pay” votes and voting on director nominees in uncontested elections.

Proxy Access Proposals. ISS maintained its case-by-case approach to shareholder proxy access proposals but expanded on the factors to be used in assessing a proxy access proposal. ISS will examine both company-specific factors and factors specific to the particular proxy access proposal, including the ownership thresholds proposed in the resolution (i.e., the percentage and duration of ownership), the maximum proportion of directors that shareholders may nominate each year and the method of determining which nominations should appear on the ballot if multiple shareholders submit nominations. The factors enumerated in the ISS policy are not intended to be exhaustive.

Pay for Performance. In connection with the analysis of a company’s say-on-pay proposal, ISS conducts a pay-for-performance assessment of how the chief executive officer’s pay aligns with company performance over time. In the 2012 updates, ISS has refined its methodology for determining pay-for-performance alignment. For companies in the Russell 3000 index, ISS will select a peer group of 14 to 24 companies, using market cap, revenue and GICS industry group as comparative markers. First, ISS will examine the alignment between the company’s total shareholder-return rank within the peer group and the chief executive officer’s total pay rank within the peer group, as measured over one-year and three-year periods (weighted 40 percent for the one year period and 60 percent for the three-year period). Second, ISS will examine the multiple of the chief executive officer’s total pay relative to the peer group median. ISS will also evaluate the absolute alignment between the trend in chief executive officer pay and the company total shareholder return over the prior five fiscal years. If ISS determines that the alignment between company total shareholder return and chief executive officer pay is weak, ISS will evaluate a number of qualitative factors including the ratio of performance- to time-based equity awards, the completeness of disclosure and rigor of performance goals, a company’s benchmarking practices, and the ratio of performance-based compensation to overall compensation.

Say-on-Pay Votes. ISS will recommend, on a case-by-case basis, voting against members of a company’s compensation committee if the prior year say-on-pay vote received the support of fewer than 70 percent of the votes cast. ISS will take into account the company’s response, including disclosure of engagement efforts with major institutional investors regarding issues that contributed to the low level of support, specific actions taken to address such issues, whether the issues raised are recurring or isolated, and whether the support level was less than 50 percent. In cases where support was less than 50 percent, ISS indicates that the “highest degree of responsiveness” will be warranted. A company that received less than 70 percent support for its 2011 say-on-pay proposal should describe in its CD&A the specific efforts to engage its major shareholders to address any issues with the company’s compensation policies as well as recent company actions taken to respond to the low level of support from the shareholders.

Say-on-Pay Vote Frequency. ISS recommends a vote against the entire board of directors if the board implemented an advisory vote on executive compensation on a less frequent basis than the frequency dictated by the majority of votes cast at the most recent shareholder meeting at which shareholders voted on the say-on-pay frequency (e.g., a majority of votes favored a say-on-pay vote every year, and the board instead implemented a say-on-pay vote every three years). If the board implemented a say-on-pay vote on a less frequent basis than the frequency that received a plurality of votes, then ISS’s recommendation will be made on a case-by-case basis taking into account the board’s rationale for selecting a frequency different from the frequency that received plurality support, ISS’s analysis of whether there are compensation concerns or a history of problematic compensation, and the company’s ownership structure and vote results.

Risk Oversight and Director Elections. ISS added an explicit reference to risk oversight as a factor it will consider in recommending whether to vote against or withhold votes in a director election. ISS indicates that the addition is intended to “address situations where there has been a material failure in a board’s role in overseeing the company’s risk management practices.”

Other Updates. ISS will now perform a full equity plan evaluation when a newly public company presents an equity plan to comply with the provisions of Section 162(m) of the Internal Revenue Code. Previously, ISS recommended voting in favor of plan amendments to comply with Section 162(m). ISS also has updated its exclusive venue management and dual-class common stock structure proposals, as well as its approach to proposals on corporate political contribution disclosure, hydraulic fracturing, recycling, corporate lobbying activities, and workplace safety and water issues.

Updated Guidance on Shareholder Proposals

On October 18, 2011, the staff of the SEC’s Division of Corporation Finance issued Staff Legal Bulletin No. 14F. This Bulletin clarifies the Division’s interpretive positions regarding (1) verification of whether a beneficial owner is eligible to submit a proposal under Rule 14a-8 of the Securities Exchange Act of 1934, as amended, (2) common errors in proof of-ownership submissions accompanying shareholder proposals, (3) the submission of revised shareholder proposals, (4) procedures for withdrawing no-action requests, and (5) the Division’s expanded use of email for correspondence relating to no-action requests.

Verifying Record Ownership. Under Rule 14a-8(b), to be eligible to submit a proposal, a shareholder must prove that it has continuously held at least $2,000 in market value or one percent of the company’s securities entitled to be voted on the proposal at the meeting for at least one year through the date the proposal is submitted. The shareholder must also continue to hold such securities through the date of the meeting and provide the company with a written statement of the shareholder’s intent to do so.

To prove such continuous holdings, a shareholder must (1) be a registered holder of the company’s securities, meaning that such shareholder’s name appears in the company’s records as a shareholder and can be independently verified by the company; (2) submit to the company written proof from the record holder of the securities (usually an agent, such as a broker or bank, acting on behalf of the shareholder); or (3) submit a copy of Schedule 13D, Schedule 13G, Form 3, Form 4 and/or Form 5 as filed with the SEC.

Change in the Division’s Position on Proving Eligibility. Prior to release of the Bulletin, the Division took the position in the no-action letter known as The Hain Celestial Group Inc. (October. 1, 2008) that introducing brokers could be considered record holders for purposes of Rule 14a-8(b). An introducing broker is a broker that engages in sales and other activities involving customer contact, such as opening customer accounts and accepting customer orders, but that is not permitted to maintain custody of customer funds or securities. An introducing broker will generally engage a clearing broker to maintain custody of a customer’s funds and securities. Introducing brokers are usually not participants in the Depository Trust Company (DTC), a registered clearing agency that acts as a securities depository, whereas clearing brokers often are.

Based on the Division’s position in Hain Celestial, companies were required to accept proof-of-ownership letters from brokers in instances where the company was unable to verify securities positions against its own records or against DTC’s securities position listing. In the Bulletin, the Division, citing the transparency of DTC participants’ positions in a company’s securities, states that it will no longer follow the Hain Celestial position and, going forward, will only view DTC participants as record holders for purposes of Rule 14a-8(b)(2)(i). Thus, if the DTC participant knows the holdings of the shareholder’s bank or broker (i.e., introducing broker) but does not know the shareholder’s holdings, the shareholder will be required to submit one proof-ofownership letter from the shareholder’s bank or broker confirming the shareholder’s ownership and another proof-of-ownership letter from the DTC participant confirming the ownership of the shareholder’s bank or broker.

No-Action Requests for Exclusion of a Shareholder Proposal. A company may exclude a shareholder proposal for an eligibility defect only after it has sent written notice to the shareholder of such defect within 14 days of receiving the shareholder’s proposal and the shareholder fails to remedy such defect within 14 days of receiving such notification. The Division will grant no-action relief to a company on the basis that a shareholder’s proof of ownership is not from a DTC participant only if the company’s notice of defect describes the required proof of ownership in a manner consistent with the guidance in the Bulletin.

Avoiding Common Errors in Proof of Ownership. Proof of share ownership must be shown to cover a continuous year up to and including the day on which the shareholder submits its proposal. The Bulletin indicates that proof-of-ownership letters that shareholders obtain from their broker or bank often contain one of the following common errors:

  • An effective date prior to the submission of the proposal, leaving a gap that is not covered by the letter
  • An effective date after the submission of the proposal and language that covers a year only from the date of the letter, not from the date of submission
  • Language that confirms ownership as of a specified date but omits any reference to continuous ownership over the required one-year period

To avoid these pitfalls, the Bulletin provides sample language for inclusion in a proof-of-ownership letter. Submission of Revised Shareholder Proposals. If a shareholder submits a revised proposal before the expiration of the company’s deadline for receiving proposals, the company must accept the revision. Such revision is deemed to replace the initial proposal and does not violate the one-proposal limitation of Rule 14a-8(c). Additionally, if the company files a no-action request pertaining to a shareholder proposal that has been revised, such request must pertain to the revised proposal.

If, however, a shareholder submits a revised proposal after the expiration of the company’s deadline for receiving proposals, the company may reject such proposal by treating it as a second proposal and notifying the shareholder of its intention to exclude the revised proposal as required by Rule 14a-8(j), which notice may cite Rule 14a-8(e) as the reason for exclusion.

Given that a shareholder must provide a written statement of its intention to hold the securities through the date of the shareholder meeting, the Bulletin clarifies that the Division does not require additional proof of ownership when a shareholder submits a revised proposal.

Withdrawal of No-Action Request. The Division has previously stated that a company seeking to withdraw a no-action request due to the withdrawal of a shareholder proposal should include with its withdrawal letter documentation demonstrating the shareholder’s withdrawal of such proposal. In instances where the proposal being withdrawn was submitted by multiple shareholders and each shareholder has designated a lead filer to act on its behalf, the company need only provide a letter from such lead filer indicating that the lead filer is withdrawing the proposal on behalf of all proponents.

Use of Email for Transmitting No-Action Responses. In the Bulletin, the Division encourages both companies and proponents to include email contact information in no-action correspondence, and it announced that it intends to transmit future no-action responses by email when email contact information is provided. The Division will continue to use U.S. mail to transmit no-action responses when it has not received email contact information from a company or proponent.

Dodd-Frank Whistleblower Report

The SEC appears to be realizing the expected results of offering awards to whistleblowers as mandated by the Dodd-Frank Act, receiving 334 whistleblower tips in the first seven weeks of the program. This raises the question of whether companies will realize the expected problems.

In November, the SEC’s Office of the Whistleblower released its first annual report on the Dodd-Frank Whistleblower Program. The act and related Regulation 21F require, among other things, that the Office report to Congress after the end of each fiscal year on its activities, the whistleblower tips it received and the Office’s response to such tips. Regulation 21F became effective on August 12, 2011, only seven weeks before the end of the fiscal year. The extrapolated annual rate of almost 2,500 tips is probably a low estimate of future volume. The numbers will likely increase once the program is more established, awards are paid and publicized, and the plaintiffs’ bar becomes more active.

Monetary Awards. The centerpiece of Section 922 of the act is the amendment adding Section 21F to the Exchange Act, requiring the SEC to pay monetary awards to eligible individuals who provide original information to the SEC that leads to successful enforcement actions resulting in sanctions over $1 million. Awards are to be in an amount equal to 10% to 30% of the sanctions collected. Regulation 21F sets forth the mechanics of the program, including, among other things, procedures for submitting tips and applying for awards and the criteria the SEC will consider in making award decisions.

Unfortunately, the same incentives that are leading to more tips at the SEC and will lead to more investigations and sanctions will almost certainly also lead to employees going directly to the SEC with any possible violations and bypassing the expensive internal reporting systems established by companies over recent years. The SEC attempted to address this likely outcome by allowing employees to take advantage of the award program even if they first report a tip internally but only if they report the tip to the SEC within the next 120 days. Many commentators view this “fix” as insufficient, and based on early results, they seem to be right.

Internal Controls. Companies should take steps right away to increase the likelihood that employees will report potential violations through the internal system before going to the SEC. Companies also need to make sure their systems will lead to the prompt investigation of tips so they can be thoroughly reviewed and investigated in less than 120 days.

While most companies have internal reporting systems, management should not be complacent. These systems should be evaluated and updated to make sure they not only work as intended but are up to the task in light of the new state of affairs. One feature that many view as effective is requiring employees to provide periodic certifications regarding whether they are aware of any compliance violations. Above all, an internal system should ensure that tips are reviewed and investigated as quickly as possible and that all necessary groups within the company are involved at the outset, including compliance, legal and human resources.

Communication. Almost as important as an internal system is how well it is communicated to employees and managers. Employees should be well aware of the program and see it as a viable process that will address their possible concerns. They should know that if they choose to report a tip, it will be addressed quickly and they will suffer no repercussions for doing so. Similarly, managers should be thoroughly trained on what to do when employees come to them with tips. Effective training can expedite the investigation process and help avoid retaliation claims by employees. All reported tips should be treated in a consistent manner by designated people using established forms and procedures. Companies should take steps to keep the reporting employee informed of the progress of any investigation. Such feedback will help foster a sense that the internal system is working, which ideally will delay a report to the SEC, giving the company as much of the 120-day window as possible. Also, word of mouth about the system’s effectiveness should lead to other employees trusting the system and using it.

Dodd-Frank Clawback Requirements

Under Dodd-Frank, every public company will soon be required to adopt a “clawback” policy for the recovery of certain incentive-based compensation from its executive officers in the event the company is required to restate its financials as a result of material noncompliance with reporting requirements. Failure to develop and implement (and to disclose) such a policy will subject an issuer to delisting by U.S. securities exchanges and associations.

That much is known. But the brief clawback provision in the Dodd-Frank Act paints with broad (and largely undefined) strokes, leaving the details to be filled in by SEC regulation. There is no statutory deadline for the SEC rule-making process on clawbacks, and although expected in the near future, no rules have yet been proposed. Indeed, on December 31, 2011, the SEC announced that it expects to propose rules by June 30, 2012, on the recovery of erroneously awarded incentive compensation and expects to adopt those rules by December 31, 2012. Until then, companies will have to wait for official guidance on a number of issues, including the following:

Clawback Trigger. Dodd-Frank provides that a policy’s clawback requirements will be triggered if the issuer “is required” to prepare an accounting restatement due to any material noncompliance with financial reporting requirements under securities laws. As written, the statute imposes a strict liability standard on issuers – whereas the Sarbanes-Oxley clawback is tied to restatements necessitated by company misconduct, no malfeasance needs to have occurred for the Dodd-Frank requirements to apply.

No Director Discretion. Under Dodd-Frank, a clawback policy will also provide that the issuer “will recover” the excess amount of incentive-based compensation. Does this word choice mean that company directors will be forced to pursue clawbacks even if the effort would cost more than the potential recovery? If directors have no discretion in the matter and if the trigger is based on strict liability, then a corporation could be forced to pursue clawback from an innocent officer who, because of typical officer indemnification provisions, would be entitled to reimbursement (and even advancement) of costs for defense against the clawback. In other words, the company could end up paying for both the prosecution and defense of its recovery efforts.

Targeted Officers. The individuals whose compensation is subject to possible clawback under Dodd-Frank include “any current or former executive officer.” The definition of “executive officer” remains open, but it certainly appears that the net will be cast over a wider pool of potential targets than just CEOs and CFOs, who alone had been subject to Sarbanes-Oxley clawbacks. As to former officers, another question arises as to how a company would pursue recovery from someone who, upon departure, had signed a mutual release of claims with the company.

Targeted Compensation. The center point of Dodd-Frank’s clawback is aiding recovery of “incentive-based compensation” paid during a three-year look-back period “preceding the date on which the issuer is required to prepare an accounting restatement” that would not have been paid under correct financial statements. Although it’s obvious that Dodd-Frank’s lookback period is longer than the 12 months provided for Sarbanes-Oxley clawbacks, the SEC’s eventual rules will need to clarify what dates will bookend the new look-back period. In other words, what is the date “on which the issuer is required to prepare an accounting restatement”?

It also remains to be seen what is meant by “incentive-based compensation,” other than stock options, which are expressly included as a type of recoverable payment. As to stock options, more questions arise: What is the proper valuation date? And for those options that have been exercised, how would a company determine the clawback amount, since it’s unclear how different financial statements may have impacted stock price? As to other types of bonuses and incentive compensation, if awards are not strictly tied to financials?

Initial answers to these and more questions should soon be coming down the pike. In the meantime, it may be a good idea for companies to begin discussing potential changes to the compensation structure for the indemnification and release of claims against its officers in response to final clawback regulations.

Proposed FINRA Private Placement Disclosure Requirements

The SEC recently issued notice of a rule filing to adopt the Financial Industry Regulatory Authority’s (FINRA) proposed Rule 5123 (the Proposed Rule). The Proposed Rule, among other things, would require FINRA members and associated persons (1) to provide disclosures to investors regarding the anticipated use of offering proceeds prior to sale and (2) to file disclosure documents with FINRA for private placements of securities following sales.

Disclosure to Investors. The Proposed Rule governs FINRA members and persons associated with FINRA members that offer or sell securities in private placements or participate in the preparation of disclosure documents for private placements. The Proposed Rule would require that disclosure documents for private placements describe the anticipated use of offering proceeds; the amount and types of offering expenses; and the amount and types of offering compensation to be provided to sponsors, finders, consultants, and FINRA members and their associated persons. This information must be included in private placement memoranda or term sheets or, if none is prepared, in a separate disclosure document, and these disclosure documents must be provided to investors prior to sale. Much of the required information is already included in SEC Form D filings, but under the Proposed Rule, the information would be provided directly to investors.

Notice Filing with FINRA. The Proposed Rule would require that private placement memoranda, term sheets or other disclosure documents and related exhibits for a private placement offering be filed with FINRA by every member who participates in the private placement, within 15 calendar days after the date of the member’s first sale of the private placement. In addition, any amendments to disclosure documents required by the Proposed Rule would have to be filed no later than 15 days after the documents are provided to any prospective investor. To the extent these documents are provided to investors, they would also be subject to the strict liability standard of Rule 206(4)-8 under the Investment Advisers Act (to which all fund managers are already subject). The Proposed Rule does not include provisions for coordination of filings when more than one FINRA member is involved in a private placement.

Exempted Offerings. The Proposed Rule would exempt several private placements, including offerings sold only to employees and affiliates of the issuer or to any of certain specified categories of purchasers. Additionally, the Proposed Rule would exempt certain specified types of private placement offerings.

Confidential Treatment by FINRA. Documents and information filed with FINRA under the Proposed Rule would be given confidential treatment. FINRA would use such documents and information solely to determine compliance with FINRA rules or for other applicable regulatory purposes, although such documents may be available to the SEC in connection with examinations of and enforcement proceedings concerning hedge fund managers. FINRA would also accord confidential treatment to its comments or similar letters, which could not then be discoverable by a litigant through a legal action.

Heightened Listing Standards for Reverse Mergers

Today, private companies going public through reverse mergers must satisfy more stringent listing standards. On November 9, 2011, the Securities and Exchange Commission approved new rules adopted by the three major U.S. listing exchanges: NYSE, Nasdaq and NYSE Amex. These new rules make it tougher for public reverse merger companies to have access to U.S. capital markets. Reverse mergers allow private companies, particularly foreign companies, to access the U.S. capital markets by merging with existing public shell companies. In the summer of 2010, the SEC launched an initiative to investigate reverse mergers. The outcome of that initiative was a determination that U.S. regulators and auditors have only limited access to the financial data of certain foreign companies, thereby undermining the ability of regulators to assess the quality of the audits reported by these companies.

Recently, the SEC has halted or suspended trading in more than 35 foreign-based companies due to a lack of accurate and current information about the finances and operations of those companies. According to SEC Chairman Mary Schapiro, “Placing heightened requirements on reverse merger companies before they become listed on an exchange will provide greater protections for investors.”

The new listing standards prohibit private companies that go public through a reverse merger from applying to list unless:

  • The company has been in the U.S. over-the-counter market or on another regulated U.S. or foreign exchange for at least one year after the reverse merger;
  • The company maintains a requisite minimum share price for 30 of 60 trading days prior to the listing; and
  • The company files all required reports with the SEC, including at least one annual report containing audited financial statements for one full fiscal year.

SEC Guidance on Form 8-K Reporting Reverse Mergers. On September 14, 2011, the SEC’s Division of Corporation Finance issued disclosure guidance summarizing its observations with respect to the review of Form 8-K filed to report reverse mergers. Generally, a company that becomes a public company following a reverse merger with a shell company must file a Form 8-K (sometimes referred to as a “Super 8-K”) with the SEC within four business days after the completion of the transaction. Notably, this Form 8-K must contain the same disclosure information that would be required in a Form 10, including audited financial statements. The following is a summary of the guidance:

  • Item 9.01(b) of Form 8-K requires pro forma financial information of both the target and acquiring companies. This should include an explanation of how the reverse merger was accounted for by the combined company.
  • Individual risk factors to the public reverse merger company must be tailored to the company’s specific facts and circumstances.
  • Identify in the MD&A any significant elements of historical income or loss that will not continue post closing.
  • Increase disclosure about officers and directors of the company, including specific experiences, qualifications, attributes, skills and part-time status. Also, involvement in certain legal proceedings during the last 10 years must be disclosed.
  • Disclose post-closing compensation agreements with executive officers and directors. In addition, a summary compensation table for the acquired company’s most recent fiscal year should be provided.
  • Describe the criteria used to determine whether the directors are independent.

Contact Information

For more information on 2012 Proxy and Disclosure Planning, please contact D. Richard McDonald, Leader of Dykema's Public Company practice, at 248-203-2859, or any of the listed Dykema attorneys.

1Star Wars: Return of the Jedi (referring to the Death Star).
2Cool Hand Luke.
3The Princess Bride (“Inconceivable!”).
4Jerry Maguire.
5A Few Good Men.

As part of our service to you, we regularly compile short reports on new and interesting developments regarding the Consumer Financial Protection Bureau. Please recognize that these reports do not constitute legal advice and that we do not attempt to cover all such developments. Readers should seek specific legal advice before acting with regard to the subjects mentioned here. Rules of certain state supreme courts may consider this advertising and require us to advise you of such designation. Your comments on this Alert or any Dykema publication are always welcome. ©2012 Dykema Gossett PLLC.

As part of our service to you, we regularly compile short reports on new and interesting developments and the issues the developments raise. Please recognize that these reports do not constitute legal advice and that we do not attempt to cover all such developments. Rules of certain state supreme courts may consider this advertising and require us to advise you of such designation. Your comments are always welcome. © 2021 Dykema Gossett PLLC.