The 2015 Proxy Season and Beyond

January 29, 2015

In This Issue:

— Proxy Access on the Horizon

— Shareholder Proposals: What is Ordinary Business Anyway?

— Is Harvard Violating the Proxy Rules?

— ISS and Glass Lewis Proxy Voting Policy Updates For The 2015 Proxy Season

— Cybersecurity and Cyber Incidents

— On Deck: Executive Pay Ratio and Other Pay Disclosures


Proxy Access on the Horizon

In recent years, some activist shareholders and institutional investors have been pushing companies to allow long-term shareholders to propose candidates for election to a company’s board of directors. "Proxy access" proposals seek to provide shareholders with a mechanism for placing their nominees for election to the board of directors in a company's proxy statement and on its proxy card, thereby avoiding the cost to a shareholder of sending out its own proxy materials. Approval of a shareholder’s proxy access proposal by shareholders is merely advisory in nature and requires implementation by the company’s board of directors. However, such approval often results in pressure from institutional investors and proxy advisory firms to implement the proposal in response to the shareholders’ expressed will.


In 2010, the SEC approved an amendment to its proxy rules automatically giving shareholders the right to nominate directors to a company’s board of directors if they held a 3 percent stake in the company for three years. The new SEC rule (Rule 14a-11), was later stayed and ultimately vacated by DC Court of Appeals in 2011, when the court concluded that the SEC had acted “arbitrarily and capriciously” in issuing the rule. The SEC subsequently withdrew the rule without issuing any revised rules. Instead, the SEC implemented changes to Rule 14a-8 to allow shareholder proposals for proxy access to be made, in effect permitting each company to make its own decision on whether to allow proxy access, and, if allowed, the specific criteria a shareholder must satisfy (so-called “private ordering”). The number of proxy access shareholder proposals is on the rise as evidenced by the 75 proposals put forth so far this season by the New York City pension funds as discussed below.

Proxy Access Proposals Today

The most successful form of proxy access proposal in the past is one that follows the ownership requirement of the SEC’s vacated Rule 14a-11. These proposals would create a proxy access right for 3 percent shareholders (or groups) who have held their stake for at least three years, (“3 plus 3”) and would cap the number of shareholder-nominated candidates in the proxy materials at 20 percent of the number of directors then serving.

Although the once anticipated flood of proxy access proposals has never materialized, the New York City Pension Funds recently announced a broad initiative to advance the cause of proxy access, by filing “3 plus 3” shareholder proposals with 75 public companies seeking the right to include director nominees in each company’s proxy statement. The proposals are phrased as non-binding recommendations to the board that it adopt a proxy access bylaw. Some companies have agreed to let 3 percent holders nominate up to one-quarter of their directors, including CenturyLink, Chesapeake Energy, Hewlett-Packard, McKesson, Verizon and Western Union.

Many companies resist potentially opening the boardroom to investors in this manner by asking the SEC for permission to exclude the proposals from their proxy materials under the SEC staff no-action letter process and Rule 14a-8 of the proxy rules. Companies that receive a proxy access proposal should first assess whether the basic procedural requirements of Rule 14a-8 are satisfied. These gating items are read literally by the SEC staff and missing one or more of them by the proponent will usually result in the exclusion of the proposal from the company’s proxy solicitation materials.

If exclusion is not available, however, a company has three choices for responding to a proxy access proposal: (1) submit the proposal to a shareholder vote and make a board recommendation as to how shareholders should vote on it, (2) preemptively adopt a proxy access bylaw or submit a competing proxy access proposal (providing potential grounds for exclusion), or (3) attempt to negotiate a compromise or alternative outcome with the shareholder proponent. A recent SEC no-action letter pertaining to preemptively adopting a proxy access proposal may significantly impact the future of these proposals.

Whole Foods Market

In December 2014, the SEC staff granted Whole Foods Market, Inc. a no-action letter request allowing the company to omit from its proxy statement a non-binding shareholder proposal to permit “3 plus 3” proxy access for up to 25 percent of the board seats up for election. Seeking to exclude the proposal, Whole Foods indicated in its no-action letter request that it had determined to submit for a vote of its shareholders at the same meeting, a proxy access proposal that would allow any single shareholder owning at least 9 percent of the company’s common stock for five years to submit nominations to be included in the company’s proxy statement.

On the basis of Rule 14a-8(i)(9), the SEC staff agreed with Whole Foods that its proposal directly conflicted with the shareholder proposal and that submission of both proposals would have the potential for inconsistent and ambiguous results. Rule 14a-8(i)(9) allows a company to exclude from its proxy statement and annual meeting materials a shareholder proposal that “directly conflicts with one of the company's own proposals to be submitted to shareholders at the same meeting.” As such, Whole Foods could exclude the shareholder’s proxy access proposal from its proxy solicitation materials. The Whole Foods request was the first time that the SEC staff considered an argument to exclude a proxy access proposal because it was “in direct conflict” with a management proposal.

If a company either preemptively adopts a proxy access bylaw or submits a competing proposal to shareholder vote with higher eligibility thresholds, however, the shareholder proponent may come back with another shareholder proposal next year, seeking to reduce the thresholds. In that event, the company will likely not have a basis for excluding a “3 plus 3” proposal in the following year because the “substantially implemented” grounds for exclusion under Rule 14a-8(i)(10) will not be available. In prior SEC staff no-action letters, the staff has declined to permit the exclusion of a proxy access shareholder proposal on the basis that the company had “substantially implemented” the proposal by adopting its own form of proxy access that required a higher shareholding threshold or a longer shareholding period as compared with the shareholder proposal.

Whole Foods must have sensed the issue because it recently filed preliminary proxy solicitation materials with reduced proxy access eligibility thresholds. Under the revised management proposal, any single shareholder or group of funds under common management (but not a group of shareholders) owning at least 5 percent of the company’s common stock continuously for five years would be eligible to nominate board candidates for inclusion in the company’s proxy statement. The approach used by Whole Foods may simply postpone for one year the shareholder activists’ “3 plus 3” shareholder proxy access proposal.

Subsequent SEC Pronouncement

Due to questions about the scope and application of Rule 14a-8(i)(9), on January 16, 2015, SEC Chair Mary Jo White directed the staff of the Division of Corporation Finance (“Division”) to review its interpretation of Rule 14a-8(i)(9) with respect to excluding shareholder proposals that directly conflict with a company proposal to be submitted at the same shareholder meeting. Concurrent with the Chair's statement, the Division staff withdrew the Whole Foods letter and indicated that it will not be providing no-action relief for pending or subsequent no-action requests relating to proxy access proposals or any other pending no-action requests relying on Rule 14a-8(i)(9) during the 2015 proxy season.

While companies are not required to obtain no-action relief from the staff to exclude a shareholder proposal under Rule 14a-8, the consequence of the Division’s announcement is that companies that determine to exclude a shareholder proposal on the basis that it directly conflicts with management’s proposal will run the additional risk of enforcement action by the SEC. While companies may be able to conclude that, consistent with the Division’s precedents, they are justified in excluding a shareholder proposal that directly conflicts with management’s proposal, there would seem to be greater risk of doing so during the current proxy season until the SEC completes the reassessment of its position on the Rule 14a-8(i)(9) exception. Any company that determines to exclude a proposal without seeking a no-action letter from the Division must, under Rule 14a-8(j), inform the Division that it intends to exclude the proposal and "file its reasons" for excluding the proposal with the Division.

Practical Considerations

Where a proposal has been received and the company intended to exclude it under Rule 14a-8(i)(9), the company is now in a difficult position, as the usual Division guidance and no-action process will be unavailable. Interestingly, the procedural materials from the Division that accompany its no-action letters include language that says:

It is important to note that the staff's and Commission's no-action responses to Rule 14a-8(j) submissions reflect only informal views. The determinations reached in these no-action letters do not and cannot adjudicate the merits of a company's position with respect to the proposal. Only a court such as a U.S. District Court can decide whether a company is obligated to include shareholders proposals in proxy materials. Accordingly a discretionary determination not to recommend or take Commission enforcement action, does not preclude a proponent, or any shareholder of a company, from pursuing any rights he or she may have against the company in court, should the management omit the proposal from the company’s proxy material.

As a result, any company receiving a shareholder proposal, and particularly companies that intended to exclude a shareholder proposal on the grounds provided by Rule 14a-8(i)(9), should consider seeking a declaratory judgment from a U.S. District Court well in advance of finalizing and filing their proxy materials for their 2015 annual meeting. Unfortunately, with the Division’s position on Rule 14a-8(i)(9) in limbo, it seems less likely that a court would follow the Division’s no-action letter precedents, introducing an additional element of uncertainty into the process where Rule 14a-8(i)(9) serves as the grounds for exclusion.

Companies should consider simply implementing their competing proposal, if implementation may occur without shareholder approval, and including the shareholder’s proposal in the proxy statement. In addition to eliminating any litigation risk for failing to comply with Rule 14a-8, this option effectively turns the shareholder proposal into a referendum on management’s alternative and changes management’s statement in opposition into a discussion of the merits of management’s alternative and why it is a better alternative than the shareholder proposal without the confusion that would result from presenting competing proposals in the proxy statement.

For future years, companies should consider steps to better prepare for, respond to and potentially avoid proxy access proposals, including maintaining a dialogue with key shareholders and monitoring market trends in this area. For example, companies may wish to consider the terms of a proxy access provision that might be generally acceptable to the company’s shareholder base, or other governance enhancements that may prevent the company from becoming a proxy access target and having it ready to propose to shareholders in the event the company receives a proxy access proposal. A company with some form of proxy access implemented may be in a stronger position to defeat a subsequent shareholder’s proposal if put to a vote, as it could be used by the company to argue that the board of directors already made a determination as to what is best for the company in light of its circumstances. Having a proxy access provision in place may also encourage activist shareholders to move on to companies with no provision in place.

A key consideration in deciding how to respond to a proxy access proposal is to assess whether the proposal is likely to receive majority shareholder support. If it does, proxy advisory firms such as ISS and Glass, Lewis & Co. (“Glass Lewis”), will expect the board to be appropriately responsive to the proposal, such as by adopting a compliant form of proxy access or explaining in its public filings why it did not, taking into account the factors ISS and Glass Lewis think are important.

Public companies should also review their advance notice bylaws to be sure they appropriately address nominations for director, particularly since there is no reason to think that traditional proxy contests will become less frequent.

Shareholder Proposals: What Is Ordinary Business Anyway?

Federal District Court Disagrees With SEC No-Action Letter

Once upon a time, a company and its management would decide what products they wished to sell and those that they would not – it’s just business. But on November 26, 2014, the U.S. District Court for the District of Delaware ordered Wal-Mart Stores Inc. to let shareholders vote on a proposal to force tighter oversight of Wal-Mart’s sale of high-capacity guns and other potentially offensive products.

The Trinity Wall Street v. Wal-Mart Decision

Trinity is an Episcopal parish headquartered in New York City. In December 2013, Trinity submitted a proposal for inclusion in Wal-Mart's 2014 proxy materials seeking a shareholder vote to recommend amendment of the charter of Wal-Mart's governance committee to add a duty to provide oversight concerning the formulation and implementation of policies and standards that determine whether or not Wal-Mart should sell a product that endangers public safety, has the substantial potential to impair the company’s reputation or would be considered offensive to the values that are integral to the company’s brand. The narrative portion of the proposal stated that these oversight and reporting duties extend to determining whether Wal-Mart should sell guns equipped with high capacity magazines and to balancing the benefits of selling such guns against the risks that these sales pose to the public and to Wal-Mart’s reputation and brand value.

Staff Says Proposal Can Be Excluded. In March 2014, the SEC staff agreed in a “no-action letter” that Wal-Mart could exclude the proposal under Rule 14a-8(i)(7), which provides that a company may exclude from its proxy materials a shareholder proposal that "deals with a matter relating to the company's ordinary business operations." According to the SEC, the general underlying policy of this exclusion is to confine the resolution of ordinary business problems to management and the board of directors, since it is impracticable for shareholders to decide how to solve such problems at an annual shareholders meeting. This is consistent with prior SEC no-action letters about shareholder proposals focused on company decisions to sell certain products, particularly controversial products such as sexually explicit materials through pay-per-view.

Two weeks after release of the no-action letter, Trinity filed its lawsuit seeking (i) a declaratory judgment that Wal-Mart's decision to omit the proposal from its 2014 proxy materials violated the SEC’s proxy rules, (ii) a permanent injunction to prevent Wal-Mart from excluding the proposal from its 2015 proxy materials, and (iii) a preliminary injunction to prevent Wal-Mart from issuing proxy materials in connection with its 2014 annual meeting that did not contain the proposal.

The District Court heard argument in April on the preliminary injunction motion. In view of the very brief time frame available for it to consider the matter prior to the printing and mailing of the proxy materials, the Court deferred to the judgment of the SEC in its no-action letter position and denied the preliminary injunction. The Court found that the proposal related to "guns on the shelves and not guns in society" and, therefore, was properly excluded from Wal-Mart's proxy materials because it dealt with an ordinary business matter. As a result, Wal-Mart excluded the proposal from its 2014 proxy statement and held its annual shareholder meeting as scheduled.

Wal-Mart then filed a motion to dismiss Trinity's original complaint. In response, Trinity filed an amended complaint seeking declaratory relief as to the 2014 proxy materials, as well as prospective relief based on Trinity's intention to submit its proposal for inclusion in Wal-Mart's 2015 proxy materials.

Court Says Proposal Was Improperly Excluded. On November 26, 2014, the District Court ruled that Trinity’s shareholder proposal was improperly excluded from Wal-Mart’s 2014 proxy materials and granted injunctive relief enjoining Wal-Mart from relying on Rule 14a-8(i)(7) to exclude the proposal from Wal-Mart’s 2015 proxy materials. Under the doctrine of “capable of repetition, yet evading review,” the Court reasoned that the Trinity’s action was neither moot nor unripe for review because (1) the challenged action was in its duration too short to be fully litigated prior to its cessation or expiration, and (2) there was a reasonable expectation that the same complaining party would be subjected to the same action again.

Noting the SEC’s published guidance for shareholder proposals relating to a company’s ordinary business operations, certain tasks can be so fundamental to management's ability to run a company on a day-to-day basis that they could not, as a practical matter, be subject to direct shareholder oversight, such as workforce management, production quality and quantity, and the retention of suppliers. According to the SEC’s guidance, however, “proposals relating to such matters [i.e., ordinary business operations] but focusing on sufficiently significant social policy issues (e.g., significant discrimination matters) generally would not be considered to be excludable, because the proposals would transcend the day-to-day business matters and raise policy issues so significant that it would be appropriate for a shareholder vote.”

According to the District Court, to the extent the proposal relates to such matters as which products Wal-Mart may sell, the proposal nonetheless ''focus[es] on sufficiently significant social policy issues" as to not be excludable, because the proposal "transcend[s] the day-to-day business matters and raise[s] policy issues so significant that it would be appropriate for a shareholder vote" (emphasis in original). Moreover, the District Court also viewed the proposal as not excludable because it does not seek to "micro-manage" Wal-Mart or "prob[e] too deeply into matters of a complex nature upon which shareholders, as a group, would not be in a position to make an informed judgment" and the proposal does not involve "intricate detail" or seek to "impose specific time-frames" or dictate a "method[] for implementing complex policies." In this regard, the significant social policy issues on which the proposal focuses include the social and community effects of sales of high capacity firearms at the world's largest retailer and the impact this could have on Wal-Mart's reputation, particularly if such a product sold at Wal-Mart is misused and people are injured or killed as a result. In this way, the District Court determined that the proposal implicates significant policy issues that are appropriate for a shareholder vote.

The District Court concluded that, “Given this guidance, Trinity's 2014 proposal is best viewed as dealing with matters that are not related to Wal-Mart's ordinary business operations.”

Practical Considerations

While purporting to follow principles of the SEC’s precedents on Rule 14a-8(i)(7), this decision narrows the SEC’s historical approach to Rule 14a-8(i)(7) arguments with respect to whether sales of particular products are within the realm of ordinary business. In ruling that the Trinity shareholder proposal could not be excluded from the proxy materials, the District Court opens the door to proposals that are of ethical or social significance and are meaningfully related to the company’s business that might otherwise be excludable, so long as the proposals request board or committee oversight of the issue without dictating details, timing or methods.

In the last couple of years, several companies have bypassed entirely the SEC no-action letter process regarding shareholder proposals and taken their positions directly to federal court. As noted elsewhere in this Alert, SEC no-action letters do not adjudicate the merits of a company’s position with respect to the proposal and only a U.S. District Court can definitively determine whether a company is obligated to include shareholder proposals in its proxy materials. It remains to be seen whether this case will embolden other shareholders to sue companies that exclude their proposals, particularly in view of the prospective relief that the Court granted Trinity respecting Wal-Mart’s 2015 proxy materials.

The District Court’s reversal of the SEC’s no-action position, coupled with the SEC’s announced reassessment of its interpretations of Rule 14a-8(i)(9), it seems less likely than ever that a federal district court would defer to the SEC’s no-action letter interpretations when deciding whether a shareholder proposal is properly excludable under Rule 14a-8.

Is Harvard Violating the Proxy Rules?

The SEC’s proxy rules allow a company to exclude any shareholder proposal from its proxy solicitation materials if that proposal or its supporting statement is contrary to any of the SEC’s proxy rules, including Rule 14a-9 which prohibits materially false and misleading statements in proxy materials. In this regard, a recent academic paper adds to the string of successes by companies in federal court for resolving some shareholder proposal disputes.

The Academic Paper

Former SEC Commissioner Joe Grundfest and current SEC Commissioner Daniel Gallagher have created a dustup with their recently published paper, Did Harvard Violate Federal Securities Law? The Campaign Against Classified Boards of Directors. In their paper, Mr. Gallagher and Mr. Grundfest suggest that companies are dropping their staggered board structures—and shareholders are voting to eliminate them—based, in part, on faulty research by Harvard University’s Shareholder Rights Project (“SRP”). According to Gallagher and Grundfest, that research relied heavily on empirical research portraying staggered boards as categorically detrimental to shareholder interests, but makes no mention of recent empirical research that directly contradicts that position.

Grundfest and Gallagher suggest that Harvard University and its clinic violated the federal securities laws by providing proxy proposal language for use by shareholder proponents that fails to include references to academic studies contrary to the views of those proponents, which they say is a “material omission” by SEC standards. The authors claim that the Harvard wording ignores five studies that do not support its conclusions on the benefits of annual elections, and therefore could “be viewed as materially false and misleading” and in violation of SEC rules that require information to be accurate and fair.

On the other hand, Professor Jonathan R. Macey of Yale University argues that the SRP proposal does not contain a material omission, as it neither purports to contain a review of the academic literature nor suggests that contrary studies do not exist. Professor Macey also questions the propriety of a sitting SEC commissioner’s levying accusations at “an academic institution and a professor” as a means of effecting changes in enforcement practices at the agency.

Harvard University

SRP is a group created by Professor Lucian A. Bebchuk, a Harvard Law School professor who has long researched corporate governance issues and has been an outspoken advocate for increased democracy in corporate America. Since 2012, SRP has floated nearly 200 proposals at some 130 companies to change policies that prevent shareholders from electing, or replacing an entire board at one meeting.

Advocates for staggered boards say they create continuity and are an effective defense against a rival company—or activist investor—that tries to take over a company through a proxy contest without paying a premium to shareholders. Opponents of staggered boards, like Professor Bebchuk, say such a mechanism silences shareholders, entrenches management and makes it less likely that suitors or activists will emerge, depressing valuations. The paper also questions whether proxy advisory firms ISS and Glass Lewis have discharged their fiduciary duties in making recommendations in favor of de-staggered board resolutions, noting that they "will have to bear the burden of explaining why [the resolutions] continue to best serve the interests of shareholders, given the new state of empirical research."

The Effect

The efforts of SRP and Professor Bebchuk have had a significant effect on the corporate landscape, corporations have been dropping their staggered board structure in droves. Only about 60 companies in the S&P 500-stock index had staggered boards in 2013, down from 300 in 2000, an 80 percent drop, according to the paper.

Going forward, we may see some companies bypassing the SEC’s no-action letter process to exclude an SRP de-staggering proposal and instead proceeding directly to federal court for a declaratory judgment that the SRP proposal is false and misleading and can either be excluded from the issuer’s proxy materials or must be modified to include information regarding the other studies. As noted earlier in this Alert, the determinations reached in the staff no-action letter process do not adjudicate the merits of a company’s position with respect to any shareholder proposal. Only a U.S. District Court can provide a definitive determination of whether a proposal is sufficiently false and misleading to allow its exclusion from a company’s proxy materials.

ISS and Glass Lewis Proxy Voting Policy Updates for the 2015 Proxy Season

The proxy advisory firms ISS and Glass Lewis, recently announced updates to their respective voting policies for domestic companies for the upcoming 2015 proxy season. These two firms have risen to prominence in recent years, wielding significant power in corporate governance matters, proxy fights and takeover votes. Hedge funds, mutual fund complexes, institutional investors and similar organizations that own shares of multiple companies pay ISS and Glass Lewis to advise them regarding shareholder votes.

The ISS and Glass Lewis policy updates are effective for annual meetings on or after February 1, 2015, and January 1, 2015, respectively. For your convenience, we have summarized below the most important updates relating to corporate governance matters.

Independent Board Chairs

The most notable ISS policy change relates to shareholder proposals that seek to separate the chairman and chief executive officer positions. For the 2015 proxy season, ISS is adding new governance, board leadership and performance factors to its current analytical framework. In this regard, ISS’s policy will continue to generally recommend that shareholders vote “for” independent chair shareholder proposals after consideration in a “holistic manner” of the following factors:

  • Scope of the Proposal: Whether the shareholder proposal is binding or merely a recommendation and whether it seeks an immediate change in the chairman role or can be implemented at the next CEO transition.
  • Company’s Current Board Leadership Structure: The presence of an executive or non-independent chairman in addition to the CEO, a recent recombination of the role of CEO and chairman, and/or a departure from a structure with an independent chairman.
  • Company’s Governance Structure: The overall independence of the board, the independence of key committees, the establishment of governance guidelines, as well as board tenure and its relationship to CEO tenure.
  • Company’s Governance Practices: Problematic governance or management issues such as poor compensation practices, material failures of governance and risk oversight, related party transactions or other issues putting director independence at risk will be reviewed as well as corporate or management scandals and actions by management or the board with potential or realized negative impacts on shareholders.
  • Company Performance: One-, three- and five-year total shareholder return compared to the company’s peers and the market as a whole.

In view of its new holistic approach in evaluating these types of shareholder proposals, ISS indicates that a “For” or “Against” recommendation will not be determined by any single factor, but that it will consider all positive and negative aspects of the company based on the new expanded list of factors when assessing these proposals.

Glass Lewis generally does not recommend that shareholders vote against CEOs who also serve as chairman of the board of directors, but it encourages clients to support separating the roles of chairman and CEO whenever the issue arises in a proxy statement.

Unilateral Bylaw/Charter Amendments

ISS and Glass Lewis have adopted new policies pursuant to which they will generally issue negative vote recommendations against directors if the board amends the bylaws or charter without shareholder approval in a manner that materially diminishes shareholder rights or otherwise impedes shareholder ability to exercise their rights (“Unilateral Amendments”).

Under the updated policy, if the board adopts a Unilateral Amendment, ISS will generally make a recommendation for an “against” or “withhold” vote on a director individually, the members of a board committee or the entire board (other than new nominees on a case-by-case basis), after considering the following nine factors, as applicable:

  • the board’s rationale for adopting the Unilateral Amendment;
  • disclosure by the issuer of any significant engagement with shareholders regarding the Unilateral Amendment;
  • the level of impairment of shareholders’ rights caused by the Unilateral Amendment;
  • the board’s track record with regard to unilateral board action on bylaw and charter amendments and other entrenchment provisions;
  • the issuer’s ownership structure;
  • the issuer’s existing governance provisions;
  • whether the Unilateral Amendment was made prior to or in connection with the issuer’s IPO;
  • the timing of the Unilateral Amendment in connection with a significant business development; and
  • other factors, as deemed appropriate, that may be relevant to the determination of the impact of the Unilateral Amendment on shareholders.

Glass Lewis has revised its policy to provide that, depending on the circumstances, it will recommend that shareholders vote “against” the chairman of the board’s governance committee, or the entire committee, in instances where a board has amended the company’s governing documents, without shareholder approval, to “reduce or remove important shareholder rights, or to otherwise impede the ability of shareholders to exercise such right” such as:

  • the elimination of the ability of shareholders to call a special meeting or to act by written consent;
  • an increase to the ownership threshold required by shareholders to call a special meeting;
  • an increase to vote requirements for charter or bylaw amendments;
  • the adoption of provisions that limit the ability of shareholders to pursue full legal recourse (e.g., bylaws that require arbitration of shareholder claims or “fee-shifting” bylaws);
  • the adoption of a classified board structure; and
  • the elimination of the ability of shareholders to remove a director without cause.

Equity Plan Proposals

Of particular importance to management are the revised ISS and Glass Lewis policies pertaining to their voting recommendations on company proposals seeking shareholder approval of equity compensation plans. Equity compensation of management remains a central focus of many institutional investors and shareholder activists.

For 2015, ISS adopted a new “scorecard” model, referred to as Equity Plan Scorecard (“EPSC”), that considers a range of positive and negative factors in evaluating equity incentive plan proposals, rather than the current six pass/fail tests focused on cost and certain egregious practices to evaluate such proposals. The total EPSC score will generally determine whether ISS recommends “for” or “against” the proposal.

Under its new policy, ISS will evaluate equity-based compensation plans on a case-by-case basis depending on a combination of certain plan features and equity grant practices, as evaluated by the EPSC factors. The EPSC factors will fall under the following three categories (“EPSC Pillars”):

  • Plan Cost (45 percent weighting): The total estimated cost of the company’s equity plans relative to industry/market cap peers. ISS will measure plan cost by using ISS’s Value Transfer Model (SVT) for the company in relation to its peers. The SVT calculation assesses the amount of shareholders’ equity flowing out of the company to employees and directors.
  • Plan Features (20 percent weighting): The presence or absence of provisions in the plan providing for (i) automatic single-triggered award vesting upon a change in control; (ii) discretionary vesting authority; (iii) liberal share recycling on various award types; and (iv) minimum vesting period for grants made under the plan.
  • Grant Practices (35 percent weighting): The issuer’s recent grant practices under the proposed plan and all other plans including (i) the company’s three-year burn rate relative to its industry/market cap peers; (ii) vesting requirements in most recent CEO equity grants (three-year lookback); (iii) the estimated duration of the plan based on the sum of shares remaining available and the new shares requested, divided by the average annual shares granted in the prior three years; (iv) the proportion of the CEO’s most recent equity grants/awards subject to performance conditions; (v) whether the company maintains a clawback policy; and (vi) whether the company has established post exercise/vesting share-holding requirements.

In its updated voting policy, ISS will generally recommend voting “against” the plan proposal if the combination of the factors listed above in the EPSC Pillars indicates that the plan is not, overall, in the shareholders’ interests, or if any of the following apply:

  • awards may vest in connection with a liberal change-of-control definition;
  • the plan would permit repricing or cash buyout of underwater options without shareholder approval (either by expressly permitting it – for NYSE and Nasdaq listed companies – or by not prohibiting it when the company has a history of prepricing – for non-listed companies);
  • the plan is a vehicle for “problematic pay practices” or a “pay-for-performance disconnect;” or
  • any other plan features are determined to have a “significant negative impact on shareholder interests.”

Political Contributions

In recent years, many issuers have received shareholder proposals seeking reports or other disclosure regarding political contributions, including lobbying and political activities. Under the updated policy on political contribution shareholder proposals, ISS will generally recommend that shareholders vote “for” proposals requesting greater disclosure of a company’s political contributions and trade association spending policies and activities, after considering:

  • the company’s policies as well as management and board oversight related to its direct political contributions and payments to trade associations or other groups that may be used for political purposes;
  • the company’s disclosure regarding its support of, and participation in, trade associations or other groups where it makes political contributions; and
  • recent significant controversies, fines or litigation related to the company’s political contributions or political activities.

Practical Considerations

Despite the policy changes discussed above, public companies should continue to tailor their individual governance policies with a view towards what is in the long-term best interests of their own shareholders as opposed to meeting the ISS and Glass Lewis guidelines. ISS notes that its 2015 policy is intended to address the recent substantial increase in bylaw/charter amendments that adversely impact shareholder rights without being subject to a shareholder vote. Companies that intend to adopt any corporate governance policies that adversely impact shareholder rights should consider seeking shareholder support before implementing such policies, if a negative ISS or Glass Lewis recommendation on re-election of directors is likely to have a material effect on the election.

Companies should review last year’s proxy compensation and governance disclosures in order to make improvements in this year’s disclosures where appropriate – particularly if the company has received comments on this disclosure from the SEC staff. The failure to address a previous year’s staff comment may provoke a more detailed review by the staff, with its attendant time delays, should it be noticed during the staff’s initial screening of the filing.

Companies should also review their corporate governance and compensation practices for potential vulnerabilities under ISS’ policy updates, such as equity compensation plans that may be up for a vote at the next annual meeting or an independent chair shareholder proposal, and decide what action, if any, to take in light of this assessment.

Companies should continue a regular dialogue with key investors, bearing in mind limitations imposed by the SEC on proxy solicitations. Shareholder engagement efforts should continue to focus on what shareholders’ greatest concerns are and the rationale for board action.

Cybersecurity and Cyber Incidents

The SEC’s Division of Corporate Finance released guidance this past year regarding the obligation of a publicly traded company or issuer to disclose cybersecurity risks and cyber incidents. According to the SEC, cybersecurity refers to “the body of technologies, processes and practices designed to protect networks, systems, computers, programs and data from attack, damage or unauthorized access.” In light of the significant cyber-attacks occurring with greater frequency, and evidence that companies of all sizes are readily susceptible to such attacks, the SEC has emphasized that ensuring the adequacy of a company’s cybersecurity measures is a critical part of a board of directors’ risk oversight responsibilities.

The SEC staff has identified cybersecurity as an important matter and includes cybersecurity as an area upon which it issues comments when reviewing a company’s periodic or current reports. To assist registrants in this regard, the SEC staff issued guidance that outlines disclosure considerations and recommends release of information to the market under certain circumstances. According to CF Disclosure Guidance: Topic No. 2, entitled “Cybersecurity,” public companies must disclose cybersecurity risks and cyber incidents to the extent relevant. This new guidance on issuers’ disclosure obligations related to cybersecurity threats and incidents introduces additional issues for management to consider and presents new potential risks for management.

As with other operational and financial risks, issuers must review the adequacy of their disclosures related to cybersecurity risks and incidents. This Cybersecurity guidance is similar to the SEC staff interpretive guidance concerning disclosure of climate change matters in so far as it does not create new disclosure standards, but instead emphasizes what the staff wants issuers to consider.

Registrants have a general duty to disclose material information regarding cybersecurity risks and cyber incidents when necessary “in order to make other required disclosures, in light of the circumstances under which they are made, not misleading.” The guidance sets forth specific disclosure considerations and obligations.

Risk Factors

Item 503(c) of Regulation S-K and Item 1A of Form 10-K require each registrant to disclose the most significant factors that make an investment in the registrant speculative or risky. A registrant should tailor its cybersecurity risk factor to the registrant’s individual facts and circumstances, including disclosing known or threatened cybersecurity threats and specific past incidents. The SEC staff has suggested that appropriate disclosure might include:

  • Discussion of the aspects of the registrant’s business or operations that give rise to material cybersecurity risks and the potential costs and consequences of such risks;
  • To the extent the registrant outsources functions that have material cybersecurity risks, a description of those functions and how the registrant addresses those risks;
  • A description of cyber incidents experienced by the registrant that are individually, or in the aggregate, material, including a description of the costs and other consequences;
  • Risks related to cyber incidents that may remain undetected for an extended period; and
  • A description of relevant insurance coverage.

Consistent with disclosure requirements for risk factors generally, cybersecurity risk disclosure must adequately describe the material risks and how each risk affects the issuer, avoiding generic disclosures and mitigating factors.

Management’s Discussion and Analysis

An issuer should disclose in its Management’s Discussion and Analysis (“MD&A”) discussion cybersecurity risks or incidents “represent[ing] a material event, trend or uncertainty that is reasonably likely to have a material effect on the issuer’s results of operations, liquidity or financial condition.” As an example, if material intellectual property is stolen in a cyber-attack, the nature and effects of that theft, if material, should be described and the impact on operations should be assessed. Even if a prior cyber incident did not have a material effect on the issuer’s financial condition, disclosure of that incident may be required if the incident caused the issuer to materially increase its cybersecurity expenditures.

Description of Business

Issuers should provide disclosure in the “Description of Business” section of its reports and prospectuses pursuant to Item 101 of Regulation S-K, if a cyber-incident materially affects a registrant’s products, services, relationships with customers or suppliers, or competitive conditions, both for the issuer as a whole and for each of its reportable business segments. For example, if a cyber-incident could materially impair the future viability of an issuer’s new service or product, the issuer should discuss the incident and its potential impact.

Legal Proceedings

If a pending legal proceeding to which an issuer is a party involves a cyber-incident, such as stolen customer information, details of such litigation may need to be disclosed in its “Legal Proceedings” disclosure pursuant to Item 103 of regulation S-K to the extent material. Such disclosure should include a description of the factual basis underlying the claim and the relief sought.

Financial Statement Disclosure

Prior to, during, and after a cyber-incident, an issuer should make decisions regarding a number of issues related to its financial statements. Cyber incidents may result in diminished future cash flows, thereby requiring consideration of impairment of certain assets including goodwill, customer-related intangible assets, trademarks, patents, capitalized software or other long-lived assets associated with hardware, software and inventory. Cybersecurity risks and cyber incidents may have a further material impact on the financial statements, including the costs of developing or maintaining cybersecurity software, incentives for customers harmed by any cyber incident to maintain their business relationship with the issuer and losses from asserted and unasserted claims, including those related to warranties, breach of contract, product recall and replacement, and indemnification of counterparty losses. To the extent a cyber-incident is discovered after the balance sheet date but before the issuance of financial statements, disclosure of such subsequent event may be necessary.

Disclosure Controls and Procedures

Finally, the SEC staff ’s guidance encourages management to consider whether there are any deficiencies in an issuer’s disclosure controls and procedures that would render them ineffective as a result of a cyber-incident. Issuers should evaluate the extent to which cyber incidents pose a risk to their ability to record, process, summarize, and report information that is required to be disclosed in SEC filings. For example, if there is a material risk that a hacker could hinder a registrant’s ability to record, process, summarize and report information that is required to be disclosed in filings with the SEC, such controls may be considered ineffective and management would be required to disclose that fact to the public.

Practical Considerations

Given the negative impacts and costs of cybersecurity attacks and events, such as remediation costs, costs of increasing cybersecurity, lost revenues, litigation and reputational damage, issuers should reassess their cybersecurity prevention, incident identification and remediation efforts, and current disclosures.

The disclosure guidance cautions that issuers should reassess, on an ongoing basis, its disclosure controls and procedures and any disclosures made in SEC filings. Inherent in this guidance is the possibility that, if a material event were to occur, and if risk of such an event were foreseen and identified, failure to make appropriate prior cybersecurity disclosures could lead to enforcement review and action by the SEC’s Division of Enforcement and could be used by investors to argue for securities violations by the registrant under the anti-fraud rules.

On Deck: Executive Pay Ratio and Other Pay Disclosures

The SEC has yet to address some overdue rulemaking mandated by the corporate governance and executive compensation provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”), although final rule making action on one area may occur in early 2015.

Proposed Pay Ratio Rules

On September 18, 2013, the SEC proposed amendments to Item 402 of Regulation S-K to implement Section 953(b) of Dodd Frank, which directed the SEC to amend its executive compensation disclosure rules to require public companies to disclose:

  • The median of the annual total compensation of all its employees except the company’s principal or chief executive officer (CEO);
  • The annual total compensation of its CEO; and
  • The ratio of the two amounts.

The SEC refers to this disclosure, which would be required in new paragraph (u) of Regulation S-K Item 402, as “pay ratio” disclosure. As proposed, smaller reporting companies, emerging growth companies and foreign private issuers would not be subject to the pay ratio disclosure requirement.

Not Required For 2015 Proxy Season. The good news is that this pay ratio disclosure is not be required for the 2015 proxy season. Assuming no changes are made to the transition period set forth in the proposed rules, should the SEC adopt the final pay ratio rules in 2015, the earliest that the disclosure is likely to be required would be the 2017 proxy season for calendar-year companies (with respect to 2016 compensation). On the other hand, there seems to be growing speculation over the utility of this information versus the costs incurred to compile the data, particularly in light of the new Republican-led Congress.

Pay for Performance

Under Section 953(a) of Dodd Frank, the SEC must amend its executive compensation rules to require disclosure by each public company of “information that shows the relationship between executive compensation actually paid and… financial performance, taking into account” the company’s stock price performance. Many commentators have noted the ambiguities in the Dodd Frank requirement and the significant technical issues it raises. Key among these is an absence of guidance about the period over which performance is to be measured, when pay is required to be taken into account, which executives’ pay is required to be taken into account, and how to measure performance.

Not Required For 2015 Proxy Season. Although the SEC has yet to propose rules on this topic, most companies are paying closer attention to pay for performance alignment. For example, U.S. companies continue to shift more of the long-term incentive mix toward grants with explicit performance conditions and increasingly use total shareholder return as a performance measure. These trends reflect an appropriate emphasis on “pay for performance” in designing executive compensation programs. According to Towers Watson, while 60 percent of U.S. public companies conducted analyses to assess how closely their executive pay levels align with company performance, fewer than half of those companies disclosed the results of their pay-for-performance analyses in their 2014 proxy statements. Companies should consider expanding the analysis of pay-for-performance in the compensation discussion and analysis section of their proxy statements as a means of supporting their say-on-pay proposals and demonstrating responsible compensation practices by their boards of directors.

Most companies are looking to and waiting for the SEC to define the key components of the Dodd Frank pay-for performance disclosure (e.g., definition of pay and performance), while giving companies flexibility as to how the information is presented so that each company can tell its unique pay-for performance story.

Clawback and Hedging Policies

The final two areas of mandated rulemaking under Dodd Frank’s corporate governance and executive compensation provisions include mandatory policies and disclosure regarding clawbacks of executive compensation and disclosure of hedging by employees and directors. The SEC’s regulatory agenda published late last year suggested that the SEC expected to propose rules by the end of 2014 to address these issues, but these proposals remain unpublished as of late January 2015.

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For more information regarding the 2015 proxy season, please contact the authors of this alert, Robert B. Murphy (202-906-8721) and Mark A. Metz (313-568-5434), or D. Richard McDonald, who leads Dykema’s public company practice group (248-203-0859).

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