January 3, 2012
The past year has been one of change and challenge for public companies and their boards, as companies have moved to implement "say-on-pay" and other provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). With the 2012 proxy season on the horizon, public companies and their directors will continue to feel the impact of Dodd-Frank as the Securities and Exchange Commission ("SEC") proceeds with its ongoing efforts to implement the law. At the same time, public companies and their boards are operating in an environment where the balance of power between boards and shareholders continues to shift. The traditional, board-centric model of corporate governance continues to gravitate toward a paradigm that includes an increased role for shareholders. Activist shareholders are seeking greater participation in companies’ governance and operations, and they are exerting increased pressure on companies to adopt so-called corporate governance "best practices."
Against this background of rapid change, we believe that it is important for public company boards to remain focused on core issues such as overseeing corporate strategy and the major risks facing their companies. At the same time, well-advised companies and their boards are positioning themselves to respond appropriately as changes occur, taking into account not only "best practices," but also their companies’ individual circumstances, the views of their significant investors and the long-term health and growth of the enterprise. To help directors understand how developments in the corporate governance world may affect their companies, this client alert provides an overview of issues for directors to consider while preparing for the 2012 proxy season.
A common theme running through many of these issues is the importance of effective shareholder engagement. We believe that "good listening" should be a priority, so that shareholder engagement occurs on an ongoing basis. While the need for engagement may seem less pressing at companies that are not facing significant challenges, all companies should have an "open door" policy so shareholders understand that the company is receptive to hearing their views and that their views are communicated to the board. Shareholder outreach may be important to avoid negative votes on director nominees, "say-on-pay" or shareholder proposals. The board should know what the company is doing to engage with shareholders and should participate in these efforts, in coordination with management, where board-level involvement is appropriate. In addition, the board should have an understanding of who the company’s shareholders are and what their policies are on major issues relevant to the company. Companies, with the assistance of their proxy solicitors, should analyze their institutional shareholder base to assess those institutions’ voting positions on key issues, including how closely they follow the voting recommendations of proxy advisory firms, and should reach out to institutions as appropriate.
1. Risk Oversight
Consistent with the nature of the board’s oversight role, the board oversees–but does not manage–risk. With companies facing continued uncertainty in the economic and regulatory environment, the subject of risk oversight remains a key area of focus for boards, and we are seeing many requests from clients for information on how best to structure board oversight of risk. Ongoing investor focus on risk oversight is apparent in the voting policy updates that Institutional Shareholder Services ("ISS") adopted for 2012, which include a policy to issue negative voting recommendations on individual directors, committee members or the entire board due to "material failures" of risk oversight. While this reflects ISS formalizing a voting recommendation standard that it has applied in the past, in isolated situations, it is indicative of investor attention to the subjects of risk and risk oversight.
Boards have adopted a variety of risk oversight structures, and there is no "one-size-fits –all" approach. Historically, many boards have addressed risk primarily through the audit committee, and additionally relied on other board committees to oversee risks that fall within their areas of expertise. Although some boards have established a separate risk committee, this practice has emerged primarily in the financial services industry due to Dodd-Frank provisions requiring risk committees at large financial institutions. Whatever structure a board adopts, we believe that it is critical for the full board to remain engaged in the risk oversight process. This means a regular focus at the full-board level, and discussions with the CEO and senior management team, on strategic issues, including: (a) understanding and concurring with the company’s risk philosophy and appetite; (b) taking a holistic picture of risk as part of the strategic planning process; (c) evaluating and understanding the major risks facing the organization; and (d) understanding how those risks are being addressed.
Boards also should be comfortable that they understand how these risks relate to the company’s business and strategy, and more fundamentally, that they understand the business and strategy itself. Boards, and those who advise them, should think carefully about how the board is spending its time and see that the board has adequate time to address critical issues such as strategy and risk. If "deeper dives" into particular areas would be helpful, the board could devote a portion of the time allocated for ongoing director education to obtaining a greater understanding of the company’s business and strategy, as well as associated risks.
Some companies have appointed a chief risk officer or another individual to oversee the risk management process, coordinate risk assessment and mitigation, and report to the board or board committees as appropriate. Although this can be useful, risk assessment, risk appetite and risk management are core functions of a company’s CEO and senior management team. Senior management should brief the board on a regular basis about these issues, particularly in annual strategic review sessions and when consideration is being given to acquisitions or new lines of business. A chief risk officer can help senior management and the board to monitor risk management and update assessments of risk. Likewise, outside advisors can benchmark against other companies’ risk management programs and good practices. However, chief risk officers and consultants cannot effectively manage risk on their own, and neither one should be viewed as a substitute for senior management leadership of the risk management process, and oversight by the board as a whole, utilizing the diverse skills sets and experiences of all board members.
2. Board Leadership
A consensus has now emerged about the need for independent board leadership. What remains is the question whether this requires an independent board chair or whether a lead director can meet this objective. The lead director is a popular alternative that many investors view as adequate where a board has a combined chair/CEO or an executive chair. However, some shareholders, particularly European investors, and some governance experts, have called for the appointment of an independent board chair, and the number of boards appointing independent chairs has increased in the last several years.
A lead director is likely to remain popular among U.S. companies, where the majority practice remains a combined chair/CEO with a lead director. Many institutional investors appear willing to accept a lead director structure, rather than an independent chair, especially if a board undertakes to review its leadership structure on an annual basis. Moreover, several recent situations illustrate that the independent chair model is not a "cure-all," demonstrating the importance of an effective working relationship, and clear delineation of roles and responsibilities, between the chair and CEO where the roles are separate. For example, in January 2010, General Motors Co.’s then-chair became the company’s CEO as well, two months after the company ousted its former CEO after the two publicly disagreed over the timing of the company’s IPO and the speed of its restructuring.
Nevertheless, shareholder proposals seeking the appointment of an independent chair continue to be popular, and these proposals have been receiving increasing levels of support. ISS generally recommends votes "for" these proposals unless a company meets several criteria, including having a lead director with duties specified by ISS. Glass Lewis & Co. ("Glass Lewis") also generally favors these proposals because it believes that having an independent chair is in the long-term best interests of companies and their shareholders.
In light of the ongoing focus on board leadership, boards should consider reviewing their leadership structures at least annually to assess whether the current structure remains appropriate in light of the company’s circumstances. For boards with a lead director, this would include an evaluation of whether the lead director’s duties are appropriate and how they compare to those specified by ISS, even if the company has not received an independent chair shareholder proposal. In addition, as part of the succession planning process, the board or responsible committee should regularly look ahead to consider whether changes in leadership structure may be appropriate in the future.
3. Director Elections
In 2011, the introduction of mandatory say-on-pay contributed to a significant decline in shareholder opposition to individual directors, as it provided an alternative to voting against compensation committee members at companies where there was dissatisfaction with executive compensation practices. This may change in 2012, as some directors experience opposition, and negative recommendations from proxy advisory firms, at companies where the board’s response to a say-on-pay vote is not viewed as satisfactory. With the growing popularity of majority voting in director elections, and increased shareholder attention to director qualifications and board composition, the re-election of directors is not automatic.
We expect that the composition of the board as a whole will continue to receive attention from shareholders, who will be evaluating the collective experience of the board in addition to individual directors. Shareholders will be seeking evidence that the board is evaluating its evolving needs and conducting a serious assessment of its composition (including issues of diversity), and that the board is reviewing the effectiveness and contributions of individual current directors and making changes when appropriate. Increasingly, boards and nominating/corporate governance committees are engaging in a structured process–whether as part of the annual board self-assessment or otherwise– of considering the background and expertise of existing directors in order to determine whether there are specific skills or attributes that would be appropriate to add to the board. This determination will be informed by a number of factors, including the company’s strategic plans and anticipated retirements from the board, although many boards are moving away from a mandatory retirement age as they conduct more meaningful assessments of directors’ contributions. A thorough review of the composition of the board will allow the board to conduct targeted efforts to identify and recruit individuals with specific qualifications that complement those already represented on the board.
The expected voting recommendations of ISS and Glass Lewis also are relevant to the election of directors. Both firms typically recommend opposing directors who do not meet the firms’ own independence standards–which are stricter in several respects than those of the major stock exchanges–if these directors serve on any of the three "key" committees (audit, compensation, nominating/governance). Both ISS and Glass Lewis also generally recommend opposing compensation committee members where a company has pay practices that the firms view as particularly egregious, and the firms may expand this practice where they view other committees as responsible for inappropriate governance practices. In addition, ISS considers the board’s response to a shareholder proposal that receives substantial support in making voting recommendations on directors. If ISS does not view the board’s response as appropriate, in subsequent years ISS may oppose incumbent directors. If the board decides that it is in the best interests of the company and its shareholders to implement a proposal in a way that differs significantly from what the proposal contemplated, shareholder outreach to explain the rationale for the board’s actions is highly advisable.
4. Executive Compensation
Executive compensation continues to be a major focal point for regulators, shareholders and the public. Although shareholder support for compensation programs generally was high in 2011, the first year of mandatory say-on-pay votes, going into 2012 companies will need to evaluate their compensation practices and disclosures with a critical eye. Companies that experienced significant levels of opposition to say-on-pay in 2011 should address perceived problems with their compensation practices. Under new SEC rules, all companies will have to discuss in the Compensation Discussion & Analysis ("CD&A") whether, and if so how, they considered their results of their most recent say-on-pay vote and how that consideration affected their executive compensation decisions and policies.
A. Lessons Learned in 2011
In 2011, most companies saw overwhelming support for their say-on-pay proposals. Every company where there was a failed say-on-pay vote received a negative voting recommendation from ISS, and failed votes were due primarily to pay-for-performance concerns, as well as pay practices that were viewed as problematic. While many companies were able to overcome negative ISS recommendations, some companies had to modify their compensation plans or arrangements in response to these recommendations and/or shareholder feedback on their say-on-pay proposals. At a number of companies that lost their say-on-pay votes, shareholder derivative suits against the company’s directors, executives and compensation consultants have followed.
Although the number of negative majority say-on-pay votes was small, say-on-pay has had a broader impact, changing the substance of compensation practices and enhancing engagement with shareholders. For example, 82% of companies responding to a survey by consulting firm Towers Watson reported that they took some action in anticipation of say-on-pay votes, with 56% of the companies reporting that they had increased direct communication with shareholders and 32% reporting that they made changes to their compensation programs. An even greater percentage (91%) of these companies reported that they plan to take additional actions in anticipation of their 2012 say-on-pay votes.
B. Preparing for 2012
In preparation for a company’s 2012 say-on-pay vote, the board and compensation committee should evaluate the results of the 2011 vote and determine whether changes to compensation practices or enhancements to compensation disclosures are appropriate. This evaluation should take into account the overall level of shareholder support in 2011, any pay practices or disclosures that were the subject of criticism, either from shareholders or from the proxy advisory firms, and any changes in a company’s shareholder base.
ISS and Glass Lewis have announced that they will be looking hard at companies where say-on-pay proposals received "significant" shareholder opposition, and at how these companies responded. ISS and Glass Lewis will be assessing the disclosures that these companies make about engagement efforts with major shareholders and specific actions taken to address issues that contributed to shareholder opposition. Companies should reach out to proxy voting groups at their major shareholders to understand the reasons for their votes on the company’s say-on-pay proposal and to address any concerns about the company’s compensation program. At many institutions, speaking with fund managers alone is not sufficient because voting decisions may be made by or with the input of a different department.
For 2012, ISS also has announced an updated pay-for-performance test, which is one of several criteria ISS looks at in evaluating say-on-pay proposals. Under this test, ISS will start with a quantitative screening that is based primarily on a comparison of CEO pay and total shareholder return, both on an absolute basis and relative to peers. If the quantitative screening shows "significant unsatisfactory" long-term pay-for-performance alignment, ISS will do an additional, qualitative review. (See our November client alert for a more detailed discussion of the ISS 2012 voting policy updates, "ISS Releases Policy Updates for 2012 Proxy Season.") ISS also considers whether companies have "problematic" pay practices in evaluating say-on-pay proposals. Similarly, Glass Lewis and many institutional investors look at whether companies have certain pay practices that they view as inappropriate. This emphasizes the need for awareness of practices that are viewed unfavorably, such as tax gross-ups and "golden coffins" providing post-death benefits, and those that are seen as good practice, like "hold-through-retirement" provisions and "clawback" policies.
Finally, the board and compensation committee should continue to focus on how the company is presenting its compensation programs in its CD&A. The CD&A should be specific about how the company measures performance and provide a meaningful discussion of how named executive officer compensation is linked to performance. Companies should use their CD&A as an opportunity to explain how they responded to their last say-on-pay votes, outline any changes in their pay practices and respond to any criticisms of these practices. If specific elements of a company’s compensation deviate from the proxy advisory firms’ notions of "best practices," the company should use its CD&A to explain the rationale for these practices.
5. Proxy Access
In July 2011, the U.S. Court of Appeals for the D.C. Circuit vacated the SEC’s mandatory proxy access rule in a decision that strongly criticized the SEC’s analysis of the rule’s economic consequences. Gibson Dunn successfully represented Business Roundtable and the U.S. Chamber of Commerce in challenging the rule. While mandatory proxy access is gone, companion amendments to the SEC’s shareholder proposal rule now permit shareholders to submit proposals seeking to implement proxy access schemes on a "private ordering" basis through company charters or bylaws.
To date during the 2012 proxy season, at least 15 companies have received these proposals. A number of the proposals are based on a model that was developed by the U.S. Proxy Exchange, a group that represents retail investors, and that would permit director nominations from any group of 100 investors that satisfy the ownership criteria in the SEC’s shareholder proposal rule (ownership of $2,000 of a company’s stock for at least one year). Six proxy access proposals have come from Norges Bank Investment Management, manager of the Norwegian government’s pension fund. The Norges proposals take the form of "binding" bylaws amendments–that is, they would automatically amend a company’s bylaws to provide for proxy access upon receipt of shareholder approval. Both types of proposals contain lower ownership criteria than the criteria (3% for three years) in the SEC’s now-vacated proxy access rule. A third variation of proxy access proposal is modeled on the criteria in the SEC’s vacated mandatory proxy access rule.
While proxy access will no doubt remain an issue that some companies will face in the form of shareholder proposals, it is far too early to suggest that it will become an accepted practice. As demonstrated by the difficulties the SEC faced as it has wrestled with the issue on and off for the past decade, many practical difficulties remain in balancing competing interests to address any perceived need for proxy access. Moreover, the low thresholds included in the various shareholder proposals do not resolve the concerns that have been raised over the ability of "special interest" director candidates to impose substantial costs on all shareholders. Thus, while public companies should continue to monitor developments in this area and keep proxy access in mind when addressing relevant topics, such as advance notice bylaws and definitions of "change of control," it is premature to consider implementation of proxy access.
6. Board Oversight of Political Activities
In recent years, shareholder activists have called for greater transparency about corporate political activity. Demands for greater transparency–and even shareholder approval of companies’ political contributions–increased dramatically after the U.S. Supreme Court’s 2010 Citizens United decision, which struck down parts of the McCain-Feingold campaign finance law banning corporate contributions to independent political expenditures.
Post-Citizens United, shareholder proposals regarding corporate political activity have cast a wider net, and overall support for these proposals has increased. These proposals generally focus on disclosure of different types of contributions, including direct political contributions, and on board oversight of corporate political spending. Another variation on these proposals seeks reports on companies’ direct and grassroots lobbying expenses. Still another variation seeks shareholder approval of political contributions. One version of this proposal submitted in 2011 sought to require approval of 75% of a company’s outstanding shares for any political contributions, while another sought an annual shareholder advisory vote on political spending. These proposals may be based on practice in the United Kingdom, where companies must obtain prior shareholder approval of corporate political expenditures.
In addition, a number of organizations have been pushing for enhanced disclosure and oversight through other initiatives, and tracking company practices in this area, including the non-profit Center for Political Accountability ("CPA"), a coalition of about 34 organizations that includes many of the most prolific shareholder proponents. For example, in 2010, CPA and the Council of Institutional Investors, together with nearly 50 institutional investors and shareholder advocacy groups, sent letters to S&P 500 companies asking them to disclose all political contributions they make with corporate funds and calling on their boards to approve and review all political donations. In October 2011, CPA and the Wharton School’s Zicklin Center for Business Ethics Research published an index rating U.S. public companies in the S&P 100 on the quality of their political disclosure and accountability practices. Notably, CPA opposes requiring shareholder approval of political contributions as it believes that disclosure and board oversight are preferable.
In the past few years, several companies have experienced negative publicity in connection with contributing corporate funds to political campaigns or initiatives. In light of the increased attention to this area, we believe it is important for boards to engage in oversight of political contribution policies and practices at their companies. In addition, consideration should be given to adopting a policy on board approval and disclosure of corporate political contributions and expenditures. Companies need to evaluate the benefits of disclosure, which is becoming a widespread practice, taking into account potential sensitivities that may arise with respect to some expenditures or contributions.
7. Shareholder Proposals
In 2011, the number of shareholder proposals decreased, and fewer shareholder proposals went to a vote, as compared to 2010. This was due in part to a large decrease in executive compensation-related proposals because of mandatory say-on-pay, as well as an increase in the number of proponents withdrawing proposals after negotiating with companies. Several key corporate governance-related shareholder proposals received substantial support, including those on special meetings, written consents, board declassification and independent chairs. Once again, shareholders are submitting proposals on these subjects in significant numbers for 2012. Environmental/social proposals that companies are seeing include proposals on climate change, the use of hydraulic fracturing (or "fracking") to tap natural gas and sustainability reports.
Special meeting and written consent proposals have been a particular focal point for activist shareholders as part of their ongoing focus on board composition, since the measures sought in these proposals would make it easier to remove incumbent directors. Many companies have responded to special meeting proposals by amending their organizational documents to allow shareholders to call special meetings, or to lower the threshold needed to do so, and to include parameters governing when and how shareholders can request a special meeting and what shareholders can address at a meeting.
Similarly, over the last few years, shareholder activists have become increasingly interested in the ability of shareholders to act by written consent, arguing that it increases the accountability of boards of directors. Most large companies effectively prohibit action by written consent, either outright or by requiring a unanimous shareholder action. While this approach currently is the most popular, it is likely to come under increasing pressure due to written consent shareholder proposals. However, support for these proposals has declined since 2010 as a result of a campaign by companies to educate institutional shareholders and proxy advisory firms about the drawbacks to action by written consent. Among other things, allowing action by written consent could empower a group of short-term shareholders to act in ways adverse to the interests of other shareholders, without the benefit of a proxy solicitation or shareholder meeting.
8. Regulatory Activity Expected in the Coming Months
Moving into 2012, there are also a number of developments on the regulatory front that will impact companies and their boards. Some of these developments include:
a. Executive compensation and related rulemaking under Dodd-Frank. Under its current schedule, by mid-2012, the SEC plans to propose and adopt final rules on "clawbacks" of executive compensation, and disclosures about: (a) the ratio of CEO compensation to median worker pay; (b) the relationship between executive compensation and company financial performance; and (c) hedging policies applicable to directors and employees. The SEC also plans to adopt in the first half of the new year final rules on the independence of compensation committees and consultants, although most of these rules will require further rulemaking by the stock exchanges. In the "clawbacks" area, most companies are taking a "wait-and-see" approach and deferring action on the revision or adoption of clawback policies until final SEC and exchange rules are in place. The pay ratio disclosure provision in Dodd-Frank may create significant challenges for companies in gathering and analyzing the data necessary to calculate the ratio, and a number of organizations have submitted comments to the SEC suggesting "fixes" designed to minimize the compliance and cost burdens associated with this provision.
b. Conflict minerals rules. The SEC is close to issuing final rules, also required under Dodd-Frank, that will require companies to conduct due diligence about the origin of certain minerals used in their products and provide an annual report to the SEC about their diligence and any "conflict minerals" that may originate in the Democratic Republic of Congo. The SEC is aiming to have a final rule in place as soon as possible, but there are a number of complex issues to address as part of the rulemaking. The SEC held a public roundtable in mid-October to seek feedback on these issues. During the comment process on the rule proposals, industry groups and others have urged the SEC to reevaluate the cost estimates of the rule. (See our October client alert for a more detailed discussion of issues the SEC is considering as part of the conflict minerals rulemaking, "SEC Hosts Roundtable on Conflict Minerals.")
c. Accounting and auditing. The SEC reported recently that it plans to make a final decision on the possible adoption of International Financial Reporting Standards ("IFRS") in the United States in 2012. In the meantime, the SEC staff is continuing its work plan on evaluating the "condorsement" approach to incorporating IFRS into the U.S. financial reporting system, a process by which the Financial Accounting Standards Board ("FASB") would gradually adopt specific parts of IFRS over time. The Public Company Accounting Oversight Board has been active on a number of fronts, and recently issued a concept release on the possibility of mandatory rotation of audit firms. It also has proposed rules to increase the transparency of audits by requiring disclosure about key participants in the audit, including disclosure of the engagement partner’s name in the audit report. (See our August client alert for more detail on the concept release, "Public Company Accounting Oversight Board Considers Mandatory Audit Firm Rotation.")
d. Proxy "plumbing." In mid-2010, the SEC issued a concept release aimed at reviewing the infrastructure, or "plumbing," of the U.S. proxy voting system, including issues relating to the accuracy, transparency and efficiency of the proxy voting and distribution process, shareholder communications and participation, and the relationship between voting power and economic interest. The SEC has indicated that it will turn to this area after completing its Dodd-Frank responsibilities, and that it will start with the proxy advisory firms, focusing on conflicts of interest involving these firms and concerns about the accuracy of information used to develop voting recommendations. Companies and their boards should keep an eye out for the SEC’s proposals and considering submitting comments to the SEC.
Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these issues. To learn more about the firm’s Securities Regulation and Corporate Governance Practice, please contact the Gibson Dunn lawyer with whom you work, or any of the following:
John F. Olson – Washington, D.C. (202-955-8522, firstname.lastname@example.org)
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Ronald O. Mueller – Washington, D.C. (202-955-8671, firstname.lastname@example.org)
Amy L. Goodman – Washington, D.C. (202-955-8653, email@example.com)
James J. Moloney - Orange County, CA (949-451-4343, firstname.lastname@example.org)
Elizabeth Ising – Washington, D.C. (202-955-8287, email@example.com)
Gillian McPhee – Washington, D.C. (202-955-8201, firstname.lastname@example.org)
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