Key Year-End Considerations for Public Companies

November 2, 2012

With the arrival of fall, calendar-year companies are gearing up for what promises to be another busy proxy season, preparing for new rules that will impact their disclosures and governance practices, and planning their 2013 board and committee calendars.  To assist public companies in these endeavors, we discuss below ten key items for corporate secretaries and in-house counsel to consider.

1.   Assess whether the work of compensation consultants creates conflicts of interest.

SEC rules requiring disclosure about compensation consultant conflicts of interest will apply beginning with the 2013 proxy season.  Specifically, new Item 407(e)(3)(iv) of Regulation S-K will require companies to provide proxy disclosure about any conflicts of interest raised by the work of compensation consultants involved in “determining or recommending” executive or director compensation.

While we expect disclosures of conflicts of interest to be fairly rare, companies will need to conduct an assessment to determine whether any conflicts exist, taking into account the six factors in SEC Rule 10C-1(b)(4).  This assessment necessarily will involve participation by the company’s compensation consultants, since much of the relevant information will be in their possession, and the assessment will need to be complete before companies finalize their 2013 proxy statements.  In addition, it is important to note that the SEC disclosure requirement extends to compensation consultants retained by the compensation committee or management, and to consultants advising on director compensation as well as executive compensation consultants.  Accordingly, companies that use separate consultants to advise on director compensation will need to conduct a conflicts assessment for these consultants as well.

Companies should check with their compensation consultants to see what conflicts analyses the consultants have done.  In addition, companies should update their D&O questionnaires in order to collect information about any business and personal relationships with compensation consultants.  Companies should collect this information from all directors, not just those serving on the compensation committee, and from all executive officers.  Finally, companies should be mindful that, at some point in 2013, stock exchange rules on the independence of executive compensation advisors will take effect.  These rules will apply not only to compensation consultants, but also to other types of advisors to the compensation committee, such as outside legal counsel.  In addition, there are interpretive questions about the scope of the exchange rules.  However, the SEC disclosure requirement and the stock exchange rules will require an assessment of the same six factors.  Accordingly, companies may wish to update their D&O questionnaires now to begin collecting information about any other compensation advisors likely to be covered by the final stock exchange rules.  For more information, see our client alert, “NYSE and NASDAQ Stock Exchanges Propose Compensation Committee and Compensation Adviser Independence Rules.”

2.   Determine whether the company is subject to the SEC’s conflict minerals rules and, if so, begin steps to comply with these rules.

Under Section 1502 of the Dodd-Frank Act, SEC rules now require companies to provide disclosures about so-called “conflict minerals,” which include specified minerals that originate in the Democratic Republic of the Congo or adjoining countries and are thought to be financing violence and human rights abuses in these countries.  The term “conflict minerals” means gold and three minerals collectively known as the “3Ts”–tantalum, tin and tungsten.

Not all companies will have to provide disclosure under the conflict minerals rules.  However, under a three-step process that the SEC has established, all Exchange Act reporting companies must make a determination about whether they are subject to the rules.  To do this, companies must evaluate whether conflict minerals are “necessary to the functionality or production of a product” that they manufacture or have “contracted to manufacture.”  Although the SEC rules do not define these terms, the adopting release provides some interpretive guidance.

For companies that determine, based on this evaluation, that they are not subject to the conflict minerals rules, no further action is necessary.  Other companies must proceed to the next steps, which involve a “reasonable country of origin inquiry” about any conflict minerals (step two) and, for companies that know or have reason to believe their conflict minerals originated in the Congo or adjoining countries, supply chain due diligence and an audit (step three).  Companies conducting the step two and three analyses must file certain disclosures with the SEC on a new Form SD.  Form SD is due on a calendar year basis; the first form is due no later than May 31, 2014 and must include conflict minerals information for the calendar year beginning January 1, 2013.

A group of business organizations recently filed a legal challenge to the conflict minerals rules.  If the rules are stayed pending resolution of the challenge, this could delay the first filing deadline, but in the meantime, companies should move forward with their compliance efforts.  In this regard, companies should do the initial assessment of whether they are subject to the conflict minerals rules as soon as possible.  Due to the complexity of the analysis and the extensive compliance efforts that will be required, companies that are subject to the rules should move forward with the remaining steps promptly, and they should be alert for additional guidance between now and the due date of the first Form SD.  For more information, see our client alert, “Conflict Minerals: Understanding the SEC’s Final Rules.”

3.   Determine whether the company will rely on the new “end-user exception” for swaps and, if so, obtain appropriate board-level approval.

If the company uses swaps to manage risk, it may have plans to rely on the so-called “end-user exception” from the Dodd-Frank Act and new CFTC (Commodity Futures Trading Commission) requirements that swap counterparties clear certain swaps at a clearing house and execute them on a facility or exchange.  New CFTC rules implement an end-user exception to these requirements for counterparties that are not financial entities, that are using swaps to hedge or mitigate commercial risk, and that report in accordance with CFTC rules on their decision to use the end-user exception and how they generally meet their financial obligations associated with entering into uncleared swaps.

For public companies that plan to rely on the end-user exception, CFTC rules require that the board (or an appropriate committee of the board) review and approve the decision to enter into swaps that are exempt from clearing and execution requirements.  This approval can be done on a swap-by-swap basis or on a general basis, and if it is done generally, the approval must occur at least annually.  The CFTC also has indicated that it expects the board (or committee) to set appropriate policies on the use of swaps subject to the end-user exception and that the board/committee should review these policies at least annually, or more often if there is a significant change in the policies.  We believe that the board (or committee) could comply with this requirement by reviewing and discussing with management policies that management develops on the use of swaps, and that this review and discussion could occur as part of the process of approving the decision to enter into swaps that are exempt from the clearing and execution requirements.

Corporate secretaries and other staff that support the board will need to confirm whether their companies will rely on the end-user exception and, if so, discuss with the board how it will oversee this area and grant the required approvals (whether at the full board level or through a committee, such as audit or finance).  If a committee will be involved, the board will need to delegate responsibility to that committee, and it would be appropriate to reflect this responsibility in the committee’s charter.  Prior to or in connection with the first approval, the board or responsible committee should receive a briefing on the end-user exception and company policies on the use of swaps.  Companies that intend to rely on the end-user exception will need to report this in accordance with CFTC rules before CFTC’ requirements for end-users to clear swaps begin taking effect, which is expected in early third quarter of 2013.  Because the information reportable under the CFTC rules must include the board (or committee) approval, that approval will need to be in place in the first or second quarter of 2013.

For more information, see our client alert, “Impact and Analysis of the CFTC’s Final Rule Relating to the End-User Exception to the Clearing Requirement for Swaps.”

4.   Prepare for the PCAOB’s new standard on auditor-audit committee communications.

The PCAOB approved new Auditing Standard No. 16, Communications with Audit Committees, on August 15, 2012.  Although AS 16 is subject to SEC approval, once approved, it is scheduled to be effective for audits of fiscal years beginning on or after December 15, 2012.  Assuming SEC approval, this means that, for calendar year companies, AS 16 will apply to the engagement of the outside auditor for the 2013 audit, and to the outside auditor’s reviews of the financial statements beginning with the first quarter of 2013.

AS 16 applies to audit firms, not companies, and it retains or incorporates many existing requirements relating to communications with audit committees.  However, AS 16 will impact the engagement process and it will affect the communications that audit committees and management receive from the outside auditor in the coming months because it will require some important new communications.  Among other things, AS 16 requires the outside auditor to establish an understanding of the terms of the audit engagement with the audit committee (rather than management), to record these terms in an engagement letter and to provide the engagement letter to the audit committee annually.  If the audit committee or its chair does not sign the audit engagement letter, the outside auditor will need to assure itself that the audit committee has nevertheless acknowledged and agreed to the terms of the engagement.  In addition, the outside auditor must communicate to the audit committee an overview of the audit strategy, including the timing of the audit and significant risks identified during the outside auditor’s risk assessment procedures.  The outside auditor also must communicate numerous matters related to the results of the audit, including information about critical accounting policies and critical accounting estimates, and must make inquiries of the audit committee to assess whether the audit committee is aware of matters relevant to the audit.

In anticipation of AS 16 taking effect, audit committees should discuss with the outside auditor the anticipated timing of the communications required under AS 16 and consider whether changes to meeting agendas will be necessary to accommodate these communications.  Committees also should consider whether updates to their charters and annual calendars are appropriate in order to reflect the new communications.  For more information, see our client alert, “PCAOB Adopts New Audit Standard on Communications with Audit Committees.”

5.   Be aware of the continued shareholder focus on hedging, pledging and clawback policies, and consider whether to adopt or update policies in light of this focus.

Policies restricting hedging and pledging of company stock continue to be a focal point for shareholders in light of recent publicity over these practices at some companies and provisions in Dodd-Frank.  Among other things, some shareholders view the practices as troubling because they may undermine the alignment of officer/director interests with shareholder interests that is otherwise thought to arise from owning company stock.  Hedging also can neutralize the incentive aspects of executives’ equity compensation by mitigating or eliminating potential downside risk.  Likewise, with the ongoing spotlight on executive compensation, shareholders now view clawback policies as an accepted part of a well-structured executive compensation program.

Dodd-Frank requires the SEC to adopt rules requiring public companies to provide proxy disclosure about whether they permit employees and directors to engage in hedging, and to adopt and disclose clawback policies.  However, the SEC has yet to propose rules in either area and the statute does not include deadlines for doing so.  Although the passage of Dodd-Frank and the expectation of SEC action shifted investor focus away from this issue for a period of time, with the continued delays in the SEC’s Dodd-Frank rulemaking agenda, we expect investor focus to return to company policies on hedging, pledging and clawbacks.

Many companies already have policies that address the hedging and pledging of company stock (for example, in their insider trading policies).  However, many companies do not publicly disclose their policies because current SEC rules require disclosure only to the extent these policies are material to an understanding of NEO (named executive officer) compensation.  With respect to pledges, SEC rules require disclosure in the beneficial ownership table about pledges by directors, director nominees, and NEOs on a person-by-person basis, and by directors and executive officers as a group.  The major proxy advisory firms view pledges negatively in evaluating executive compensation practices.  As part of its proposed voting policy updates for 2013 (discussed in item 10 below), ISS would add pledges of company stock to the list of its most “problematic” pay practices and has requested comment on how pledges should impact voting recommendations for say-on-pay proposals and director elections.

In light of these considerations, companies should evaluate their policies and consider modifying them to prohibit hedging and pledging by executive officers and directors, or adopting a policy to this effect if they do not already have one.  In addition, companies should disclose their policies in the proxy statement (or elsewhere) so shareholders and proxy advisory firms are aware of them.

With respect to clawbacks, some companies had held off on adopting policies pending the adoption of SEC rules on this subject.  Given that these rules are not imminent, companies without clawback policies should consider adopting a policy in the near term, recognizing that modifications may be necessary once the SEC takes action.  In addition, companies should disclose their policies in their proxy statements.

6.   Be mindful of the continued focus on disclosure about cyber risks.

In recent years, well-publicized incidents of data theft and other cyber breaches have highlighted the cyber security risks that are an inherent part of doing business in today’s digital age.  In September, after unsuccessful efforts to pass legislation imposing heightened cyber security standards at the national level, U.S. Senator Jay Rockefeller sent letters to the CEOs of all Fortune 500 companies requesting information on how these companies are addressing cyber security.

In the absence of further legislative or regulatory action in this area, the SEC staff’s October 2011 guidance on cyber security disclosures continues to apply.  (See CF Disclosure Guidance: Topic No. 2.)  The Disclosure Guidance is intended to assist public companies in assessing what disclosures about cyber security risks and incidents may be necessary under existing SEC rules.  Companies should periodically revisit this guidance in evaluating the need for disclosure, and they should be aware that the SEC staff continues to look closely at disclosures in this area, in some instances questioning companies about their rationales for not disclosing cyber breaches.  In this regard, the SEC staff has issued comments to companies that have experienced well-publicized cyber breaches, questioning risk factor disclosure that only addresses in hypothetical terms the risk that a breach could occur.

As companies work on the 2012 Form 10-K, they should review their existing processes for assessing the materiality of cyber security matters and determine what (if any) disclosures to include on this subject.  Companies should compare disclosures made by other companies in the same industry as part of this process.  Outside of the periodic reporting cycle, it is important that companies prepare for the possibility of a cyber incident, and the related need to consider what disclosures may be necessary, including a Form 8-K.  For more information, see our client alert, “SEC Issues Interpretive Guidance on Cybersecurity Disclosures Under U.S. Securities Laws.”

7.   Consider using a new approach to the board evaluation process.

Companies should consider whether their boards would benefit from changing the format of the next annual board evaluation.  Written questionnaires are the most common form of evaluation, but these can become a “check the box” exercise after several years of successive use, even if the questions undergo an annual update.  As a general matter, it is good practice to change the format of the evaluation process every few years in order to keep it fresh.  Recent experience suggests there has been an uptick in the number of boards using an interview format for evaluations, and that boards are finding this approach very constructive.  Directors are likely to feel more comfortable providing candid feedback to an outside party.  Accordingly, in many cases, an outside facilitator (such as a lawyer or consultant) conducts the interviews, summarizes the feedback and reports it to the board.  Where a company is engaged in or threatened with litigation relating to potential claims against directors, consideration should be given to having interviews conducted on a privileged basis by counsel as part of their legal advice to the board.  Because interviews can be more time-consuming than other evaluation approaches, some boards use an interview format every few years, as an alternative to their regular approach.

Regardless of how a board conducts its evaluations, the board should use the evaluation process to assess key aspects of its operations, such as the board’s leadership structure and composition, adequacy of communications and committee structure.  In addition, it is important to address any issues that surface during the evaluation in order to maximize board effectiveness.

8.   Carefully consider and provide support for any changes to director compensation.

The June 2012 Delaware Chancery Court decision in Seinfeld v. Slager suggests that boards and committees should take additional care in reviewing and approving changes to director compensation.  In Seinfeld, the court refused to dismiss a claim that directors had breached their fiduciary duties and wasted corporate assets by awarding themselves grants under an equity plan.  The plan gave the board “sole and absolute discretion” to determine the amounts, terms and conditions of awards under the plan, subject to typical limits on the aggregate number of shares available for grant and the size of annual awards to individuals.  The court also held that the heightened, “entire fairness” standard of review–and not the business judgment rule–applied to the claim because the equity plan, although shareholder-approved, did not impose sufficient limits on the total pay that could be awarded to directors under the plan.

Seinfeld involved a very specific fact pattern.  However, the case reaffirms that director compensation decisions, like other interested transactions, are likely to receive heightened judicial scrutiny.  In light of this, boards considering changes to director compensation should conduct appropriate diligence, including reviewing benchmarking data.  Boards should be comfortable that there is sufficient support for changes in director compensation, and the minutes should reflect the rationale for these changes.

9.   Evaluate the need for disclosures about company activities involving Iran.

On October 9, President Obama issued an executive order implementing certain provisions of the Iran Threat Reduction and Syria Human Rights Act.  The statute greatly expands the scope of Iran sanctions and was signed into law in August.  Among its most important provisions, the statute places tighter restrictions on U.S. companies that indirectly transact business with Iran through foreign subsidiaries.

Additionally, the statute imposes disclosure obligations on public companies that knowingly violate Iran sanctions.  Specifically, if a company or any of its “affiliates” knowingly engaged in a sanctionable transaction involving: (a) blocked persons (for example, terrorist organizations or the government of Iran); (b) the proliferation of weapons of mass destruction; (c) substantial investment in the Iranian petroleum industry; or (d) the transfer of weapons, technology, or other goods/services that are likely to be used for human rights abuses against the Iranian people, then the company must provide disclosure about this violation in its quarterly and annual reports filed with the SEC.  The statute does not define the term “affiliate.”  The company must file a separate notice of the disclosure for publication on the SEC’s website, which triggers SEC reporting to the President and ultimately a determination by the President about whether to impose sanctions on the company.  No SEC rulemaking is necessary to implement these provisions, although the SEC does have the authority to clarify the reporting obligations through rulemaking.  Accordingly, companies must comply with the disclosure requirements for Forms 10-K and 10-Q due on or after February 6, 2013.

This deadline is approaching fast, so companies should review their activities, and the activities of their affiliates worldwide, to determine whether there has been any conduct that may be subject to disclosure.  Companies also should review their disclosure controls and procedures and consider whether modifications are appropriate to facilitate the collection of information about potentially disclosable conduct going forward.  From a compliance perspective, the expanded prohibitions under the Iran Threat Reduction and Syria Human Rights Act place companies at risk of inadvertently engaging in activities involving Iran that are now illegal under the statute.  In light of this, companies should review the activities of their foreign affiliates, as well as their compliance programs, and consider appropriate changes in order to promote compliance with the law and avoid the possibility of problematic disclosures.  For more information, see our client alert, “New Iran Sanctions Legislation: Tighter Restrictions on Indirect Dealings and Enhanced Reporting Obligations.”

10.   Assess the impact of voting policy updates from the major proxy advisory firms.

The major proxy advisory firms update their proxy voting policies annually, with ISS typically releasing its updates in late November, followed by Glass Lewis.  On October 15, ISS issued drafts of key 2013 policy updates for public comment and the comment period will remain open until November 9.  According to ISS’s annual policy survey results, which the firm released in early October, executive compensation remains the most important area of focus for both investors and companies.

While Glass Lewis announced changes to its pay-for-performance model for evaluating say-on-pay proposals back in July, including changes to its peer group selection methodology, ISS also is considering changes to its pay-for-performance analysis for 2013.  As part of its 2013 policy updates, ISS has proposed: (a) changing its peer group selection methodology to include peers from the same GICS groups represented in companies’ own peer groups, as disclosed in the proxy statement; and (b) considering realizable pay for large-cap companies as part of its qualitative review of pay-for-performance, which is the second layer of review that ISS conducts for companies where the first-step, quantitative analysis demonstrates “significant unsatisfactory long-term pay-for-performance alignment.”

Additionally, in response to “an evolved market view of board responsiveness to majority-supported shareholder proposals,” ISS has proposed revising its policy in this area, so that ISS would recommend votes “against” or “withhold” votes on all incumbent directors if the board failed to act on a shareholder proposal that received support from a majority of votes cast at the prior year’s annual meeting.  Currently, ISS issues negative voting recommendations if the board failed to act on a proposal that received a majority of shares outstanding the prior year, or a majority of the votes cast both in the prior year and in one of the two years before that.  Finally, we understand that ISS is considering recommending “against” or “withhold” votes on a director at all companies where the director serves on the board if the director had an attendance problem at any of these companies.  Currently, ISS issues a negative voting recommendation only at the company where the director’s attendance at board and applicable committee meetings fell below 75% without an “acceptable reason.”

With the possibility of an increased ISS focus on director attendance, companies may wish to monitor attendance as the year-end approaches.  Once final 2013 voting policies are available, companies should assess their executive compensation and governance practices in light of any updates in order to evaluate how the updates will impact them and to identify any practices that may be viewed as problematic.  In evaluating policy updates for 2013, companies also should look at their shareholder bases and how closely their shareholders follow the recommendations of the proxy advisory firms.  For more information, see our client alert, “ISS Releases Draft 2013 Proxy Voting Policies.”

Gibson Dunn’s Securities Regulation and Corporate Governance Monitor blog is available at  We encourage you to sign up at the Monitor website to receive email alerts when we post information on developments and trends in securities regulation, corporate governance and executive compensation.

Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these issues.  Please contact the Gibson Dunn lawyer with whom you work, or any of the following:

John F. Olson – Washington, D.C. (202-955-8522, [email protected])
Brian J. Lane – Washington, D.C. (202-887-3646, [email protected])
Ronald O. Mueller – Washington, D.C. (202-955-8671, [email protected])
Amy L. Goodman – Washington, D.C.  (202-955-8653, [email protected])
James J. Moloney – Orange County (949-451-4343, [email protected])
Elizabeth Ising – Washington, D.C. (202-955-8287, [email protected])
Stephen W. Fackler – Palo Alto and New York (650-849-5385 and 212-351-2392, [email protected])
Michael J. Collins – Washington, D.C. (202-887-3551, [email protected])
Sean C. Feller – Los Angeles (213-229-7579, [email protected])
Gillian McPhee – Washington, D.C. (202-955-8201, [email protected])

© 2012 Gibson, Dunn & Crutcher LLP

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