By Stephen M. Honig
The Securities and Exchange Commission has taken action to move forward its agenda, outlined in our May 2009 column, to ratchet up control of public boards.
Recent SEC proposals require proxy disclosure of the relationship between compensation and risk, the role of compensation consultants, and board experience and its relationship to risk. Other proposals would speed up disclosure of shareholder meeting results and make technical changes to the manner in which equity grants are valued.
The most comprehensive proposals involve proxy disclosure, beginning with the 2010 season. It seems likely that these SEC proposals, although open for public comment until mid-September, will be adopted substantially as written.
Compensation proposals
These proposals require that the Compensation Discussion and Analysis ("CDA") cover compensation programs for any employees (at present, the CDA addresses only named executives) who create incentives that materially affect company risk. Detailed disclosure requirements focus on high-risk business units, most profitable business units, business units that provide a significant percentage of revenues, and compensation programs that are significantly different from overall company approaches.
If disclosure is required, discussion must cover: philosophy of compensating high-risk employees; risk assessment (if any) applied to designing the program; claw-backs and equity holding periods before compensation becomes "final"; and how compensation policies are or have been adjusted to address changes in company risk.
We might even expect an additional disclosure requirement in the final version, given recent studies indicating that companies select larger "peers" for comp comparisons, thus inflating pay scales. Compensation committees and counsel presently should begin gathering information and structuring substantive discussion so that the 2010 proxy disclosures can be responsive to these requirements.
Another proposal concerns valuing equity awards in disclosure tables. Reversing current practice, the SEC proposes fair value on date of grant (rather than annual valuation).
In the current economy, a decline in securities value between grant date and year-end reduces reported value of equity compensation, not fairly reflecting what the board intended.
The SEC also seeks comment on whether valuation of equity awards should be disclosed for the year in which the awards are earned, not year of grant (as currently required); this question thrusts counter to the SEC's preference for grant date valuation.
It is unclear what level of comment will be elicited from the Bar on these proposals; the recent SEC proposals for shareholder access to the company proxy mechanism (see our article in the July issue) resulted in massive protest from major national securities law firms (as well as the NACD) - although those proxy access rules are far more volatile than the proposed disclosure provisions.
Role of consultants
Suspicion that executive compensation consultants skew results in exchange for consulting fees in other areas, statistically verified by at least one empirical study, led the SEC to propose disclosure concerning consultants. Proposed rules require disclosure of other consulting services, discussions of relative fees for compensation as opposed to other services, and disclosure of the roles of management, board and the compensation committee in approving non-compensation services. (Separately, legislation submitted to Congress on July 16, 2009, would direct the SEC to create new standards of independence for comp advisors, including consultants and attorneys.)
Board governance
The SEC proposals also require proxy disclosure of the rationale for current leadership structure; whether the positions of CEO and board chair have been combined; whether there is a lead independent director, and his role; the board's role in managing risks; and whether persons charged with risk assessment report to the board or a committee.
A proposed amendment to Item 404 of Regulation SK and Item 7 of Schedule 14A also would require proxy disclosure of why the company believes that it has the best structure for management at time of filing.
Such requirement assumes that conclusion and may force boards to assert that management structures presently represent best practices. Alternatively, boards may have to disclose that current management is, in fact, not optimally structured.
Proposed rules would expand proxy disclosure for incumbent and nominee directors to include specific experience relating individual skills to specific company and board needs; and any public directorships held during the prior five years (currently, only present directorships need be disclosed); and involvement in material legal proceedings during the past 10 years (currently, five).
Counsel should plan to review director and officer questionnaires to elicit this expanded information for the next proxy season, and it is possible that the requirement of explaining specific relevant experience will also drive nominating committees to consider whether director skill-sets actually do meet governance needs.
The SEC also seeks comments on important compensation-related issues: should compensation expertise of compensation committee members be required?; should disclosure address the ratio of executive compensation to rank and file compensation?; should the numerical value of executive tax gross-ups be required?; what should be said about holding equity compensation until retirement, or claw-backs, in face of subsequent poor performance?
A recent survey conducted by the New England Chapter of the National Association of Corporate Directors revealed that while directors ranked risk management as either the highest or one of the highest priorities, there was a split concerning specific regulatory control. This split reflects the view that once business identifies an issue, business will take care of it; it is not the role of government to specify the manner in which business proceeds.
Finally, proposed amendments to the '34 Act would require shareholder vote results to be filed on Form 8-K with the Commission within four business days following any meeting, altering the current disclosure scheme which relies on Forms 10-Q or 10-K. As SEC Commissioner Elisse Walter stated, there is no reason for shareholders to wait as long as a few months to find out voting results within their own company.
TARP compensation
The SEC proposes new Rule 14a-20 under the '34 Act to require that TARP recipients provide a separate shareholder vote on executive compensation for proxies solicited while TARP obligations remain outstanding.
The NACD Survey reveals that, with respect to TARP recipient companies, the appetite for specific governmental involvement is much greater; 88 percent said the government should have input into executive compensation for companies holding bailout money, and 40 percent believe that the government should have actual control.
The SEC's TARP proposals will be considered under the shadow of the pending review by Obama's "pay czar," Kenneth Feinberg, of the executive pay packages for the "seven companies that are on government life support"; it is expected that Feinberg will use his power to reject pay arrangements as leverage to negotiate reductions in at least some instances.
Discretionary director voting
In a move long presaged, the SEC in late July approved a New York Stock Exchange proposal prohibiting broker/dealers from voting street name shares in uncontested director elections for meetings held on or after Jan. 1, 2010. Because the proposal addresses NYSE member brokerage firms, rather than NYSE-listed companies, new Rule 452 will reach virtually all NYSE, NASDAQ and AMEX companies except for mutual funds.
The potential effect of this provision is not fully understood. Companies with a high percentage of shares held by "retail customers" have difficulty obtaining shareholder action. With the growth of electronic proxy delivery, retail voting may further decline.
The trend requiring an absolute majority of all shares to elect directors will make the loss of broker discretionary votes more critical. We might expect an increase in "vote no" campaigns because it will be harder for directors to gain reelection without brokerage firm votes.
It has also been proposed, in a perceptive comment by the Altman Group, that institutional shareholders, hedge funds and proxy advisory firms may have greater influence on director elections, as companies must depend on their votes.
A sharpening debate
The SEC is tightening the noose around directorship. While increased regulation is understandable and was subject to prior policy discussions, the question remains as to whether increased regulation will either improve directorship performance or pave the way for greater director liability. Certainly with more specific hoops to jump through, there are more chances for foot fault.
This debate is likely to be sharpened by recent developments. As July ended, New York Attorney General Andrew Cuomo announced stunning survey results of Wall Street compensation. In 2008, 738 people at Citigroup, for example, were receiving bonuses equal to or in excess of $1 million, while the bank posted a $27.7 billion loss. Nine major banks, recipients of over $165 billion of TARP money, paid executive bonuses at a higher rate than in the past.
Shareholder advocate Lucian Bebchuk, director of Harvard's Corporate Governance Program, speculated in the Wall Street Journal on-line that if 2009 compensation continued at the same pace as in the first six months, TARP recipient banks would pay bonuses aggregating $156 billion, almost equal to all TARP investments.
Finally, in August, Bank of America consented to a $33 million fine for misleading investors as to its intentions to permit bonuses to Merrill Lynch executives of up to $5.8 billion, prior to closing BOA's bailout acquisition of that troubled securities firm.
Federal Judge Jed Rakoff, as of this column's deadline, has refused to approve the settlement, implying it is too paltry; counsel will draw little comfort from the bank's answer to the court, which avers that the law firms were in charge of the "details" and that the bank itself was blameless.
Perhaps prodded by such disclosures, just prior to its July adjournment, the House of Representatives passed legislation requiring financial firms with over $1 billion of assets to provide more comp disclosure, and requiring all public companies to hold shareholder advisory votes on executive compensation (although the legislation, which will be considered by the Senate in September, likely would not affect the 2010 spring proxy season). Further, the call for substantive regulation of pay, at least in the financial sector, may prove irresistible, given governmental interest in the soundness of the financial infrastructure.
Finally, the trickle-down impact of ever-tightening regulation on larger, privately held enterprises and on non-profits, while to some degree inevitable, remains to be measured; the specific nature of the proposed disclosures and practices are crafted for public enterprises, and the degree to which the distillate from these proposals actually will affect other entities is not clear.
Stephen M. Honig is a partner in Duane Morris' corporate department in the firm's Boston office. You can reach him at smhonig@duanemorris.com.
September 2009 / NEIH
