February 6, 2015
With preparations for the 2015 proxy season in full swing at U.S. public companies, many of the issues that have been "hot topics" in prior years–such as executive compensation and risk oversight–continue to be front and center for boards of directors. However, events over the last year highlight the importance of boards being both proactive and prepared–anticipating how trends and developments may impact a company and planning accordingly. This can be challenging as the array of matters that warrant board-level attention continues to expand and directors continue to be called upon to devote more time to their duties. Nevertheless, part of being an effective board of directors is prioritizing those matters on which the board should focus its time and resources. To help boards remain attuned to the most relevant issues in 2015, below we discuss some key areas that will merit board consideration in the coming months.
1. Board refreshment, tenure and diversity; board evaluations.
In the last several years, there has been a greater focus on board composition; specifically, on whether a company has the "right" directors that reflect the appropriate mix of skills, experience and attributes for the company now and in the coming years. In the last 12 months, director tenure and "refreshing" the composition of boards have emerged as significant corporate governance issues. With director retirement ages on the rise and director turnover slowing, institutional investors and commentators are expressing more interest in director tenure and its impact on board refreshment and diversity.
Director tenure and boardroom diversity
Some institutional investors have expressed concern that long-term board service may adversely impact director independence and engagement, and that it hinders greater boardroom diversity. Under American governance standards, nothing precludes a director from being independent due to length of service on a board. By contrast, in the United Kingdom, a presumption now exists that directors who have served for more than nine years are not independent, although under the U.K.’s "comply or explain" regime, companies can explain why those directors are considered independent.
Recently, some U.S. institutional investors have begun integrating tenure considerations into their director voting policies. In May 2014, for the first time among mainstream investors, State Street Global Advisors adopted a voting policy under which a preponderance of "long-tenured" directors at a company may trigger a vote against those directors. Similarly, both the Council of Institutional Investors (CII) and the California Public Employees’ Retirement System (CalPERS) have revised their corporate governance policies to include director tenure among the factors that should be considered in assessing a director’s independence. Institutional Shareholder Services (ISS) has solicited comment on whether it should revise its voting policy on director elections to take into account director tenure, although it did not do so for 2015. And ISS’s corporate governance rating product, ISS Governance QuickScore 3.0 (QuickScore), now considers a tenure of more than nine years as potentially compromising a director’s independence.
Ongoing efforts to increase diversity in the boardroom have led a number of countries (including Norway, France and Germany) to adopt quotas or voluntary targets to increase the representation of women on boards. In a September 2014 speech on gender diversity in the boardroom, Securities and Exchange Commission (SEC) Chair Mary Jo White encouraged shareholders and other stakeholders to make companies aware that diversity "is an issue that is important, that they want more information on what is being done to promote diversity, and, if not enough is being done, what actions they expect to be taken."
Considerations for nominating/governance committees
Nominating/governance committees can be proactive on board composition issues by engaging in regular succession planning at the board level: evaluating the composition of the board annually, looking at the skills and experience represented on the board and identifying additional attributes that would be helpful, considering retirements that are on the horizon, and doing targeted recruiting to identify new director candidates. To the extent traditional notions of diversity have not received high priority, consideration should be given to incorporating them into the succession planning process in a more meaningful way. Nominating/governance committees have a host of tools at their disposal to assist with these endeavors, including use of a skills matrix for mapping current experience represented on the board and pinpointing areas where deeper expertise may be appropriate; search firms; engagement with larger shareholders to understand whether they have concerns about tenure, diversity or other aspects of the board’s composition; and evaluations of both the full board and individual directors.
In addition to new directors, the succession planning process should include planning for transitions in key roles on the board. While boards planning for a CEO transition should be thinking about how this will impact the board’s leadership, a regular review of the board’s leadership structure allows the board to assess whether that structure remains appropriate and think about which directors could fill the positions of lead director or chairman (if not the CEO). Likewise, succession planning for committee chairs enables the board to identify potential candidates for these important roles.
Disclosures
In light of these developments, boards also can expect some shareholders to seek more disclosure about the board’s approach to director tenure, board refreshment and the board evaluation process. In September 2014, the CII issued a report calling on companies to provide more disclosure about the board evaluation process to show, among other things, "how the board identifies and addresses gaps in its skills and viewpoints." Many companies already are providing more robust proxy disclosure about matters such as director qualifications, diversity (including gender and ethnicity), tenure and the board evaluation process and are revising their corporate governance guidelines to affirmatively address consideration of diversity in the director selection process.
2. Shareholder activism.
Shareholder activism has become the "new normal," as the pace and success of activist efforts have escalated. Today, market capitalization is no longer a deterrent, and even the largest companies may find themselves the subject of activist attention. For example, Gibson Dunn’s Activism Update–2014 Year in Review, which studied activist campaigns during 2014 at 64 U.S.-listed companies with equity market capitalizations of greater than $1 billion, reports that 22% of those campaigns involved companies with market capitalizations of greater than $20 billion. One development that has enhanced the ability of shareholder activists to set their sights on larger companies is a growth in alliances with other parties–both institutional investors, who may partner with activists publicly or support their efforts behind the scenes–and strategic buyers of various sorts. These alliances may include "wolf packs," or activist investors who acquire a company’s stock and support common goals at a company, but attempt to operate without forming a group that otherwise triggers Section 13(d) disclosure requirements under the federal securities laws or takeover defenses such as poison pills.
Areas of activist focus
Activists are increasingly focusing on strategic, financial and operational issues, and their tactics are changing. Common objectives for activists now include spinning off "non-core" businesses or selling a company, pushing for the return of capital through the initiation or increase of dividends or share buybacks, opposing capital allocations that do not create shareholder value, and reducing executive compensation and other corporate costs. While activists once sought board representation as a way of making inroads at companies in order to advance these types of strategic goals, they are now pressing these goals independent of seeking seats on the board. At the same time, activists are now more likely to seek board representation outside the context of shareholder meetings through negotiations that result in the appointment of one or more of their designees to company boards. Although the number of instances when a proxy campaign proceeds through the conclusion of a special or annual meeting is relatively small, activists also are having greater success in proxy contests. In 2014, there was an unprecedented result at the annual meeting of Darden Restaurants, Inc., where hedge fund Starboard Value received sufficient shareholder support to replace the company’s entire board of directors. This followed a lengthy battle over Darden’s strategic plans, including whether to spin off its Red Lobster restaurant chain, which Darden ultimately did over Starboard’s objection.
Considerations in dealing with activists
Many boards are following developments in shareholder activism and working with their senior management teams to see that their companies are prepared should an activist come knocking at the door. Thoughtful preparation includes looking inward by examining the company and anticipating areas–including strategic, operational, financial and governance–where the company could draw criticism. This will allow the company to communicate proactively with the investor community about these areas, and to prepare specific responses to identified vulnerabilities.
Shareholder engagement also is an important component of preparation. Over the past several years, companies increasingly have been communicating with major shareholders on a more regular basis and discussing a growing range of issues. Companies can use these discussions as an opportunity to develop relationships, build support for the incumbent board and management, and articulate an effective message about the company’s strategic and financial goals and management’s plans to achieve them. Additionally, companies should implement procedures to monitor shareholder activity on an ongoing basis and identify any unusual trading activity for potential activist positions.
Finally, companies should undertake regular reviews of their certificates of incorporation and bylaws. Activists will look at these documents for the tools to implement their strategies, such as shareholder-requested special meetings and the written consent process.
3. Oversight of cyber risks.
Risk oversight remains an area of continued focus and ongoing challenge for boards of directors. Nowhere is this more apparent than with cyber risks, which have emerged rapidly as both an enterprise-level threat and a board-level issue, as the frequency and severity of data breaches has continued to grow. In a June 2014 speech, SEC Commissioner Luis Aguilar emphasized that overseeing "the adequacy of a company’s cybersecurity measures needs to be a critical part of a board of director’s risk oversight responsibilities."
Allocation of responsibility
In recent years, there has been a growing recognition among boards that risk is inherent in, and risk management integral to, every aspect of a company’s operations. As a result, many boards are now taking a more holistic approach to risk oversight, in which risk is a regular part of the board’s evaluation of strategy and a host of other matters that come before the board. Perhaps recognizing that risk oversight is a mammoth task, many boards continue to wrestle with how to allocate this responsibility at the board level. According to the 2014-2015 NACD Public Company Governance Survey issued by the National Association of Corporate Directors (NACD), almost one in four public company directors participating in the survey believed that their boards have not assigned risk oversight to the correct body, and 52% believed that primary responsibility for risk oversight should rest with the full board.
Fortunately for boards, effective oversight of cyber risks does not mean that directors are expected to become IT experts. Many of the sound practices that boards use in overseeing other types of risk apply equally to cyber risks, although translating these practices into the cyber arena creates certain challenges due to the complex and technical nature of IT issues, and the sophistication of many cyber attacks. Sound practices start with an appropriate risk oversight structure. While many boards may delegate primary responsibility for oversight of cyber risks to a committee, cyber issues have enterprise-wide ramifications, making engagement at the full board level particularly appropriate as well.
Accordingly, in addition to the responsible committee receiving regular reports on cyber security issues, appropriate time for the topic should be reserved on the full board agenda, at periodic intervals, so the board can consider cyber issues and receive reports from the relevant committee and from senior management responsible for addressing cyber risks. This will allow the board to remain informed about the same types of fundamentals it considers in evaluating other types of risk, such as what the company’s biggest exposures are, what steps management has taken to manage these exposures and how the company’s practices compare against appropriate benchmarks. For cyber risks, these may include industry practices and the NIST (National Institute of Standards and Technology) Framework for Improving Critical Infrastructure Cybersecurity, which has emerged as a primary source of risk management standards. The board also should be comfortable that management has an appropriate response plan that is ready for deployment if a data breach occurs, and the board should understand key elements of the plan, such as how the company would identify the extent of any unauthorized access, what steps the company would take to "close the breach" by restoring security to a level that management deems appropriate given the nature of the breach, and what processes the company has in place to make disclosures about the breach.
Information flow to board
Making sure that directors have the information they need is critical to effective risk oversight and is another component of risk oversight that poses particular challenges when dealing with cyber issues. According to the 2014-2015 NACD Public Company Governance Survey, approximately 52% of directors participating in the survey said they are not satisfied with the quantity of information provided by management on cyber security and IT risks, and 35.5% were not satisfied with the quality of information on these topics. This suggests the need for greater emphasis on providing directors with relevant, high-quality information that is in plain English. Taking the time and effort to distill information so that the content is as accessible as possible will pay dividends by enabling both the board and management to focus on the most important issues. In some cases, additional background may be necessary to facilitate board understanding of IT concepts or specific cyber risks. While management is appropriately the primary resource for this type of information, boards also can consider continuing education on cyber issues, as well as the use of outside experts.
Disclosures
Companies also should be mindful of the importance of communicating what their boards are doing to oversee cyber risk. Investors and the SEC staff are increasingly likely to be looking for disclosures about cyber issues in the Form 10-K and proxy statement. Depending on the company, cyber issues may impact proxy disclosures about board oversight of risk, and disclosures in the Form 10-K relating to the description of business, risk factors, Management’s Discussion & Analysis and legal proceedings. In March 2014, the SEC held a roundtable discussion among public and private sector participants to consider cyber security issues and assess the need for additional SEC guidance on cyber security disclosure. However, in the absence of further legislative or regulatory action, the SEC staff’s existing guidance on cyber security disclosures, issued in 2011, continues to apply.
Liability for oversight failures
Finally, boards should take note that, to date, efforts to hold directors liable for cyber incidents have been unsuccessful. Consumer class action and other lawsuits following a serious data breach have become common, and in 2014, shareholders filed derivative suits against the boards of directors of Target Corporation and Wyndham Worldwide Corporation following highly publicized cyber incidents at these companies, alleging breach of fiduciary duty and oversight failures among other things. In October, the Wyndham suit was dismissed, suggesting that, while not impossible, it will be difficult for plaintiffs to succeed on these types of claims. The Wyndham result is consistent with other cases seeking to impose liability on directors for allegedly failing to perform their oversight responsibilities. As the Delaware Court of Chancery has noted, director liability based on the duty of oversight is "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment."
4. Bylaw provisions addressing shareholder litigation.
Recent cases have focused attention on bylaw provisions aimed at more effectively managing shareholder litigation against public companies as the frequency and cost of this litigation have continued to escalate.
Exclusive forum bylaws
The primary tool to emerge in seeking to manage shareholder litigation is the exclusive forum bylaw, which specifies a single forum (such as the Delaware courts) for certain types of shareholder litigation against a company and its directors and executives, such as derivative suits and claims involving breach of fiduciary duty. Exclusive forum bylaws are designed to limit a company’s exposure to multiple similar claims in different courts and prevent forum shopping by plaintiffs’ attorneys. In June 2013, the Delaware Court of Chancery upheld the validity of two companies’ exclusive forum bylaws. To date, courts outside of Delaware have respected these provisions, although a significant number of courts have not yet ruled on them.
At most companies with exclusive forum provisions, the board has added them to the bylaws without seeking shareholder approval, pursuant to its authority to amend the bylaws under state law. A variety of factors will bear on decisions about whether to adopt an exclusive forum bylaw. These include questions about potential enforceability, and company-specific factors such as a company’s historical and projected exposure to the types of litigation covered by exclusive forum bylaws, the company’s jurisdiction of incorporation and other likely venues for such litigation, and the views of its major shareholders. Boards should weigh these factors carefully in deciding whether to adopt exclusive forum provisions.
For many companies and their boards, the positions of the major proxy advisory firms also are a factor. We understand that at this time ISS is not likely to recommend votes "against" individual directors solely because the board has approved an exclusive forum provision without seeking shareholder approval. For 2015, Glass Lewis is maintaining its existing policy of recommending votes "against" the nominating/governance committee chair when the board adopted an exclusive forum bylaw without shareholder approval during the last year.
Fee-shifting bylaws
Another tool for deterring shareholder litigation that has received attention, but proven more controversial, is a fee-shifting bylaw, which seeks to shift the legal fees associated with certain types of shareholder litigation to the plaintiff-shareholder if the shareholder’s lawsuit is unsuccessful. In contrast to exclusive forum bylaws, which regulate where (but not whether) shareholders may bring suit, fee-shifting bylaws are viewed as a more substantive (and potentially more problematic) limitation on shareholders’ ability to seek legal remedies. After a June 2014 decision by the Supreme Court of Delaware holding that a corporation’s board could adopt fee-shifting bylaws without shareholder approval, the Delaware legislature was poised to amend the state’s corporate law to prohibit them, but deferred action to study the measure further. The Delaware legislature is nonetheless expected to consider the issue again in 2015, but it is unclear what form any legislation will take, and if and when it will be enacted.
To date, a small number of public companies have adopted fee-shifting bylaws, but institutional investors and others have raised concerns about their impact on shareholder rights. At a recent conference, a member of the SEC staff cautioned that companies should consider whether fee-shifting bylaws would apply to claims covered by provisions of the federal securities laws. The staff is paying close attention to companies’ disclosures about the adoption of fee-shifting bylaws and any effect that a fee-shifting bylaw may have on shareholders bringing claims under the federal securities laws. Finally, both ISS and Glass Lewis oppose fee-shifting provisions. Under the voting policies of both firms, directors could receive negative voting recommendations if the board approves a fee-shifting bylaw without shareholder approval, and where companies submit fee-shifting provisions to a shareholder vote, ISS and Glass Lewis generally will oppose them.
5. Executive compensation.
Executive compensation continues to remain in the spotlight due to say-on-pay votes, making it an ongoing priority for compensation committees and boards. While say-on-pay results have leveled off at a point that reflects significant support for executive compensation programs, companies know that past favorable votes are no guarantee of future success. Company performance can vary from one year to the next, impacting the link between pay and performance. Accordingly, continued attention to the fundamentals of an appropriate and well-articulated compensation program is vital. These include designing compensation plans that make sense in the context of the company’s particular business strategy, emphasizing pay for performance, engaging regularly with shareholders and preparing effective proxy statement disclosures.
One thing that did not change for the 2014 proxy season was continued strong support for say-on-pay. In 2014, as in 2013, votes in support of say-on-pay proposals among Russell 3000 companies averaged approximately 91%, and approximately 98% of those companies received majority support for their say-on-pay proposals. These numbers held steady in 2014 despite an increase of almost 10% in the number of say-on-pay proposals on the ballot, resulting largely from proposals at companies that had adopted triennial say-on-pay. Pay-for-performance "disconnects" continued to be the primary reason for shareholder opposition to say-on-pay at specific companies. According to ISS, the most common issues involved granting only time-based equity, using "non-rigorous" performance hurdles, lowering performance hurdles from prior years without lowering payouts, awarding "problematic" retention/discretionary awards (particularly during periods of poor financial performance), and benchmarking pay above the median of company peers.
Preparing for 2015
Overall, historic say-on-pay results bode well for companies, but negative voting recommendations from ISS and Glass Lewis continue to have a significant effect on support for say-on-pay proposals. This, together with the potential for year-over-year differences in compensation driven by performance changes, means that each year warrants a fresh look at how a company’s executive compensation practices are likely to fare under the pay-for-performance analyses conducted by ISS and Glass Lewis, as well as other major criteria the firms consider, such as whether a company has "problematic" pay practices. This kind of proactive analysis can help a company anticipate potential issues, target shareholder outreach efforts where appropriate, and develop disclosures that address these issues and are tailored to the company’s shareholders. As companies prepare their executive compensation disclosures, there is a continued focus on using the CD&A as a communications tool to tell the story of the company’s compensation practices. There is also a growing emphasis on making the design and presentation of that story more user-friendly by including more easy-to-follow tools such as supplementary tables, charts and graphs. In January, the SEC staff issued guidance on the use of graphics in proxy statements and other SEC filings, demonstrating an acceptance and accommodation of visual aids as a way of making information more accessible to readers. The types of information that companies opt to depict in visual format may vary from one company to the next, often based on feedback from investors as to what aspects of a company’s compensation programs are unclear; for example, a company may decide to use a chart or graph to address an issue that emerged as focal point for shareholders through the company’s engagement activities.
For 2015, ISS also has adopted a new approach to evaluating equity compensation plans with its new "scorecard" for equity plan proposals for which companies are seeking shareholder approval. Under its prior policy, ISS used a series of "pass/fail" tests to evaluate equity plan proposals, providing more certainty to companies and their boards. The scorecard approach offers a more "nuanced" and holistic evaluation of equity plan proposals and considers over a dozen positive and negative factors related to a plan’s features and a company’s historical grant practices. Accordingly, voting recommendations generally will depend on a balance of the relevant factors, although certain highly "egregious" plan features will continue to result in an automatic negative voting recommendation.
Status of Dodd-Frank rulemaking
The SEC has not yet adopted final rules on the pay ratio disclosures mandated by the Dodd-Frank Act. Adoption is currently projected during 2015. These rules will require public companies to disclose the median annual total compensation of all employees (excluding the CEO), the annual total compensation of the CEO, and the ratio of these two amounts. The proposed rules have been met with over 126,000 comment letters to date, many of which are form letters voicing support. Critics of the proposed rules have expressed concerns regarding the cost of compliance as well as the lack of economic benefit and potentially misleading nature of the required disclosures. Board should ask their advisors to keep them apprised of developments with respect to these rules.
The SEC also has extended its projected action dates for proposing rules under the three other executive compensation-related provisions of the Dodd-Frank Act that require SEC rulemaking. These provisions will require companies to: (a) adopt and disclose clawback policies; (b) provide disclosure about whether companies permit employees and directors to engage in hedging; and (c) provide disclosure about the relationship between compensation "actually paid" to executives and a company’s financial performance. Proposals are expected at some point prior to October 2015.
6. Proxy access and other shareholder proposal issues.
The 2015 proxy season has become the year in which proxy access is a leading topic of discussion due to the proliferation of shareholder proposals asking boards to provide for proxy access. In addition, some of the most popular shareholder proposals in 2014 have reemerged for the 2015 proxy season, including proposals on the three most common topics from 2014: political and lobbying activities, independent board chairs and climate change.
Proxy access proposals
The new hot topic for shareholder proposals in the 2015 proxy season is proxy access, with an estimated 100 proxy access proposals having been submitted so far. While a flurry of proxy access proposals initially was anticipated after the SEC’s proxy access rule was vacated in 2011, it did not materialize and instead proxy access proposals either were directed at companies with governance or performance issues or were advocated by individual shareholders seeking proxy access for groups with small shareholdings. This changed last Fall when the New York City Comptroller Scott Stringer, on behalf of several pension funds, announced that he was submitting proxy access shareholder proposals to 75 companies. The proposal asks the board of each company to adopt and seek shareholder approval of a bylaw giving shareholders the right to include their director nominees in the company’s proxy materials if they have held at least 3% of company stock for at least three years, with the number of nominees not to exceed 25% of the board (the same thresholds in the SEC’s vacated proxy access rule). The proposal is non-binding, so it would not automatically become effective even if it received a majority vote.
The Comptroller identified the 75 targeted companies based on three priority issues: climate change, board diversity and say-on-pay. Notably, company performance was not among the screening criteria. Unlike companies that have received proxy access shareholder proposals in the past, this initiative targets a wider range of companies, including companies that have not faced governance challenges historically. Other companies have received proxy access proposals for their 2015 annual meetings outside of this coordinated effort. In December, the SEC staff concurred that Whole Foods Market, Inc. could exclude a proposal that would grant proxy access to shareholders that have held at least 3% of company stock for three years because the company planned to put its own proposal–with 9%-ownership/five-year thresholds–to a vote at the annual meeting. The exclusion was based on a provision in the SEC’s shareholder proposal rule that permits a company to exclude a proposal from its proxy statement when the company has determined that the topic is appropriate for a shareholder vote but is putting forth a management proposal with different terms for consideration at the same meeting. Following a request for review of the staff’s decision, SEC Chair Mary Jo White directed the staff to review this provision and the staff announced that it would no longer issue no-action letters on this provision–whether they relate to proxy access or other subjects–during the 2015 proxy season.
The staff’s position leaves several options for addressing proxy access proposals, as well as other proposals where companies may wish to submit a proposal with different terms, like those requesting that a certain percentage of shareholders have the ability to request a special meeting. Companies and their boards will need to consider these alternatives carefully. In addition, with the popularity of proxy access proposals, and the expectation that the staff’s review will impact shareholder proposals on a range of topics, companies and their boards will want to monitor developments in both of these areas.
Independent chair proposals
For companies that have received a proposal seeking an independent board chair (or may in the future), ISS has adopted a new voting policy for 2015 that will inform how companies respond to these proposals. The crux of ISS’s policy–that it will generally recommend votes "for" proposals seeking an independent chair–has not changed. However, the new ISS policy includes an expanded set of criteria for evaluating these proposals and reflects a "more holistic" approach to evaluating the criteria. As a result, companies will no longer need to satisfy all of the criteria in the voting policy–which previously included having a designated lead director with duties specified by ISS and not exhibiting "sustained poor total shareholder return (TSR) performance" over one- and three-year periods–in order for ISS to recommend "against" the shareholder proposal. In a set of FAQs on its new policy, ISS also indicated that proposals seeking an independent chair in connection with the next leadership transition may be viewed more favorably than those seeking immediate separation of the chairman/CEO roles.
A senior ISS staff member stated at a conference that one of the goals of the ISS policy change is to move away from a "check the box" response to independent chair proposals and instead allow companies to explain why their existing board leadership structures are appropriate for the company. The ISS policy change will give ISS greater flexibility in evaluating independent chair proposals, but they also will make it more difficult for companies to assess ISS’s likely voting recommendation in advance. Moreover, ISS has stated that it tested the updated policy at companies where independent chair shareholder proposals went to a vote in 2014 and indicated, without further detail, that a higher proportion of these proposals would receive ISS support under the new policy. In light of these considerations, companies should take a methodical approach to evaluating the application of ISS’s voting policy by comparing their circumstances against each of the specific criteria addressed in the voting policy and related FAQs. Then, in preparing their proxy disclosure opposing the proposal, companies should endeavor to address any governance or performance features that ISS may view as problematic and explain why the company believes support for the proposal is not warranted. If ISS issues a negative voting recommendation, outreach to major shareholders may be appropriate. Finally, companies should be mindful of ISS’s existing voting policy on implementation of majority-supported shareholder proposals. ISS will recommend votes against individual directors, committee members or the entire board, as it deems appropriate, if the board fails to respond to a shareholder proposal that received support from a majority of shares cast in the previous year. In its FAQs, ISS explains that a company policy of adopting an independent chair structure on the resignation of the current CEO would be considered responsive. Other, "partial" responses will be considered on a case-by-case basis.
Environmental and social proposals
For 2015, companies also are seeing significant numbers of proposals on environmental and social (E&S) issues, continuing a trend from last year. The 2014 proxy season was a record one for E&S proposals in several ways, with the number of E&S proposals reaching an all-time high and accounting for more than 50% of all shareholder proposals submitted. The number of E&S proposals that received majority support also reached a record level in 2014, as did the number of proposals submitted on climate change.
Proposals directed at board oversight of E&S issues also have become more common in the last several years. Shareholders have submitted proposals seeking the formation of board-level committees responsible for overseeing public policy matters (such as social and political issues), sustainability matters (such as environmental issues) or specific E&S issues such as human rights. According to a 2014 study of S&P 500 companies by the Investor Responsibility Research Center Institute, 277 of S&P 500 companies publicly disclose some form of board oversight of public policy and sustainability issues. Of these companies, 32% assign these responsibilities to a stand-alone public policy/sustainability committee, while 34% assign these responsibilities to the nominating/governance committee.
Litigation
One final shareholder proposal development that companies and their boards should note is that litigation has re-emerged as part of the shareholder proposal landscape and as an additional avenue for both shareholders and companies to challenge shareholder proposals. The 2014 proxy season saw an increase in litigation related to shareholder proposals, primarily by companies seeking declaratory judgments to exclude proposals. However, litigation has also been brought by shareholders, including a lawsuit against Wal-Mart Stores, Inc., which omitted a shareholder proposal from its proxy statement after obtaining a no-action letter from the SEC staff concurring with the exclusion of the proposal on the basis that it involved the company’s ordinary business operations. Not long after the staff granted the no-action request, the shareholder brought suit seeking to enjoin the company from holding its 2014 annual meeting without including the shareholder proposal in its proxy materials.[1] The court denied an initial motion by the shareholder for an injunction and the meeting went forward, but the court subsequently disagreed with the SEC staff and held in December 2014 that the proposal did not deal with ordinary business matters. Although the proposal related to the products that Wal-Mart sells, the court held that it was "best viewed as dealing with matters that are not related to Wal-Mart’s ordinary business operations" because it does not dictate to management, but instead "seeks to have Wal-Mart’s Board oversee the development and effectuation of a Wal-Mart policy." (emphasis in original).
The holding, which is on appeal, raises a number of important issues, including the scope of the "ordinary business" exclusion in the SEC’s shareholder proposal rule and whether simply phrasing a proposal as a request for a board-level policy is sufficient to remove a shareholder proposal from the ordinary business exclusion. The SEC previously had rejected a proposed standard under which shareholder proposals involving matters that require board action would be viewed as not excludable under the ordinary business standard. The Wal-Mart case remains the case-to-watch in this area, and in the wake of this and other developments in the arena of shareholder proposal litigation, we expect that the prospect of litigation will increasingly become part of the calculus for companies and shareholders as they navigate the shareholder proposal process.
7. Developments impacting audit committees.
In 2015, there are a handful of changes that will impact the work of audit committees, as well as some emerging developments to watch as the year unfolds.
PCAOB standards
Most immediately, new Public Company Accounting Oversight Board (PCAOB) auditing standards expand the procedures auditors must perform, and the communications that auditors must make to the audit committee, in several important areas. Under a new PCAOB standard on related party transactions, the outside auditor must make inquiries of the audit committee or its chair about the committee’s understanding of "significant" related party transactions and whether the committee has "concerns" about these transactions. For purposes of the standard, the definition of "related party transaction" comes from the accounting literature (Financial Accounting Standards Board (FASB) Accounting Standards Topic 850) and therefore includes significant intercompany related party transactions as well as transactions disclosable in the proxy statement under SEC rules (Item 404 of SEC Regulation S-K). To evaluate the audit committee’s understanding of these transactions, the outside auditor is likely to ask about the committee’s understanding of the review and approval process for related party transactions, and of how pricing and other terms may be arms-length. If the nominating/governance committee oversees related party transactions covered by SEC rules, inquiries from the outside auditor will need to be coordinated with the nominating/governance committee or its chair.
As a result of other changes to PCAOB standards, the outside auditor is expected to make inquiries of the compensation committee chair and compensation consultants about the company’s executive compensation as part of the auditor’s review of financial relationships and transactions with executive officers. The outside auditor is supposed to make inquiry about the structure of the company’s compensation for its executive officers, not the reasonableness of its compensation. It is anticipated that auditors will report to audit committees about executive compensation arrangements as part of the auditors’ required communications. Boards will want to consider how best to coordinate these inquiries and communications, including the extent to which the compensation committee (or its chair) should be part of any discussions about executive compensation.
PCAOB guidance on questions audit committees should ask the auditor
The communications that auditors must make to audit committees under PCAOB standards are intended to help keep audit committees informed. Consistent with this goal, in Fall 2014, PCAOB Chair James Doty encouraged audit committees to ask outside auditors four questions about the PCAOB inspection process that the PCAOB had outlined in a prior report on this process. These questions are: (a) whether the company’s audit was selected for PCAOB inspection; (b) whether the PCAOB identified deficiencies in other audits involving auditing or accounting issues similar to those presented in the company’s audit; (c) what the audit firm’s responses to the PCAOB’s findings were; and (d) what the PCAOB’s findings were with respect to the audit firm’s quality control systems and what the firm is doing do address those findings.
Audit committee disclosures
The PCAOB confirmed in 2014 that it will not move forward with mandatory audit firm rotation in the foreseeable future. With this issue off the table, there have been calls for more disclosure about the audit committee’s role in overseeing the outside auditor and other aspects of its work. The SEC has indicated it may issue a "concept release" in 2015 on the auditor-audit committee relationship to solicit feedback on changes the SEC could make to its proxy disclosure requirements to provide greater transparency about the work of audit committees and to make the audit committee report more useful to investors.
Many companies already are taking steps to enhance the audit committee-related disclosures in their proxy statements–as reflected in the audit committee report, auditor ratification and auditor fee sections of the proxy statement. Surveys by Ernst & Young examining the proxy statements of Fortune 100 companies during the last three years found a steady upward trend in disclosures about audit committees and their work, and in 2014, movement toward "centralizing . . . disclosures as part of efforts to communicate more effectively." In light of this, audit committees that have not already done so may wish to take a fresh look at the audit committee report and related proxy disclosures and consider whether these could be enhanced to provide more meaningful information about the audit committee’s activities.
Audit committee financial experts
As part of the updated version of its corporate governance benchmarking tool, QuickScore, ISS now scores companies based on the number of financial experts (zero, one or two) serving on the audit committee. Previously, ISS tracked this information but it was a "zero-weight" factor, meaning that it did not impact companies’ scores. In light of this change, if a company’s board has designated only one financial expert, it may wish to consider designating a second, assuming there are additional audit committee members who meet the relevant criteria.
8. SEC disclosure effectiveness project.
The SEC has commenced a disclosure effectiveness project to review existing disclosure requirements and develop recommendations on ways to update the SEC’s disclosure regime. Over the coming year, companies and their boards can expect to hear more about this project as it moves forward.
Scope and timing of project
In several public statements, Keith Higgins, Director of the SEC’s Division of Corporation Finance, has addressed the scope of the project, offering insights into likely priorities. Initially, it is expected that the project will focus on disclosure requirements for periodic and current reports (Forms 10-K, 10-Q and 8-K) and disclosures in the financial statements. Areas that the staff will be looking at include modernizing disclosure requirements and eliminating duplicative disclosures, areas where more transparency/disclosure may be appropriate, how and when disclosures are made, and evaluating whether to tailor disclosure requirements for specific groups of companies (for example, based on company size or industry). One item that has received a good deal of attention is the possibility of a "core disclosure" or "company disclosure" system. Under this approach, there would be a "company file" consisting of core information that would be updated through information that is provided in periodic and current reports. The company file also would display information in a more topical fashion, so that investors could identify and access categories of information about a company, such as information about its business, financials, management and subsidiaries.
At this point, the SEC has not indicated a specific timeline for rulemaking in this area, but as a next step it plans to issue "concept releases" to solicit feedback on possible changes. The SEC has already opened an initial comment process for interested parties to provide recommendations on issues the SEC should consider as part of the disclosure effectiveness project.
Disclosures under existing rules
In one of his statements, Keith Higgins emphasized that "disclosure effectiveness is not just about [SEC] rules." He observed that in recent years, a number of companies have made significant changes to the presentation of information in their proxy statements to make this document more investor-friendly, and he encouraged companies to consider similar improvements in their other SEC filings. In light of this, companies may wish to think about whether there are additional steps they can take to improve their disclosures and make them more useful for investors. One step is enhancing the presentation of information through the use of tools like executive summaries, and graphs and other visual aids. Other possible steps include reducing duplicative disclosures and boilerplate disclosures (such as generic risk factors that could apply to any company), and eliminating information that is outdated and not required.
9. Sustainability issues.
Companies are providing more information on sustainability issues, and initiatives seeking sustainability reporting continue to gain momentum. The concept of "sustainability" is broad, encompassing subjects ranging from climate change and other environmental matters to workplace safety, operational integrity, community engagement, corporate citizenship, human rights and diversity. In 2013, 72% of S&P 500 companies published a sustainability or corporate responsibility report, compared to just under 20% in 2011, according to the Governance & Accountability Institute. Focusing on sustainability topics that present material issues is another key area for boards.
SASB and other initiatives
To date, sustainability reporting has largely been voluntarily and most common at large public companies, although some companies have enhanced their sustainability disclosures as a result of discussions with investor groups and shareholder proposals. In September, the European Union adopted a directive that will require large companies to report on environmental, social and employee-related matters, and human rights, anti-corruption and bribery issues. In an effort to focus companies on sustainability reporting, a number of organizations have issued guidelines or frameworks for these disclosures. One is the Sustainability Accounting Standards Board (SASB), which has begun developing sector-specific standards for disclosure of material sustainability information. SASB is a private sector body, so it does not (and cannot) mandate disclosures. Instead, the goal of SASB’s standards is to help public companies determine whether disclosure of sustainability information is required in SEC filings based on current SEC disclosure requirements, including existing standards on what information is material.
Sustainability issues also are on the radar screens of the stock exchanges. Both the NYSE and NASDAQ OMX have joined the United Nations Sustainable Stock Exchanges Initiative, which aims to encourage companies to improve their environmental, social and governance disclosures voluntarily. In March 2013, a group of over 100 institutional investors released a series of recommendations for integrating disclosure on environmental and social issues into listing standards for stock exchanges around the world.
In addition, in the last several years, there has been an effort to encourage "integrated reporting," which is a process designed to result in a single, periodic report that addresses various aspects of an organization’s activities and illustrates how they affect the organization’s short- and long-term value. In addition to financial results, integrated reporting covers topics including strategy and operations, governance and compensation, and environmental and societal impacts.
Reviewing sustainability disclosures
Boards should be cognizant of the developments related to sustainability issues and should understand which environmental and social issues are most relevant to the company’s business and to its shareholders. The board should confirm with management that the company’s existing disclosures include appropriate information about sustainability issues that are material to the company. It is foreseeable that in the coming years, both mandatory and voluntary reporting initiatives will impact the level of transparency, and the kinds of information, that shareholders and other stakeholders expect to see in this area.
[1] Gibson Dunn represents Wal-Mart in this matter.
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