The 2010 proxy season will mark the beginning of a number of corporate governance changes in the United States. Most of these changes will come about as a result of the implementation of proxy disclosure enhancement rules by the U.S. Securities and Exchange Commission (the "SEC"), although other changes (such as the elimination of broker discretionary voting in electing directors) will play a part. The new disclosure will require boards of public companies to engage in thoughtful consideration of issues relating to board composition and structure, as well as the oversight of risk management and the relationship of compensation policies to risk.
Except as described below, the new rules will not affect foreign private issuers unless they voluntarily choose to follow disclosure rules applicable to U.S. domiciled companies.
Proxy Disclosure Enhancements
On December 18, 2009, the SEC adopted a number of changes to the rules applicable to proxy disclosure by U.S. companies, including the following that are discussed in more detail below:
- Enhanced disclosure of biographical information concerning directors and nominees for director and the board's assessment of the attributes and qualifications of individual directors and nominees;
- Disclosure concerning the board leadership structure and the board's role in risk oversight;
- Disclosure concerning the use of compensation consultants and potential conflicts of interest; and
- Disclosure of compensation policies that increase the company's exposure to risk.
The SEC also adopted changes to the reporting of equity compensation in the Summary Compensation Table and changed the time period for reporting the results of voting to four business days. The new rules are effective for companies having a year end on or after December 20, 2009, and filing their Annual Report on Form 10-K on or after February 28, 2010. On January 20, 2010, the SEC issued additional Compliance and Disclosure Interpretations ("C&DIs") responding to questions under the proxy disclosure enhancement rules.
Board Composition and Director Qualifications
The new rules require companies to disclose, for each director or nominee for director, the "specific experience, qualifications, attributes or skills" that led the board or the nominating committee of the board to conclude that the person should serve as a director, "in light of the [company's] business and structure". Information extending beyond the past five years, if material, must be included. The rule applies to all members of the board, not just those up for re-election, so that companies with staggered boards must consider why directors who are not up for re-election should continue to serve as directors. To meet the new requirements, a company must be prepared to explain the specific combination of skills and experience that, in effect, justifies each director's position on the board. Accordingly, the disclosure concerning various members of the same board could be very different, as one member might be valued for his or her industry experience and contacts, while others might contribute expertise in finance, accounting, marketing or strategic planning. In the January 20, 2010 C&DIs, the SEC emphasized that the disclosure must address the director's individual qualifications. Moreover, the SEC noted that merely identifying an individual as the audit committee financial expert will not satisfy the requirements of the rule. Explanations of a director's qualifications for a specific committee, and the director's risk management expertise, both required by the rule as initially proposed, are not required by the final rule.
In keeping with the focus on the individual backgrounds of the board members, the new rules require companies to list each of the public companies on which a board member or nominee served as a director over the past five years, even if the board member or nominee is not any longer a director of the other company. New disclosures are also required regarding legal proceedings to which a director or nominee has been subject, and the time period covered by certain disclosure requirements has been extended from five to ten years.
As in the past, the company must disclose the minimum criteria and qualifications that it demands of all board members. In addition, under the new rules, the company must indicate whether, and if so how, the nominating committee or the board considers diversity in identifying nominees for director. The SEC's adopting release does not define "diversity" and makes it clear that, for some companies, it could mean diversity in ethnicity or gender, while for others it might mean diversity of experience or point of view.
Among the consequences that are likely to flow from these new requirements are:
- Individual biographies contained in the proxy statement may need to be re-written, and board members may take new interest not only in their own biography but in the biographies of other board members; and
- Boards and nominating committees may wish to review their procedures for evaluating board composition, as well as their nominating processes.
The SEC's adopting release and January 20, 2010 C&DIs acknowledge the importance of either having or developing internal procedures for assuring appropriate responses to the new disclosure requirements. For example, the C&DIs note that companies with staggered boards may need to develop an assessment process to enable them to make required disclosures for all of their directors.
In reviewing both the internal procedures and the external disclosures, a board may wish to keep in mind the possibility of contested elections in the future. As noted below, the SEC has deferred its consideration of "proxy access", whereby significant shareholders might propose one or more nominees for director and require the company's proxy statement to include soliciting materials in support of the shareholders' nominees. The company's 2010 proxy disclosures could influence how the company is perceived by activist shareholders and other investors, however, and this in turn could affect any contest that might ensue if proxy access is adopted for the 2011 proxy season.
Leadership Structure and Role in Risk Oversight
The new rules require companies to briefly describe the "leadership structure" of the board, particularly whether the same person serves as principal executive officer and chairman of the board. If the same person serves in both roles, the company must disclose whether it has a lead independent director, and what role that director plays in the leadership of the board. The company also must indicate why it has determined that its leadership structure is appropriate given the specific characteristics and circumstances of the company.
Separately, the company is required to disclose the extent of the board's role in risk oversight, and the effect this has on its leadership structure. Such disclosure would, for example, address whether the board had a separate risk committee, and the differing roles played by the audit committee and other committees or the board as a whole in overseeing risk management.
Use of Compensation Consultants
The new rules require disclosure of fees paid to compensation consultants and their affiliates when they played a role in determining or recommending the amount or form of executive or director compensation, and they also provided other services to the company, if the amount of the non-executive compensation services exceeds $120,000. Disclosure is required as to whether the decision to engage the consultant for non-executive compensation services was made or recommended by management, and whether the board approved such engagement. Services to broad-based non-discriminatory plans and the provision of surveys and other information, if not customized for the company, are excluded from the disclosures.
Relationship between Compensation and Risk
The new rules require that the company include a separate narrative disclosure of the relationship of the company's compensation policies and practices (for executive and nonexecutive level employees) to its management of risk, if the risks arising from those policies and practices are "reasonably likely to have a material adverse effect" on the company. The rule provides a non-exclusive list of situations that could trigger disclosure:
- Where a business unit carries a significant portion of the company's risk profile;
- Where compensation at one business unit is structured differently than other units within the company;
- Where a business unit is significantly more profitable than others within the company;
- Where compensation expense for a business unit is significant in comparison to its revenues; and
- Where compensation practices vary significantly from the overall risk and reward structure of the company, such as when compensation rewards the achievement of a task, while income and risk from the accomplishment of the task extend over a longer period of time.
The adopting release and the rule itself emphasize that each particular situation must be analyzed independently, but suggest a number of examples of issues to be addressed, such as: the general design philosophy behind the practices; the risk assessment or incentive considerations involved in structuring and awarding compensation; "claw-backs" and holding periods that would mitigate the short-term focus of compensation practices; and possible adjustments to reflect changes in the company's assessment of risk.
The January 20, 2010 C&DIs clarified that, if disclosure is required in response to this new rule, the disclosure should be presented together with the rest of the company's compensation information, and should not be difficult to locate or otherwise obscured. Consistent with the adopting release, the information should not be presented in the company's Compensation Discussion and Analysis. Companies that do not believe that a disclosure is required of them, however, may wish to include a discussion of risk and its relationship to their compensation policies and incentive plan structures in the Compensation Discussion and Analysis.
New York Stock Exchange Rule Changes
Effective for meetings on or after January 1, 2010, brokers who are members of the New York Stock Exchange ("NYSE") will no longer be allowed to vote at their own discretion on director elections if they do not receive instructions from the beneficial owner within ten days prior to the election. Although most observers have applauded this change to NYSE Rule 452, there is some concern that it may make it harder to obtain a quorum or may increase the influence of larger shareholder voting blocks. As a result of the rule change, many companies are expected to try harder to reach out to retail voters, who might otherwise expect their broker to vote for them. As Rule 452 regulates NYSE member brokers, rather than individual companies, it could potentially affect how votes are submitted on behalf of U.S. shareholders in elections outside the United States.
The NYSE corporate governance rules were also amended, effective January 1, 2010, to eliminate certain disclosure requirements that were considered duplicative of SEC or other NYSE requirements, and to allow other disclosures to be made on the listed company's website, rather than in the company's proxy statement. Companies no longer need to affirmatively indicate in their annual report that their CEO has confirmed to the NYSE that the company has complied with all applicable NYSE requirements. Companies (including foreign private issuers) must, however, inform the NYSE of any failure to comply with NYSE rules, even if not material, promptly upon any executive officer becoming aware of the noncompliance.
For foreign private issuers filing Form 20-F, the NYSE noted that the company would be required to compare its home country corporate governance practices to those otherwise required by any U.S. securities exchange on which its shares are listed and include such comparison in the company's Form 20-F, pursuant to new Item 16G of Form 20-F. Foreign private issuers that file annual reports on Form 40-F or Form 10-K can include such information in the annual report or on the company's website. Website disclosures must be updated promptly upon any change.
Proxy Access and Related Developments
The most controversial proposal that the SEC considered in 2009 related to "proxy access", under which holders of a minimum percentage of a company's shares would be permitted to nominate one or more directors and to require the company to include the shareholder's nominee and soliciting materials for the nomination in the company's proxy statement. Rather than adopting the proposal in 2009, the SEC reopened the comment period through January 19, 2010. The fate of proxy access is difficult to predict, but it looms in the background of boardroom discussions of the nomination and corporate governance process.
In the meantime, on October 27, 2009, the SEC adopted Staff Legal Bulletin 14E ("SLB 14E"), which reverses the SEC's prior positions on whether proposals concerning the evaluation of risk and management succession planning for a company's chief executive officer can be excluded as relating to the company's ordinary business functions under Rule 14a-8 under the U.S. Securities Exchange Act of 1934, as amended. In SLB 14E, the SEC stated that it will look to the nature of the risk that the shareholder proponents wish to have evaluated, and permit exclusion of the proposal only if the risk itself relates to the company's ordinary business functions. Proposals relating to CEO succession planning will no longer be deemed to relate to the company's ordinary business functions, unlike other matters of employee hiring and retention generally.
A Last Surprise: Climate Change Disclosure
On January 27, 2010, the SEC issued interpretive guidance to the effect that existing disclosure rules require companies to consider the impact of business and legal developments (including international accords) relating to climate change and, where material, to include a discussion of these matters in their general business description, disclosure of legal proceedings, risk factors or management's discussion and analysis of financial condition and results of operations. While the focus on climate change may come as a surprise, it is consistent with the SEC's existing position that companies must include forward-looking disclosure with respect to possible changes in their industry and the regulatory environment.
As interpretive guidance, the SEC's position is immediately applicable and would apply to filers of Form 20-F as well as U.S. domestic companies.
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