A Look At Riskmetrics Group’s Policy Update For The 2010 Proxy Season

Introduction

RiskMetrics Group, the highly-influential proxy advisory firm formerly known as Institutional Shareholder Services ("RMG"), recently released its annual U.S. Corporate Governance Policy Update for the 2010 proxy season. The 2010 Policy Update outlines changes to the policies RMG utilizes in making voting recommendations to clients regarding director elections and other matters put to a shareholder vote. In light of RMG‟s significant influence, and the recent approval of a New York Stock Exchange proposal eliminating broker discretionary voting for uncontested director elections, companies should consider the extent to which RMG‟s policy changes could result in negative recommendations from RMG on voting for a company‟s director nominees or on other matters they intend to put to a shareholder vote in the upcoming proxy season. To view the full text of the 2010 Policy Update, please see: http://www.riskmetrics.com/sites/default/files/RMG2010USPolicyUpdates.pdf

Significant changes reflected in the 2010 Policy Update include:

• RMG will evaluate a company‟s director nominees on a "case-by case basis" where the company adopted a "short-term" poison pill (having a duration of less than 12 months) rather than automatically recommending against/withhold with respect to all the company‟s nominees (other than "new nominees") in the year after the adoption of the poison pill;

• Boards that adopt a "long-term" poison pill without a shareholder vote will receive against/withhold recommendations every three years – rather than just in the year after the poison pill‟s adoption – if the poison pill continues to be maintained;

• If a company includes a management "say on pay" proposal, RMG will initially address "problematic pay practices" by means of a negative recommendation on that proposal, rather than recommending against/withhold with respect to all the company‟s compensation committee members;

• RMG will generally recommend voting against shareholder proposals to establish new board committees; and

• In formulating its recommendation with respect to management proposals seeking an increase in the number of authorized shares, RMG will now look for, and analyze, an explanation of the specific reasons for the proposed increase, including a discussion of the company‟s historical use of existing shares and recent total shareholder return.

Further, while RMG has previously limited its review to shareholder voting at publicly-traded corporations, it will now provide proxy voting analyses and recommendations for meetings of publicly-traded limited partnerships and limited liability companies, and intends to develop other specialized policies as needed. In addition, RMG will now provide analysis and voting recommendations with respect to proposals to approve bankruptcy plans of reorganization, in particular as they relate to equity holders.

The summary below highlights the significant changes to corporate governance and executive compensation applicable to publicly traded U.S. companies included in the 2010 Policy Update.

Board of Directors

Voting on Director Nominees

Definition of "New Nominee"

Traditionally, RMG has not recommended against or withhold votes on director nominees who will be elected by shareholders for the first time, even where it has recommended such votes for other board nominees. However, in certain situations (such as for a company with a classified board), a nominee may never have been elected by shareholders but nevertheless have served on the board for a year or more. Under RMG‟s revised guidelines, if a company has taken an action that RMG views as problematic RMG will not treat such a director as a "new nominee" if he or she was on the board when the action was taken or has been on the board long enough that RMG believes he or she should be held accountable for the board‟s prior decision. RMG will presume that a nominee who joined the board within the 12 months prior to the upcoming shareholder meeting is a new nominee if it is unable to determine whether the nominee joined the board before or after the relevant action was taken.

Voting on Directors following the Adoption/Renewal of a Non-Shareholder Approved Poison Pill

Previously, RMG‟s policy was that if a board adopts or renews a poison pill without shareholder approval and without a commitment to put the poison pill to a shareholder vote within 12 months or reneges on any such commitment, it would recommend an "against" or "withhold" vote with respect to all of the company‟s director nominees (other than new nominees, who would be considered on a "case-by-case" basis) standing for election at the next annual meeting. The policy did not include any explicit distinction between "short-term" and "long-term" poison pills.

Under its revised policy, RMG has recognized that a short term poison pill could serve as a "valuable tool" to maximize shareholder value in the face of an opportunistic offer. As such, RMG will not automatically recommend an "against" or "withhold" vote with respect to director nominees if the board adopts a poison pill with a term of 12 months or less (a "short-term" poison pill). Instead, where a short term poison pill is adopted, RMG will evaluate the company‟s director nominees on a "case-by case basis" taking into account whether the company had time to put the poison pill up to a shareholder vote, the board‟s rationale for adopting the poison pill, and the company‟s governance structure and practices and track record of accountability. Companies adopting "short-term" poison pills should be mindful of the factors that RMG considers when communicating the reasons for doing so, in order to increase the likelihood of avoiding a negative RMG recommendation for its director nominees at the next annual meeting.

Under RMG‟s updated policy, it will recommend that shareholders withhold votes from or vote against all director nominees (except new nominees, who would be considered on a "case-by-case" basis) at companies that adopt poison pills with a term greater than 12 months or renew any existing poison pill (including a short-term pill) without shareholder approval or make a material, adverse change to an existing poison pill without shareholder approval. A commitment or policy that puts a newly-adopted poison pill to a binding shareholder vote may potentially offset an adverse vote recommendation.

Moreover, director nominees of companies that maintain long-term poison pills will receive negative recommendations every three years, rather than just in the year after the poison pill‟s adoption. For companies with classified boards, its nominees will receive negative recommendations each year. In 2010, RMG will only apply this policy to companies that adopted or renewed poison pills after November 2009. However, RMG notes that the policy may be applied retroactively in the future.

Voting on Directors for "Egregious Actions"

RMG‟s stated goal is to prevent failings in oversight exposed by the global financial crisis and address concern over a boardroom environment where past failures may not be part of the evaluation process in considering whether a director is, or continues to be, fit for the role and best able to serve shareholders‟ interests. RMG will recommend an against or withhold vote where it believes extraordinary circumstances raise substantial doubt about a director‟s ability to serve as an effective monitor of management and in the best interests of shareholders. RMG has updated its policies to enumerate the circumstances that will be considered in its evaluation, including material failure of governance, stewardship, or fiduciary responsibilities; failure to replace management as appropriate; and "egregious" actions related to past service on other boards that raise substantial doubt about a nominee‟s ability to effectively oversee management and serve in the best interests of shareholders.

Classification of Directors and the Definition of Director Independence

The NYSE and the NASDAQ require that (other than in the case of a "controlled company") a majority of the board of directors be classified as "independent" in order for a company to be listed on either exchange. In addition, the Securities and Exchange Commission (the "SEC") prohibits the NYSE, NASDAQ and other national securities exchanges and associations from listing any security of an issuer unless, among other things, each member of the issuer‟s audit committee is classified as "independent." Although the NYSE and NASDAQ have their own standards to determine whether a director falls into the category they have each deemed "independent," RMG continues to make its own determination of independence and will recommend against any director it classifies as an "inside director" or an "affiliated outside director" if the director serves on a company‟s audit, compensation or nominating committee or the company lacks any such committee (even if the director is considered independent under NYSE or NASDAQ guidelines) or the board‟s independent directors, based on RMG‟s classifications, make up less than a majority of the board.

RMG has updated its guidelines for evaluation of director independence, including as they relate to professional and transactional services, in order to "reflect a more pragmatic approach and to increase clarity on application of this policy".

Transactional/Professional Relationships

RMG‟s previous policy was to consider an outside director to be "affiliated" if:

• the director or a relative is employed by a significant customer or supplier of, or has a transactional relationship with, the company involving annual payments exceeding the greater of $200,000 and 5% of the recipient‟s gross revenues (the NASDAQ‟s materiality test). In addition, a director was considered "affiliated" if he or she had any other "material financial tie or other related party transactional relationship" to the company; or

• the director or a relative provides "professional services" to the company or an officer of the company in excess of $10,000 per year.

Under RMG‟s updated policy, RMG determines whether a director is "affiliated" by evaluating whether the director or any immediate family member has any material transactional relationship with the company or is a trustee, director or employee of a charitable organization that receives material grants or endowments from the company. Under the updated policy, RMG will apply a materiality test for transactional relationships (and charitable contributions) based on whether the company follows an NYSE (greater of $1 million or 2% of the recipient‟s gross annual revenues) or NASDAQ (greater of $200,000 or 5% of the recipient‟s gross annual revenues) listing standard. For companies that do not follow either listing standard, RMG will continue to apply the NASDAQ-based materiality test. The RMG update helpfully indicates that no other transactional relationships involving a director will be considered material.

The updated policy also clarifies that a director would be considered "affiliated" if the director or any immediate family member is a partner in, or the controlling shareholder or an executive officer of, an organization which has any material transactional relationship with the company. In addition, a director would be considered "affiliated" if the director or any immediate family member is a partner in, or the controlling shareholder or an employee (whether or not an executive officer) of, an organization that provides "professional services" to a company or an officer of the company in excess of $10,000 per year.

Clarification of Professional Services

RMG updated its policy regarding professional services to clarify that the definition includes services that are advisory in nature, generally involve access to sensitive company information or to strategic decision-making, and typically have a commission- or fee-based payment structure which could create a conflict of interest.

Applying this new standard, RMG now generally considers insurance services, information technology (where tied to a previous transactional relationship such as a purchase of hardware or software), marketing (particularly market research and market, branding and advertising strategy services), lobbying, executive search, property management and realtor services to be professional services. By the same principle, "Of Counsel" relationships are deemed by RMG to be professional unless the individual does not receive any form of compensation (in excess of $10,000 per year), or has retired from the firm providing the professional service. On the other hand, RMG considers educational services or the services of a company providing a professional service to one of its directors or to an entity with which one of its directors is affiliated, to be transactional, rather than professional, services. In the latter situation, RMG states that there is no direct financial tie which could compromise that directors independence.

Substantive Changes to the Classification of Insider Director

RMG changed one of the criteria for inside directors from "Non-employee officer of the company if among the five most highly paid" to "Among the five most highly paid individuals". RMG believes that if a director is among the most highly paid individuals at the firm, regardless of whether the director is an officer, there is still a conflict of interest.

RMG also now applies a $10,000 per year de minimis threshold for additional compensation for non-employee directors serving as officers due to statutory requirements (e.g. corporate secretary) in order to classify the director as an "Insider".

Shareholder and Management Proposals

Board-related Shareholder Proposals

Establish/Amend Nominee Qualifications

To address a new type of shareholder resolution which seeks to establish or amend director qualifications to require the selection of a nominee who possesses particular expertise, RMG will recommend voting on a case-by-case basis, based on the reasonableness of the criteria and to what degree they may preclude dissident nominees from joining the board, considering:

• Board committee structure, existing subject matter expertise, and board nomination provisions relative to that of the company‟s peers;

• Board and management oversight mechanisms regarding the issue for which board oversight is sought;

• Company disclosure and performance relating to the issue for which board oversight is sought and any significant related controversies; and

• The scope and structure of the proposal.

Establishment of Board Committees

Previously, RMG generally recommended voting against shareholder proposals to establish a new standing board committee, as such proposals seek a specific oversight mechanism/structure that potentially limits a company‟s flexibility to determine an appropriate oversight mechanism for itself. Now, to address proposals relating to temporary board committees sought to be established for a particular purpose (such as investigating a particular issue), RMG will generally recommend a vote against shareholder proposals to establish any new board committee, whether existing in perpetuity or not.

Shareholder Proposals Relating to Corporate Governance

Shareholder Ability to Call Special Meetings or Act by Written Consent

RMG has historically recommended voting against proposals that restrict or prohibit shareholders‟ ability to call special meetings or act by written consent and for proposals that remove such restrictions. Out of concern that management-sponsored proposals, while having the stated intention of providing shareholders with the right to call a special meeting or act by written consent, actually substantively restrict the shareholders‟ ability to do so (e.g., unattainably high thresholds, broad discretion given to the board to reject proposals, advance notice restrictions leaving only a small window of time to propose and hold a special meeting, etc.), RMG clarified the factors it will consider in making a recommendation with respect to such proposals, including the minimum ownership threshold necessary to call special meetings or act by written consent, investor ownership structure, exclusionary or prohibitive language and other limiting factors.

Supermajority Vote Requirements

RMG continues to recommend voting for proposals to lower supermajority vote requirements. However, RMG has expressed concern that, in light of recent credit market conditions, investors have been able to take control of distressed companies through the conversion of "rescue" or highly dilutive securities and that such investors may seek amendments to the company‟s governing documents that provide it with effective control with little or no input from minority shareholders. In such cases, RMG believes existing supermajority vote requirements may help protect minority shareholders‟ interests. Accordingly, with respect to such companies, RMG will recommend voting on a case-by-case basis on proposals to reduce supermajority vote requirements, taking into account ownership structure and quorum requirements and supermajority vote requirements.

Shareholder and Management Proposals Relating to Anti-Takeover Defenses

Net Operating Loss Poison Pills and Protective Amendments

RMG evaluates management proposals to implement a poison pill for the stated purpose of protecting a company‟s net operating loss ("NOL"), to ensure that the NOL poison pill cannot be used as a management entrenching device. RMG has updated the factors it will consider to include the company‟s governance structure and track record in addition to other factors in evaluating whether to recommend voting for or against ratification of an NOL poison pill.

RMG has not previously addressed management proposals to adopt ownership limitations intended to protect the value of NOLs. RMG has expressed concern that, notwithstanding a high estimated tax value of NOLs that would benefit shareholders, such ownership limitations, coupled with a companys problematic governance structure, could serve as an antitakeover device. Accordingly, in evaluating a proposed NOL protective amendment, RMG will now consider factors similar to those considered when evaluating an NOL poison pill.

Proposals Relating to M&A/Capital Restructuring

Plans of Reorganization (Bankruptcy)

RMG will make recommendations on a case-by-case basis on proposals to shareholders seeking approval of bankruptcy plans of reorganization, taking into account, among other factors:

• The estimated value, financial prospects and governance of the reorganized company;

• The percentage ownership of current shareholders in the reorganized company;

• Whether shareholders are adequately represented in the reorganization process;

• The extent to which the plan addresses the causes of the bankruptcy filing;

• The existence of a superior alternative to the plan of reorganization; and

• Governance of the reorganized company.

Common/Preferred Stock Authorization

While retaining its policy to recommend voting on proposals seeking an increase in the authorized number of common or preferred shares on a case-by-case basis, RMG has modified the considerations to be taken into account to focus on the specific reasons for the proposed increase, the dilutive impact of the request, the risk to shareholders of not approving the request (in the case of common stock) and whether the preferred stock would be "blank check" preferred stock. In addition, RMG will consider past board performance (use of authorized shares during the last three years, one- and three-year shareholder return and board governance structure and practices).

As a result of these changes, shareholders may be less likely to approve new share requests due to RMG recommendations if the company does not provide specific reasons for its request, underperforms its industry peers, or has problematic governance in the view of RMG. Accordingly, companies should carefully draft the disclosure in connection with any request to increase the authorized capital of the company to address these criteria.

Shareholder Proposals Relating to Corporate Responsibility

Greenhouse Gas Emissions

RMG continues to recommend voting for proposals that require reporting on the company‟s greenhouse gas ("GHG") emissions. However, RMG will no longer generally recommend voting against, and will now recommend voting on a case-by-case basis, on proposals that call for the adoption of GHG reduction goals from products and operations, taking into account the feasibility of the request, among other factors.

Diversity

RMG has added a definition of diversity to specifically refer to gender and racial diversity, as opposed to professional diversity. RMG will now generally recommend voting for proposals requesting reports on the company‟s efforts to diversify the board and recommends voting on a case-by-case basis on proposals asking the company to increase the gender and racial minority representation on its board, taking into account, among other factors, whether the proposal seeks a prescriptive change to the nominating committee charter versus a non-prescriptive report on company diversity initiatives.

Executive Compensation

One of the most important changes this year surrounds the impact that "say on pay" advisory votes will have on RMG‟s recommendations concerning poor pay practices. While the movement for providing shareholders the ability to cast a nonbinding vote on executive compensation certainly has been around for several years, this year accelerated its arrival as: (1) the inclusion of a "say on pay" vote is mandated for companies receiving financial assistance under the Troubled Asset Relief Program as part of the executive compensation and corporate governance standards imposed by Emergency Economic Stabilization Act of 2008, as amended by American Recovery and Reinvestment Act of 2009¹; and (2) the House of Representatives passed the "Corporate and Financial Institution Compensation Fairness Act of 2009" this summer, which would require all public companies to hold an advisory "say on pay" vote annually with respect to executive compensation generally². RMG advises that if a company has a management "say on pay" resolution on the ballot, RMG will apply any compensation-related recommendations to that proposal as opposed to a vote against compensation committee members, other than in situations where an egregious practice is identified or where a company previously received a negative recommendation on such a proposal and the issue is ongoing.

This year‟s executive pay evaluation philosophy focuses on an integrated policy consisting of three sections: Pay for Performance, Problematic Pay Practices, and Board Communication and Responsiveness.

Within the "Pay for Performance" umbrella, RMG will now also consider the alignment of the CEO‟s total direct compensation and total shareholder return over a period of five years for companies that have one-year and three-year shareholder returns in the bottom half of their industry groups. Where RMG finds misalignment between CEO pay and performance, it will recommend a vote against a management "say on pay" proposal and/or the election of directors or equity plans.

In addition, RMG has identified the pay practices it finds most problematic and that are more likely to result in a recommendation to vote against a management "say on pay" proposal. RMG has also updated its policy to include a separate focus on factors that may promote "excessive" risk taking. (In addition, RMG may recommend a vote against an equity-based incentive plan proposal if non-performance-based equity awards are the major contributor to a pay-for-performance misalignment and may recommend a withhold vote or a vote against compensation committee members (or, perhaps, the entire board) in "egregious" situations, where there is no management "say on pay" resolution on the ballot, or where the board has failed to properly respond to concerns raised in prior management "say on pay" evaluations.

While each factor will be examined on a case-by-case basis, RMG deems the following factors most problematic:

• "Egregious" employment contracts with multi-year guarantees for salary increases, non-performance based bonuses and equity compensation;

• "Overly generous" package for a new CEO containing any problematic pay practices or excessive make whole provisions;

• "Abnormally large" bonus payouts without justifiable performance linkage or proper disclosure;

• "Egregious" pension benefits including additional years of unworked service or including long-term awards in pension calculations that result in significant additional benefits;

• "Excessive" perquisites;

• "Excessive" severance and/or change in control provisions providing for change in control payments exceeding 3 times base salary and target bonus, single trigger change in control payments, and new or materially amended agreements that provide for modified single triggers or an excise tax gross-up;

• Tax reimbursements related to perquisites or other payments;

• Dividends or dividend equivalents on unvested performance shares or units;

• Executives using company stock in hedging activities; and/or

• Repricing or replacing underwater stock options/stock appreciation rights without prior shareholder approval.

RMG also notes that factors such as clawback provisions and stock ownership/holding guidelines could mitigate the impact of factors that could otherwise promote "excessive" risk-taking.

For a detailed list of these practices, including additional factors which are deemed less problematic, please see the Frequently Asked Questions on U.S. Compensation provided by RMG on November 19, 2009, available at: http://www.riskmetrics.com/sites/default/files/RMG2010USPolicyUpdates.pdf

In addition, RMG reiterated its position that option exchanges should be a "last resort" tool for management, and if used, should only apply to "deeply underwater" options. RMG indicates that the threshold exercise price should generally be the higher of the 52-week high or 50 percent above the current stock price in order to assure that options are "deeply underwater". However, RMG urges that this factor should be considered along with other factors and that a company should disclose the eligible participants in such a program.

Companies need to regularly review their corporate governance and employee compensation practices in light of RMG policies, particularly in light of the recent proxy voting changes. Many companies adopted corporate governance policies in prior years that were consistent with RMG positions, however due to changes in RMG‟s recommendations, those previously favored policies may now lead to a vote against directors.

Footnotes

1 For a discussion of the SEC‟s proposed rules implementing this shareholder approval requirement, please refer to the section entitled "Say on Pay Votes for TARP Recipients" of our previous memorandum "SEC Proposes Rules Concerning Proxy Disclosure of Executive Compensation and Corporate Governance and Shareholder Approval of Executive Compensation". (http://www.friedfrank.com/siteFiles/Publications/388037AB789F3BD549FF39C08BF4F24B.pdf) Final rules are expected soon.

2 For a discussion of the proposed legislation, please refer to our previous memorandum "Executive Compensation Update: Frank Bill Passes House". (http://www.friedfrank.com/siteFiles/Publications/D431B84E12B075A926BFC847EA71CB39.pdf)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.