SEC Adopts Proxy Rule Changes for 2010 Proxy Season

22 December 2009 Publication
Authors: Joshua A. Agen Steven R. Barth Peter D. Fetzer Jay O. Rothman

Legal News Alert: Transactional & Securities

On December 16, 2009, the SEC adopted amendments to its executive compensation and governance disclosure requirements that will require public companies and management investment companies to make new or modified disclosures in the proxy statement and other public filings beginning in 2010.1 The disclosure requirements relate to:

  • Compensation policies and practices that present material risks to the company
  • Compensation table disclosure of the value of stock and option awards to directors and executive officers
  • The qualifications and background of directors and director nominees
  • Board leadership structure
  • Board involvement in risk oversight
  • Potential conflicts of interest involving the use of compensation consultants

The SEC also amended its Form 8-K requirements to require earlier disclosure of voting results from shareholder meetings.

Differences From the Proposed Rules
The SEC action finalizes rule changes that were originally proposed in July 2009, and the final rules reflect a number of changes from the proposal.2 The most significant of these are summarized below:

  • Compensation Risk Assessment.

    • Under the proposed rules, companies would have been required to address compensation policies and practices for both executives and non-executives as they relate to risk-management practices and risk-taking incentives to the extent that risks arising from such policies and practices “may have a material effect” on the company. This disclosure would have been required as part of the Compensation Discussion and Analysis (CD&A) section in the company’s proxy statement.
    • Under the final rules, companies will be required to address compensation risk substantially as under the proposed rules, but only to the extent that risks arising from compensation policies and practices “are reasonably likely to have a material adverse effect” on the company. The change in the disclosure threshold from “may have a material effect” to “reasonably likely to have a material adverse effect” was intended to avoid disclosure of potentially insignificant and speculative information and permit consideration of offsetting measures designed to limit risks, and may result in companies whose compensation policies and practices do not pose significant risks being able to omit this disclosure entirely.
    • The final rules also relocate the compensation risk assessment disclosure out of the CD&A into a separate section of Item 402 of Regulation S-K. In explaining its decision to move the disclosure out of CD&A, the SEC cited potential confusion that could result from including the compensation risk assessment, which covers compensation of non-executive officers as well as that of executive officers, in the CD&A, which otherwise relates only to the compensation of named executive officers.
    • Smaller reporting companies will not be required to provide the new compensation risk disclosures. The SEC defines smaller reporting companies generally to include most public companies with a public float of less than $75 million as of the last business day of the company’s most recently completed second fiscal quarter.
  • Director Qualifications. In contrast to the proposed rules, the final rules will not require disclosure of the particular experience, qualifications, attributes, and skills of each director and nominee that qualify such director or nominee for service on specific board committees. Consistent with the proposed rules, disclosure of such items relating to board service will be required, but the proposal’s specific reference to “risk assessment skills” has been deleted in the final rules.
  • Director and Officer Legal Proceedings. In addition to lengthening the period of time during which legal proceedings involving directors, director nominees, and executive officers is required from five to 10 years, as proposed, the final rules also add two new categories of legal proceedings that trigger disclosure. The new categories of legal proceedings relate to certain securities, commodities, financial institution and insurance company-related laws, and regulations and sanctions or orders of certain self-regulatory and similar organizations.
  • Board Diversity. The final rules expand the required disclosure concerning the nominating committee’s process for identifying and evaluating nominees for director to include disclosure of whether and how the nominating committee or the board considers diversity in identifying nominees for director. The implementation of any policy with regard to the consideration of diversity in identifying director nominees must be described as well as how the nominating committee or the board assesses the effectiveness of such policy.
  • Compensation Consultant Independence. The proposed rules included requirements to disclose fees paid to, and other information concerning, compensation consultants providing executive compensation consulting services to the board, compensation committee, or management. The disclosures were intended to address potential compensation consultant conflicts of interests. The final rules include similar disclosure requirements, but include additional exemptions. Under the final rules, the compensation consultant independence disclosure will not be required if the fees paid for non-executive compensation consultant services are $120,000 or less, and consulting services that are limited to providing information to the company, such as a survey, that is not customized or is customized based on parameters not developed by the consultant will not be considered executive compensation consultant services. Consistent with the proposed rules, the final rules also provide an exception for services involving only broad-based non-discriminatory plans.
  • Stock and Option Award Reporting. Consistent with the proposed rules, the final rules require reporting of all stock and option awards granted during the applicable fiscal year at the full grant date fair value. The final rules clarify that companies reporting stock and option awards for a fiscal year ending on or after December 20, 2009 will be required to present recomputed disclosure for each preceding fiscal year, but will not be required to include different named executive officers for any preceding fiscal year based on recomputing total compensation for those years, or to amend prior disclosure.
  • Proxy Solicitation Procedural Clarifications Deferred. The proposed rules included a number of technical clarifications and refinements relating to the proxy solicitation process and voting, but the SEC has deferred consideration of these proposals pending its consideration of its most recent proxy access proposal. These proposals are discussed in Foley’s July 20, 2009 Legal News Alert available at http://www.foley.com/publications/pub_detail.aspx?pubid=6199.

Effectiveness and Application
The rule amendments are effective February 28, 2010, except that the amendments concerning the reporting of equity-based awards in the Summary Compensation Table and Director Compensation Table require companies providing such disclosure for a fiscal year ending on or after December 20, 2009 to present recomputed disclosure for each preceding fiscal year. The adopting release does not describe the intended application of the effective date, which may not be clear in every circumstance. For example, the release does not indicate whether the rule amendments would apply to a preliminary proxy statement that is filed prior to February 28, 2010 if the final proxy statement is filed after February 28, 2010.

The final rules apply generally to companies required to provide disclosure under Item 402 of Regulation S-K, except that smaller reporting companies will not be required to provide the new compensation risk disclosures.

Practice Tips
Since the rule amendments are generally effective for the 2010 proxy statements, calendar-year companies that are affected by the changes will need to adapt quickly. Some recommendations for specific responses to the final rules are set forth below.

  • Recommended Process for Compensation Risk Assessment. Companies should consider the following actions to implement the final rules on compensation risk assessment:

    • Identify material internal and external risks in the context of the company’s business activities and markets of operation
    • Determine how compensation practices and arrangements influence these risks
    • Identify policies that will mitigate or limit these risks but still align compensation to the achievement of company’s strategic plan
    • Meet with the senior risk officer (or equivalent officer) to assess risk in executive compensation
    • Consult with outside experts
    • Document the foregoing assessments and disclose in the proxy statement (if applicable)

Compensation committees in particular should consider and document key factors and practices relating to compensation risk, including, potentially, longer-term performance periods, the alignment of compensation with the company’s strategic plan, both upside potential and downside risks and consideration of both absolute and relative metrics (including peer group comparisons when practical). Potential compensation risk “red flags” include such practices as uncapped upside potential in incentive arrangements, incentives tied to a short timeframe, incentives to “swing-for-the-fence,” equity awards with limited downside risks, and a misaligned mix between base salary and incentive compensation

Additional recommendations and other considerations relating to the final rules on compensation risk assessment were discussed in more detail during a recent session of Foley’s National Directors Institute Web Conference titled “Compensation Committee Issues,” which is available at http://www.foley.com/news/event_detail.aspx?eventid=2996.

  • Update or Supplement Director and Officer Questionnaires. Companies should ensure that their director and officer questionnaires solicit the information that will be required in 2010 proxy statements such as the specific qualifications of directors for board service and certain legal proceedings over the previous 10, rather than five, years. In addition, due to the final rules’ addition of two new categories of legal proceedings that were not in the proposed rules, any director and officer questionnaires that have been updated based on the proposed rules will likely need to be modified or supplemented to include questions on these categories, which are described below.
  • Revisit Determination of Named Executive Officers. The revised method of reporting equity awards under the rule amendments may change the identity of the most highly paid executive officers, thereby resulting in a change to the “named executive officer” group for whom proxy statement disclosure of compensation is required. Accordingly, companies should revisit this determination early in the process of preparing their proxy statements.

Summary of the Rule Changes

Compensation Risk Assessment
The final rules will require narrative disclosure of companies’ compensation policies and practices as they relate to risk management.3 Specifically, companies will be required to discuss their policies and practices in compensating their employees — including, in contrast to the CD&A, employees who are not named executive officers — to the extent that risks arising from such policies and practices are reasonably likely to have a material adverse effect on the company. In preparing this discussion, companies will need to consider the level of risk that employees might be encouraged to take to meet their incentive-compensation targets or conditions. As noted above, the final rules on the compensation risk assessment are generally consistent with the proposed rules, except that the disclosure threshold was changed from “may have a material effect” to “reasonably likely to have a material adverse effect,” and the disclosure has been relocated out of CD&A.

The rules include the following illustrative list of generally applicable compensation policies and practices that might warrant discussion:

  • Compensation policies and practices at business units:
  • That carry a significant portion of the company’s risk profile
  • With compensation structured significantly differently from the rest of the company’s business units
  • That are significantly more profitable than other business units
  • Where compensation expense is a significant percentage of the unit’s revenues
  • Compensation policies that vary significantly from the overall risk and reward structure of the company (such as policies under which bonuses are awarded upon accomplishment of a task for which income and risk to the company extend over a significantly longer period of time)

The rules also provide the following examples of the types of issues that may need to be addressed for the business units or employees discussed (i.e., if the related risks are reasonably likely to cause a material adverse effect):

  • The general design philosophy of the company’s compensation policies for employees whose behavior would be most impacted by the incentives established by the policies, as such policies relate to or affect risk taking by employees on behalf of the company, and how they are implemented
  • The company’s risk assessment or incentive considerations, if any, in structuring compensation policies or in awarding and paying compensation
  • How the company’s compensation policies and practices relate to the realization of risks resulting from the actions of employees in both the short term and the long term such as through policies requiring claw backs or imposing holding periods
  • The company’s policies regarding adjustments to its compensation policies to address changes in its risk profile
  • Material adjustments the company has made to its compensation policies or practices as a result of changes in risk profile
  • The extent to which the company monitors its compensation policies and practices to determine whether its risk management objectives are being met in providing incentives for its employees

The proposing release emphasized that companies should evaluate whether discussion of these issues is appropriate in light of their importance to investors based on the individual company’s circumstances, and that the level of detail should vary depending on the particular facts of the company or business unit involved. Separately, the CD&A retains its current requirement to discuss, to the extent material, exposure to downside performance risk and cost-benefit analysis with respect to the compensation of named executive officers.

Compensation Table Disclosures for Equity Awards to Eliminate GAAP Expense Framework
Since its adoption in 2006, the SEC’s current framework for reporting stock and option awards in the Summary Compensation Table (showing the dollar amount of all outstanding equity awards expensed during the year for financial reporting purposes rather than the aggregate grant date fair value of that year’s awards) has been criticized by investors, practitioners, and commentators as potentially misleading and confusing to investors. For example, reporting the expense can result in a negative compensation number in years in which equity awards are forfeited, and using the expense to determine the most highly paid executives for purposes of inclusion in the Summary Compensation Table can result in significant variation from year to year for reasons unrelated to companies’ compensation decisions. The SEC has received a number of comments opposing the current framework, and many companies have responded to its perceived weaknesses by providing “alternative” Summary Compensation Tables using the aggregate grant date fair value.

The final rules unwind the current framework and require companies to report each year’s stock and option awards in the Summary Compensation Table and Director Compensation Table using the aggregate grant date fair value of the awards. Companies reporting stock and option awards for a fiscal year ending on or after December 20, 2009 will be required to present recomputed disclosure for each preceding fiscal year (i.e., 2007 and 2008, for calendar year end companies), but will not be required to include different named executive officers for any preceding fiscal year based on recomputing total compensation for those years, or to amend prior disclosure.

The final rules also require that equity awards subject to performance conditions should be reported in the Summary Compensation Table and the Director Compensation Table at a value based on the probable outcome of the conditions. A footnote to the table must disclose the value of the award assuming that the highest level of performance conditions is achieved (assuming that the highest level of performance was also not the probable outcome included in the table). In contrast to the proposed rules, the final rules retain the requirement under the current rules to disclose the grant date fair value in the Grants of Plan-Based Awards Table.

The final rules did not adopt the proposal to alter the reporting of salary and bonus forgone at the election of an executive in the Summary Compensation Table. The proposed rules would have required non-cash awards received upon such an election by the executive to be reported in the Summary Compensation Table in the form elected. Instead, under the final rules, companies will continue to report the forgone amounts in the salary or bonus column, with footnote disclosure of the receipt of non-cash compensation that refers to the Grants of Plan-Based Awards Table.

Director and Director Nominee Qualifications
The new rules expand required disclosures regarding directors and director nominees. Companies will be required to disclose the specific experience, qualifications, attributes, and skills of each director and nominee that led to the conclusion that the person should serve as a director of the company, when considered in light of the company’s business and structure. As noted above, the requirement to make such disclosure with respect to board committees was not adopted as proposed. The expanded disclosure requirements will apply to incumbent directors and nominees selected by the company and to any nominees put forward by other proponents. Companies also will be required to disclose any public company directorships held by each director and nominee at any time during the past five years, rather than current directorships only.

Director, Director Nominee, and Executive Officer Legal Proceedings
Disclosure will be required of certain bankruptcy-, criminal-, or securities-related legal and similar proceedings that have occurred during the preceding 10 years, rather than, as under the previous rules, the preceding five years. As noted above, the final rules add two additional categories of proceedings to the list triggering disclosure. Specifically, disclosure will be required if, within the last 10 years, a director, nominee for director, or executive officer was the subject of, or a party to:

  • A judicial or administrative order, judgment, decrees, or finding relating to:
  • An alleged violation of any securities or commodities law or regulation
  • Any law or regulation with respect to financial institutions or insurance companies
  • Any law or regulation prohibiting mail or wire fraud or fraud in connection with any business entity
  • Any sanction or order of any self-regulatory organization, any registered entity (as defined in the final rules), or any equivalent exchange association, entity, or organization that has disciplinary authority over its members or persons associated with a member

Director Diversity Policy
In the proposing release for the new rules, the SEC solicited comments concerning whether it should amend its rules to require disclosure of additional factors considered by a nominating committee when selecting someone for a board position. In response to several commenters who indicated that disclosure about board diversity was important to investors, the final rules expand the required disclosure concerning the nominating committee’s process for identifying and evaluating nominees for director to include disclosure of whether and how the nominating committee or the board considers diversity in identifying nominees for director. The implementation of any policy with regard to the consideration of diversity in identifying director nominees must be described as well as how the nominating committee or the board assesses the effectiveness of such policy. Companies may wish to revisit their nominating committee charters to assess what form their disclosure concerning board diversity will take.

Board Leadership Structure
Under the final rules, consistent with the proposed rules, companies will be required to disclose the leadership structure of their boards of directors and justify it, providing an explanation for why they believe such structure is appropriate given their specific characteristics or circumstances. Companies will be required to disclose specifically whether and why they have combined or separated the principal executive officer and board chair positions. Companies that have combined principal executive officer and board chair positions also will be required to disclose whether they have a lead independent director and, if they do, the specific role that the lead independent director has in the leadership of the company.

Board Role in Risk Oversight
Under the final rules, companies will be required to disclose the extent of the board’s role in their risk oversight such as how the board administers its risk oversight function, and the effect that this has on the board’s leadership structure. Such disclosure might include, for example, whether the company’s risk management function is implemented and managed by the entire board or through a committee and whether the persons overseeing risk management report to the board or a committee.

Conflicts of Interest Involving Compensation Consultants
Consistent with the proposed rules, the final rules include new disclosures intended to address potential compensation consultant conflicts of interest, although the circumstances in which the additional disclosures are required have been curtailed somewhat from the original proposal. Fee disclosure related to the retention of a compensation consultant will be required as follows:

  • If the compensation committee (or the board or other persons performing similar functions) engages its own consultant to provide advice or recommendations on the amount or form of executive and director compensation and such consultant or its affiliates provide other non-executive compensation consultant services to the company, disclosure of fees paid for both types of services is required if the fees for the non-executive compensation consulting services exceed $120,000 during the company’s fiscal year. If this disclosure is required, companies also must disclose whether the decision to engage the compensation consultant for such non-executive compensation consulting services was made or recommended by management and whether the board has approved such services.
  • If the compensation committee (or the board or other persons performing similar functions) has not engaged its own consultant, fee disclosures are required with respect to any consultant or its affiliates providing executive compensation consulting services and non-executive compensation consultant services at the behest of management, if the fees paid for such non-executive compensation consultant services exceed $120,000 during the company’s fiscal year.
  • Fee and related disclosure for consultants that work with management is not required if the board has its own, distinct consultant, regardless of whether the fees paid exceed $120,000.
  • Services involving only broad-based non-discriminatory plans or the provision of information, such as surveys, that are not customized for the company, or are customized based on parameters that are not developed by the consultant, are not treated as executive compensation consulting services for these purposes.

Form 8-K Disclosure of Shareholder Voting Results
Currently, companies are required to report the results of shareholder votes in the periodic report for the period in which the vote was taken. Consequently, results of shareholder votes may not be disclosed until some time after the vote is taken. Under new Item 5.07 of Form 8-K, companies will be required to report within four days after they submit any matter to a shareholder vote (i) the date of the meeting and whether it was an annual or special meeting; (ii) if the meeting involved the election of directors, the name of each director elected, a brief description of each other matter, and the voting results; and (iii) the terms of any settlement between the company and any other participant terminating any solicitation subject to Rule 14a-12(c) under the Securities Exchange Act of 1934, as amended. Companies will be required to disclose preliminary voting results within four business days, followed by an amendment with final voting rules, unless they are able to disclose final voting results within four business days.

Rules for Management Investment Companies
The rules expand disclosures for directors and director nominees, leadership structure, and risk oversight for management investment companies such as mutual funds registered under the Investment Company Act of 1940. Specifically, the rules require proxy statements and the statement of additional information of an investment company to describe the investment company’s leadership structure and explain why the investment company believes the leadership structure is appropriate. The rules also require an investment company to disclose whether the chairman of the board of the investment company is an “interested person” of the investment company. If the chairman of the board is an “interested person,” the investment company must disclose whether it has a lead independent director and the role of lead independent director. The rules require investment companies to disclose the board’s role in the investment company’s risk oversight, how the board administers its oversight function, and the effect that this has on the board’s leadership structure. Finally the rules require investment companies, with respect to each director, to briefly discuss the specific experience, qualifications, attributes or skills that led to the conclusion that the person should serve as a director in light of the investment company’s business and structure.

Any Form N1-A filed before the February 28, 2010 effective date of the new rules will not need to comply with the final rules, but Form N1-As filed on February 28, 2010 or thereafter will need to include disclosure responsive to the new requirements. Post-effective amendments to existing registration statements filed to comply with the new rules will be eligible for filing and immediate effectiveness under Rule 485(b) of the Securities Act of 1933.

 


1 The final rulemaking release, SEC Release No. 33-9089, is available at http://www.sec.gov/rules/final/2009/33-9089.pdf.

2 Foley’s Legal News Alert discussing the proposed rule changes is available at http://www.foley.com/publications/pub_detail.aspx?pubid=6199.

3 Smaller reporting companies will not be required to provide the new compensation risk disclosures.

 


Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues.

If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or the following individuals:

Peter C. Underwood
Milwaukee, Wisconsin
414.297.5630
punderwood@foley.com

Steven R. Barth
Milwaukee, Wisconsin
414.297.5662
sbarth@foley.com

Peter D. Fetzer
Milwaukee, Wisconsin
414.297.5596
pfetzer@foley.com

Jay O. Rothman
Milwaukee, Wisconsin
414.297.5644
jrothman@foley.com

Joshua A. Agen
Milwaukee, Wisconsin
414.297.5535
jagen@foley.com

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Related Services