Because an insider is not permitted to be aware of MNPI when adopting a 10b5-1 trading plan, it has been presumed that trades executed under a 10b5-1 plan should not be able to outperform the market.  However, there have been prior studies, and more recently a November 27, 2012 Wall Street Journal (WSJ) article titled “Executives’ Good Luck in Trading Own Stock”, that have cast doubts on this premise.  In light of the WSJ article, which the CII letter liberally references, the CII is expressing its concern that the rules governing 10b5-1 plans are too lax and that insiders may be abusing the use of these plans.  The CII letter calls for greater involvement by company boards of directors and stricter regulatory rules including:

• Adoption of 10b5-1 plans may occur only during a company open trading window
• Prohibition of an insider having multiple, overlapping 10b5-1 plans
• Mandatory delay of at least three months between 10b5-1 plan adoption and the first trade under the plan
• Prohibition on frequent modifications/cancellations of 10b5-1 plan

The CII also advocates pre-announced disclosure of  10b5-1 plans and immediate disclosure of plan amendments and plan transactions.  Moreover, the employer’s board of directors would need to adopt policies covering 10b5-1 plan practices, monitor plan transactions, and ensure that such company policies discuss plan use in the context of equity hedging and ownership.

Some of the above concepts are considered by practitioners to constitute best practices but the CII letter’s recommendations, if adopted, would make them mandatory and place more accountability on companies. Indeed, if the CII proposals were implemented, it would likely materially alter the processes and practices for future 10b5-1 trading plans.

What Next?

Rule 10b5-1 trading plans can be a valuable tool for insiders with respect to managing their company securities.   Noncompliance with the SEC’s 10b5-1 regulations could cause the loss of the affirmative defense and thereby undermine the raison d’etre for trading under a 10b5-1 plan. Companies and their executives will want to monitor the SEC’s response to the CII letter and whether the SEC takes regulatory or enforcement actions regarding 10b5-1 plans.  Whether or not the SEC does implement any changes to the rules governing 10b5-1 trading plans, companies may want to review their insider trading policies and procedures regarding 10b5-1 trading plans to ensure that such plans are operating within the regulatory framework of Rule 10b5-1.

If you have any questions regarding this information, please contact Gregory Schick at (415) 774-2988.

Disclaimer

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.

In this regard, we reviewed EGC new IPO public filings with the Securities and Exchange Commission (SEC) for the ten weeks following the enactment of the JOBS Act and provide below our general observations on the executive compensation disclosures in such filings.

The executive compensation related provisions in the JOBS Act were effective upon enactment and are discussed below.  

Definition of an “Emerging Growth Company”

Under Section 101 of the JOBS Act, an “emerging growth company” means an issuer, other than an issuer that completed its IPO on or before December 8, 2011, that had total annual gross revenues of less than $1 billion during its most recently completed fiscal year.  Such an issuer remains as an EGC until the earliest of the:

• last day of its fiscal year during which it had total annual gross revenues of $1 billion or more (subject to inflationary adjustment by the SEC every five years);
• last day of its fiscal year following the 5^th anniversary of its IPO;
• date on which it has issued more than $1 billion in non-convertible debt during the previous 3-year period; or
• date on which it is deemed to be a “large accelerated filer” (which requires, among other things, having common equity held by non-affiliates with a market value of $700 million or more).

Significant Reduction in Executive Compensation Disclosure Requirements

Pursuant to Section 102(c) of the JOBS Act, an EGC is permitted to comply with Item 402 of Regulation S-K, which requires extensive quantitative and qualitative disclosure regarding executive compensation, by disclosing only the considerably more limited executive compensation disclosures required of a "smaller reporting company" (SRC).  Accordingly, among other things, an EGC:

• does not have to provide a Compensation Discussion and Analysis (CD&A);
• does not have to provide a disclosure of the relationship of compensation policies and practices to risk management;
• only has to provide a Summary Compensation Table (“SCT”) and an Outstanding Equity Awards at Fiscal Year-End Table with accompanying narrative text and does not have to provide any of the other compensation tables required for non-SRC issuers; and
• can limit its SCT to only its principal executive officer and its two most highly compensated officers (rather than also including the principal financial officer and a third most highly compensated officer) and to two (rather than three) fiscal years of compensation information.

Commentary on Executive Compensation Implications:  This significant reduction in the executive compensation disclosure requirements for EGCs provided by the JOBS Act may seem somewhat surprising given the federal government’s focus over the past several years on compelling fulsome disclosure of compensation programs and policies and agreements as they relate to the senior executives of publicly traded companies, including providing descriptions on the rationale for the issuer’s executive compensation decisions.  While SRCs enjoy the benefits of only having to provide scaled back executive compensation disclosures, EGCs may potentially be much larger in size and resources (and with a concomitant greater number of investors) than SRCs.  Thus, it remains to be seen whether the marketplace adopts these lessened compensation disclosure standards or will prefer to see disclosures that are otherwise required of non-SRCs.

We separately note that, except for qualifying performance-based compensation, Section 162(m) of the Internal Revenue Code generally limits a public reporting company’s tax deduction to $1 million of annual compensation paid to the company’s “covered employees” which consist of the company’s executive officers (other than the principal financial officer) who are required to be disclosed in the SCT.  While Section 162(m) does provide a transitional relief period of up to several years for new IPO companies, when Section 162(m) does become applicable to an EGC, such EGC will presumably have fewer covered employees to address by virtue of the JOBS Act limiting the number of executive officers that must be included in the SCT.

Exemption from Say-on-Pay, Say-on-Golden Parachutes and Other Compensation Related Provisions of the Dodd-Frank Act 

As we have previously commented (see for example our blog from July 26, 2010 “The Regulatory March to Reform Executive Compensation Practices Takes Another Step Forward”), the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) implemented numerous new laws affecting executive compensation and corporate governance at publicly held companies.   As a result of the Dodd-Frank Act, the Securities Exchange Act of 1934 (Exchange Act) now requires publicly held companies to provide their shareholders with the ability to render separate non-binding advisory votes to approve: (1) named executive officer compensation (Say-on-Pay), (2) the frequency of Say-on-Pay votes (Say-on-Frequency), and (3) golden parachute arrangements for the company’s named executive officers in connection with merger/acquisition and other similar transactions (Say-on-Golden Parachutes).   The Dodd-Frank Act also imposed other new executive compensation related disclosures on publicly held companies.

Pursuant to Section 102(a) of the JOBS Act, an EGC is exempt from complying with the following Dodd-Frank Act requirements (some of which have even yet to be implemented by the SEC):

• the Say-on-Pay, Say-on-Frequency and Say-on-Golden Parachutes for a minimum of three years (and potentially up to six years).  Note that by comparison, SRCs are exempt from Say-on-Pay and Say-on-Frequency votes only until January 21, 2013 and are not exempt from the Say-on-Golden Parachutes vote.
• disclosure relating to the relationship between executive compensation and financial performance of the issuer.
• disclosure as to the ratio between the annual total compensation of the CEO and the median of the annual total compensation of all employees of the company.

Commentary on Executive Compensation Implications:  The exemption from these Dodd-Frank Act requirements (which were created less than two years ago), and specifically the mandatory Say-on-Pay vote (which itself only commenced in 2011), is also somewhat surprising given the general desire to provide shareholders with a greater voice in their company’s executive pay practices.  Of course, as with most disclosure requirements, a company may elect to forego the above exemptions and voluntarily comply with some or all of the requirements that apply to non-EGCs.  And, the marketplace (or the shareholders of a particular EGC) may induce certain EGCs to provide these additional disclosures even if not technically required.

Confidentially Submit a Draft IPO Registration Statement Prior to Public Filing

Section 106 of the JOBS Act permits an EGC to submit a draft registration statement confidentially to the SEC for nonpublic review and such statement need not become publicly available until 21 days prior to the EGC’s first road show.  Additionally, the SEC announced in April 2012 that a registration fee is not required with a confidential draft registration statement.

Commentary on Executive Compensation Implications:  Since disclosure of executive compensation is generally a sensitive topic, and particularly so with respect to a private company that has not publicly made such disclosures until the IPO process, this represents a potentially beneficial reason for issuers to consider initially pursuing this confidential filing route in its IPO process.

SEC Directed to Review Regulation S-K

Section 108 of the JOBS Act directs the SEC to conduct a review of Regulation S-K to (i) comprehensively analyze the current registration requirements of the regulation and (ii) to “determine how such requirements can be updated to modernize and simplify the registration process and reduce the costs and other burdens associated with these requirements for issuers who are emerging growth companies.” 

The SEC is required to provide its recommendations to Congress no later than 180 days after April 5, 2012.

Commentary on Executive Compensation Implications:  It is currently unknown what recommendations will be made by the SEC to make the registration process more efficient and less burdensome for prospective issuers who are EGCs than already provided by the JOBS Act.  It will also be interesting to see if the SEC recommends any changes to the executive compensation disclosure rules which were significantly expanded in 2006 and which subsequently have already had further revisions.

Exclusion of Holders of Employee Benefit Plan Securities from the Exchange Act Registration “Held of Record” Definition

Prior to the JOBS Act, Section 12(g) of the Exchange Act and its related rules required a company with more than $10 million in assets and more than 500 holders of record of any class of its equity securities to register under the Exchange Act and begin complying with the extensive disclosure and financial reporting obligations applicable to publicly held companies. 

Section 502 of the JOBS Act now excludes securities held by persons who received them pursuant to employee compensation plans from the “held of record” definition.  Additionally, Section 501 of the JOBS Act increases the holder threshold to 2,000 holders, provided no more than 500 are unaccredited investors.  

Commentary on Executive Compensation Implications:  These amendments to Section 12(g) may be significant for larger privately held companies because it means that such private companies with numerous optionees, or awardees of compensatory equity awards other than stock options, can be less concerned with exceeding this threshold and thereby becoming subject to the disclosure and reporting requirements of a public company without having gone public in the traditional sense.

EGC IPO S-1 Filings Since JOBS Act Enactment

We looked at the nine EGC Form S-1 new IPO registration statements that were publicly filed with the SEC during the ten week period from the JOBS Act enactment through June 18, 2012.  We excluded from our survey those Form S-1 registration statements of companies that either (1) did not qualify as an EGC or (2) checked the box on their S-1 that stated that they were an SRC.  We note that the S-1 registration statements we reviewed had not yet been declared effective so it is conceivable that their executive compensation disclosures could be modified in future S-1 amendments.

While not a statistically significant sample size and while these filings present only a very preliminary indication of any future trend or what might become custom and practice since the JOBS Act was enacted less than three months ago, it does initially appear that new EGC filers  are generally omitting the CD&A section from their S-1 registration statements and are providing compensation disclosure on only the reduced number of executive officers.  Our findings are summarized below:

Number of Form S-1 Registration Statements: 9
Number of S-1s in which CD&A was Omitted: 7
Number of S-1s with CD&A and also reporting on Five Executive Officers: 2

All of the nine filers recited in their Form S-1s that they were EGCs, but one filer specifically stated that they would not be taking advantage of the lessened EGC requirements.  Most of the filers which did not provide a CD&A also reported only on the minimum number of three officers but some did report on more than three officers including one filer which expressly stated in their S-1 that they were voluntarily reporting on an additional executive officer.

What Next?

Companies that are contemplating an IPO will want to consider what level of executive compensation disclosure to provide in light of the JOBS Act.  Similarly, companies that complete the IPO process and qualify as an EGC will need to determine post-IPO whether or not to take full advantage of the JOBS Act reduced executive compensation requirements.   Some of these decisions of course may be affected by the EGC’s specific factual circumstances.

As noted above, the SEC is required to review and analyze Regulation S-K including specifically how to make the registration process more efficient and less burdensome for EGCs. Companies will want to monitor these developments and consider providing input into this process especially during any public comment period.

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988 or Nicole Slattery at (858) 720-7467.

Disclaimer

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.

Section 10C essentially provides that limited partnerships, companies in bankruptcy proceedings, registered open-end management investment companies registered under the Investment Company Act of 1940, and foreign private issuers that provide annual disclosures to shareholders of the reasons why the foreign private issuer does not have an independent compensation committee will not be subject to the Exchanges' listing requirements regarding compensation committee member independence. Section 10C further expressly provides that controlled companies are exempt from its requirements. The Final Rules provide a slightly modified definition of a "controlled company" for purposes of these rules and which more closely tracks the definition currently used by the NYSE and Nasdaq.

In response to the requirements of Section 10C, the SEC over one year ago on March 30, 2011 released the Proposed Rules (see our blog on the Proposed Rules from April 25, 2011 “SEC Proposes New Rules Calling For Greater Independence Standards for Compensation Committees and Their Advisors”) which are the foundation for the adopted Final Rules.

Below is a brief overview of the Final Rules (which are contained in new Rule 10C-1 of the Exchange Act which provides the listing standards related to compensation committees and in new Item 407(e)(3)(iv) to Regulation S-K which provides the disclosure requirements related to compensation consultant conflicts of interest).

Compensation Committee - Independence Requirements

The Final Rules will compel the Exchanges to establish listing standards that require each member of a listed issuer’s compensation committee to be: (i) a member of the board of directors and (ii) “independent.”  The term “independent” is not defined in the Final Rules  Instead, the Final Rules provide that “independent” is to be defined by the Exchanges after taking into consideration “relevant factors” which shall include, but are not limited to:

• the source of compensation of a director of an issuer, including any consulting, advisory or other compensatory fee paid by the issuer to the director; and
• whether the director of an issuer is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer.

The Exchanges are given the flexibility to establish their own minimum independence criteria for compensation committee members after considering the relevant factors enumerated above.  An Exchange may add other factors subject to approval by the SEC.  The Final Rules authorize the Exchanges to establish listing standards that exempt particular relationships between members of the compensation committee and listed issuers that might otherwise impair the member’s independence, taking into consideration the size of an issuer and any other relevant factors.  The listing standards adopted by the Exchanges shall generally apply to any committee of the board of directors that performs functions typically performed by a compensation committee, including oversight of executive compensation, whether or not such committee also performs other functions or is formally designated as a "compensation committee".

The existing independence requirements for audit committee members under Exchange Act Rule 10A-3 and the Final Rules' requirements for compensation committee members are generally similar.  However, with respect to defining compensation committee member independence, the Exchanges will only have to consider the above relevant factors.  In contrast, the SEC's rules for audit committee independence prescribe specific minimum criteria and permit the Exchanges to adopt even more stringent independence requirements if desired.  Thus, an audit committee member cannot accept any consulting, advisory or other compensatory fee and cannot be an affiliated person of the issuer or its subsidiaries.  With respect to compensation committee member independence, the Exchanges will have more flexibility in determining whether or not to impose any specific criteria that would per se preclude compensation committee membership.

Compensation Committee – Authority and Funding

The Final Rules include a number of requirements that are intended to ensure that the compensation committee has the requisite authority and autonomy to perform its role.  These include the following:

• Each compensation committee must have the authority, in its sole discretion, to retain or obtain the advice of compensation consultants, independent legal counsel and other advisers who are retained by the compensation committee (collectively, “compensation advisers”);
• Each compensation committee must be directly responsible for the appointment, compensation and oversight of the work of any compensation adviser; and
• Each issuer must provide appropriate funding for the payment of reasonable compensation, as determined by the compensation committee, to compensation advisers.

Compensation Advisers - Independence Requirements

The Final Rules require that the Exchanges' listing standards provide that the compensation committee may select a compensation adviser only after taking into consideration the competitively neutral independence factors set forth below.  Moreover, the Exchanges may add other independence factors that must be considered by the compensation committees of their listed issuers in addition to the mandatory independence factors.  The Final Rules do not require a compensation adviser to be independent, only that the compensation committee consider the below six factors before selecting a compensation adviser (whether it is a compensation consultant, legal counsel or other adviser).  Such independence factors are listed below.  The Proposed Rules only had contained the first five factors but the Final Rules added the last item listed below as an additional factor that must be considered.  The Final Rules contain a specific instruction that compels the compensation committee to conduct an independence assessment of any compensation adviser (other than in-house legal counsel) that provides advice to the committee including, for example, outside legal counsel.  This would also include performing an independence assessment on outside legal counsel or other compensation advisers who are retained by management or the issuer and who may also provide advice to the compensation committee.  The six factors are:

• The provision of other services to the issuer by the person that employs the compensation adviser;
• The amount of fees received from the issuer by the person that employs the compensation consultant, legal counsel or other adviser, as a percentage of the total revenue of the person that employs the compensation adviser;
• The policies and procedures of the person that employs the compensation adviser that are designed to prevent conflicts of interest;
• Any business or personal relationship of the compensation adviser with a member of the compensation committee;
• Any stock of the issuer owned by the compensation adviser; and
• Any business or personal relationship of the compensation adviser or the person employing the adviser with an executive officer of the issuer.

Opportunity to Cure Defects Before Delisting

Consistent with the requirements of Section 10C, the Final Rules require the Exchanges to establish procedures (if their existing procedures are not adequate) before the Exchange can prohibit the listing of, or delist, any security of an issuer.  Moreover, the Exchanges’ rules may provide that if a member of a compensation committee ceases to be independent for reasons outside the member’s reasonable control, that person, with notice by the issuer to the applicable Exchange, may remain a compensation committee member of the listed issuer until the earlier of the next annual meeting of the listed issuer or one year from the occurrence of the event that caused the member to no longer be independent. 

Exemptions From Listing Standards

In addition to the exemptions from the compensation committee independence rules provided by the Reform Act and which are mentioned above, the Final Rules provide some additional exemptions from the listing standards as shown below. In addition to controlled companies, the Final Rules expressly exempt smaller reporting companies from the listing standards.

• The listing standards are intended to apply only to issuers with listed equity securities. Accordingly, listed issuers with only debt securities would not be subject to these listing rules.
• Issuers of security futures products and standardized options are exempted from the listing standards.
• The Exchanges may exempt a category of issuers from the listing requirements as each Exchange determines is appropriate.  In April 2012, the Jumpstart Our Business Startups Act (JOBS Act) was enacted and which created a new category of issuer called the "emerging growth company" and it will be interesting to see if the Exchanges exempt emerging growth companies from some or all of these listing standards.

Compensation Consultants - Disclosure and Conflicts of Interest

Amendment to Item 407(e)(3) of Regulation S-K.  Under existing Item 407(e)(3)(iii) of Regulation S-K, companies are required to make certain disclosures regarding any role of a compensation consultant in determining or recommending the amount or form of executive and/or director compensation.  The Final Rules add a new disclosure requirement under new Item 407(e)(3)(iv) that will compel companies to disclose the nature of any conflict of interest, and how the conflict is being addressed, with respect to any compensation consultant who is identified under existing Item 407(e)(3)(iii).  The Final Rules include a specific instruction that identifies the six factors set forth above in assessing compensation adviser independence as among the factors that issuers should consider in determining whether there is a conflict of interest for the compensation consultant that may need to be disclosed.  This new disclosure rule of Item 407(e)(3)(iv) will apply to all issuers (including without limitation, controlled companies, non-listed issuers and smaller reporting companies) subject to the SEC's proxy statement reporting requirements.  Consulting work on broad-based plans and/or providing non-customized benchmark data will be exempted from the disclosure requirements of Item 407(e)(3).

Timing

To facilitate timely implementation of the Final Rules, within 90 days after publication of the Final Rules in the Federal Register, the Exchanges must propose to the SEC rules or rule amendments that comply with the Final Rules. Further, each Exchange will need to have final rule or rule amendments that comply with the SEC’s Final Rules no later than one year after publication of the Final Rules in the Federal Register.

The new disclosure requirements of Regulation S-K Item 407(e)(3)(iv) will become applicable in any proxy or information statement for annual (or special) meeting of shareholders at which directors will be elected on or after January 1, 2013.

What Next?

Listed companies may wish to review the independence and potential conflicts of interest for each of their compensation committee members, compensation consultants, compensation committee legal counsel and any other advisers in light of the relevant factors cited in the Final Rules.  Listed companies may also wish to monitor the rulemaking proposals which will be proffered in the near-term by the Exchanges so that they will be better prepared for the implementation of the new listing standards and with respect to making any needed modifications in their practices and/or governing documents such as the compensation committee charter.

In any event, while the Final Rules may not technically require compensation advisers to be independent, a company’s ability to affirmatively disclose that all advisers to the compensation committee are independent may be more favorably received by investors and proxy voting advisers and may potentially assist a company with obtaining a more positive Say-on-Pay vote in future years.

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988.

Disclaimer

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.

While the SEC's pay for performance regulations may not be effective in time for the 2012 proxy season, it does not mean that the alignment between executive pay and company performance is not being scrutinized.  In December 2011, Institutional Shareholder Services Inc. ("ISS"), a proxy advisory firm, released a comprehensive white paper ("Evaluating Pay for Performance Alignment") detailing its new pay for performance evaluation processes that will be effective for the 2012 proxy season and which ISS will utilize to evaluate whether or not a company's executive compensation practices are in proper alignment with its performance.  In its white paper, ISS noted that 94% of the institutional respondents to one of its policy surveys indicated that pay for performance is a critical/important consideration with respect to their Say on Pay vote determination.

ISS Evaluating Pay for Performance Alignment White Paper

The ISS white paper is detailed and contains a fair amount of complexity.  The discussion below is necessarily just a brief overview and the white paper provides much more details and rationale for the ISS methodology.  In a nutshell, the ISS methodology focuses on CEO pay and quantitatively compares it to long term total shareholder return ("TSR").  If the quantitative analysis indicates that there may be misalignment, then ISS will perform an in-depth qualitative review to determine either the likely cause of a perceived long-term disconnect between pay and performance, or factors that mitigate the initial quantitative assessment.  If after these evaluations have been completed, ISS believes that the company's executive compensation pay practices are an outlier then this, in their view, means that shareholders of such company may want to communicate their concern to the company about its pay-setting and could potentially cause ISS to recommend voting against the company's Say on Pay proposal.

In performing its quantitative assessment, ISS looks at the following three measures:

• Relative Degree of Alignment ("RDA") – Comparison of CEO pay and TSR, relative to an ISS selected peer group, over one and three year periods
• Multiple of Median – Relative comparison of the CEO's pay to the peer group median pay for the same time periods
• Pay to TSR Alignment – An absolute comparison of the trends of the CEO's annual pay and the Company's TSR over prior five year period

The ISS generally uses the Company's publicly disclosed compensation data in SEC filings with respect to CEO pay numbers.  The peer comparison group is selected by ISS and generally consists of 14 to 24 companies which are intended to be similar in terms of size, industry and market capitalization over one and three year periods.  The ISS constructs peer groups for all Russell 3000 companies twice per year utilizing Global Industry Classification Standard ("GICS") classifications and revenue/total assets and market value data.

ISS back-tested their pay alignment methodology using historical data.  The white paper states that the three quantitative measures were statistically significant predictors of Say on Pay votes, especially the RDA measure.  The white paper also states that companies whose quantitative assessments indicated that there was high concern for potential misalignment between pay and performance received fewer affirmative Say on Pay votes than companies which ISS determined were low concern companies.

After computing the three quantitative measures, ISS evaluates the results to see if there is a concern that the company's pay for performance practices are not in alignment.  If the quantitative analysis indicates significant misalignment, then ISS will perform a qualitative analysis on some or all of the following:

• Strength of Performance - Review of the ratio of performance to time based awards along with the overall ratio of performance based compensation to total compensation
• Company's Peer Group Benchmarking – Review the company's selected peer group to see if the company is benchmarking to larger companies that are resulting in inflated compensation
• Financial/Operational Metrics – Evaluate the rigor of the company's performance goals upon which the compensatory payouts are based
• Special Circumstances – Assess any special circumstances (e.g., the hiring of a new CEO in the prior fiscal year) that could distort the quantitative analysis

Summary

Pay for performance will continue to be the mantra of corporate governance advocates and the subject of scrutiny by proxy advisory firms and institutional investors.  Therefore, among other things, companies may wish to examine the ISS white paper and assess how their pay for performance practices would be measured under the white paper's methodology.

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988.

Disclaimer

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.

• the source of compensation of a director of an issuer, including any consulting, advisory or other compensatory fee paid by the issuer to the director; and
   
• whether the director of an issuer is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer.

The Exchanges are given the flexibility to establish their own minimum independence criteria for compensation committee members after considering the relevant factors enumerated above. An Exchange may add other factors subject to approval by the SEC. The Proposed Rules would authorize the Exchanges to establish listing standards that exempt particular relationships between members of the compensation committee and listed issuers that might otherwise impair the member’s independence, taking into consideration the size of an issuer and any other relevant factors.

It is interesting to note that the existing independence requirements for audit committee members under Exchange Act Rule 10A-3 and the Proposed Rules' requirements for compensation committee members are generally similar, although there is at least one significant difference which relaxes the independence standards for compensation committees. With respect to defining compensation committee member independence, the Exchanges will only have to consider the above relevant factors. In contrast, the SEC's rules for audit committee independence prescribe specific minimum criteria and permit the Exchanges to adopt even more stringent independence requirements if desired. Thus, an audit committee member cannot accept any consulting, advisory or other compensatory fee and cannot be an affiliated person of the issuer or its subsidiaries. This could be an important difference since, for example, a director who is a member of a venture capital firm or private equity fund which is a major investor of the issuer and who therefore is deemed to be an affiliate of the issuer may still be able to serve on the compensation committee whereas he/she would be unable to serve on the audit committee.

Compensation Committee – Authority and Funding

The Proposed Rules include a number of requirements that are intended to ensure that the compensation committee has the requisite authority and autonomy to perform its role. These include the following:
 

• Each compensation committee must have the authority, in its sole discretion, to retain or obtain the advice of compensation consultants, independent legal counsel and other advisers (collectively, “compensation advisers”);
   
• Each compensation committee must be directly responsible for the appointment, compensation and oversight of the work of any compensation adviser; and
   
• Each issuer must provide appropriate funding for the payment of reasonable compensation, as determined by the compensation committee, to compensation advisers.

COMPENSATION ADVISERS - INDEPENDENCE REQUIREMENTS

The Proposed Rules will require that the Exchanges' listing standards provide that the compensation committee may select a compensation adviser only after taking into consideration the competitively neutral independence factors set forth below. The Exchanges may add other independence factors that must be considered by the compensation committees of their listed issuers. The Proposed Rules do not require a compensation adviser to be independent, only that the compensation committee consider the below factors before selecting a compensation adviser (whether it is a compensation consultant, legal counsel or other adviser). Such independence factors are:
 

• The provision of other services to the issuer by the person that employs the compensation adviser;
   
• The amount of fees received from the issuer by the person that employs the compensation consultant, legal counsel or other adviser, as a percentage of the total revenue of the person that employs the compensation adviser;
   
• The policies and procedures of the person that employs the compensation adviser that are designed to prevent conflicts of interest;
   
• Any business or personal relationship of the compensation adviser with a member of the compensation committee; and
   
• Any stock of the issuer owned by the compensation adviser.

OPPORTUNITY TO CURE DEFECTS BEFORE DELISTING

Consistent with the requirements of Section 10C, the Proposed Rules will require the Exchanges to establish procedures (if their existing procedures are not adequate) before the Exchange can prohibit the listing of, or delist, any security of an issuer.  Moreover, the Exchanges’ rules may provide that if a member of a compensation committee ceases to be independent for reasons outside the member’s reasonable control, that person, with notice by the issuer to the applicable Exchange, may remain a compensation committee member of the listed issuer until the earlier of the next annual meeting of the listed issuer or one year from the occurrence of the event that caused the member to no longer be independent.

EXEMPTIONS FROM LISTING STANDARDS

In addition to the exemptions from the compensation committee independence rules provided by the Reform Act and which are mentioned above, the Proposed Rules provide some additional exemptions from the listing standards including the following.
 

• The listing standards are intended to apply only to issuers with listed equity securities. Accordingly, listed issuers with only debt securities would not be subject to these listing rules.
   
• Issuers of security futures products and standardized options are exempted from the listing standards.
   
• The Exchanges may exempt a category of issuers from the listing requirements as each Exchange determines is appropriate. In determining appropriate exemptions, the Exchanges are required by Section 10C to take into account the potential impact of the requirements of the Final Rules on small reporting issuers.

COMPENSATION CONSULTANTS - DISCLOSURE AND CONFLICTS OF INTEREST

Amendments to Item 407 of Regulation S-K. The Proposed Rules’ amendments to Item 407 of Regulation S-K would require the following disclosures in any proxy or information statement relating to an annual meeting of shareholders (or a special meeting in lieu of the annual meeting) at which directors are to be elected.  These new disclosure rules would apply to all issuers (including without limitation, controlled companies) subject to the SEC's proxy statement reporting requirements.
 

• Disclose whether the issuer’s compensation committee “retained or obtained” the advice of a compensation consultant during the issuer's last completed fiscal year.
  
  
  • The phrase “obtained the advice” relates to whether a compensation committee or management has requested or received advice from a compensation consultant, regardless of whether there is a formal engagement of the consultant or a client relationship between the compensation consultant and the compensation committee or management or any payment of fees to the consultant for its advice.
     
• Disclose whether the work of the compensation consultant raised any conflict of interest.
  
  
  • The term “conflict of interest” is not defined. However, the Proposed Rules include an instruction that identifies the factors set forth above in assessing compensation adviser independence as among the factors that issuers should consider in determining whether there is a conflict of interest that may need to be disclosed.
     
• Disclose the nature of any conflict of interest and how the conflict is being addressed.
  
  
  • If a compensation committee determines that there is a conflict of interest with the compensation consultant, then the issuer must provide a clear, concise and understandable description of the specific conflict and how the issuer addressed it. 

The proposed amendments would also eliminate the existing exception from the requirement to identify compensation consultants and describe their engagement for those cases in which a consultant’s role is limited to consulting on a broad-based plan for providing information that either is not customized for a particular registrant or that is customized based on parameters that are not developed by the compensation consultant, and about which the compensation consultant does not provide advice.

SMALLER REPORTING COMPANIES

As written, the Proposed Rules would apply to smaller reporting companies.  However, the SEC has sought comment on whether smaller reporting companies should be exempt from any of the above-proposed disclosure requirements or to scale the proposed amendments to reflect the characteristics of small entities and the needs of their investors in the Final Rules. Further, as noted above, the Proposed Rules permit the Exchanges to exempt particular categories of issuers, including smaller reporting companies, from the rules or rule amendments they adopt in compliance with the Proposed Rules.

TIMING

The Final Rules must be adopted by July 16, 2011. To facilitate timely implementation of the Final Rules, the SEC has proposed that each Exchange provide to the SEC, no later than 90 days after publication of the Final Rules in the Federal Register, proposed rules or rule amendments that comply with the Final Rules. Further, each exchange would need to have final rule or rule amendments that comply with the SEC’s Final Rules no later than one year after publication of the Final Rules in the Federal Register. The new disclosure requirements of Item 407 presumably will become applicable to definitive proxy statements that are filed after the publication of the Final Rules.

WHAT NEXT?

Companies may wish to start reviewing the independence and potential conflicts of interest for each of their compensation committee members, compensation consultants, compensation committee legal counsel and any other advisors in light of the relevant factors cited in the Proposed Rules.  While the Final Rules may not require independent compensation advisors, a company’s ability to affirmatively disclose that such advisors are all independent will presumably be more favorably received by investors and proxy voting advisors and may assist a company with obtaining a more positive Say-on-Pay vote in future years.

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988 or Nicole Slattery at (858) 720-7467.

Disclaimer

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.

If you have any questions regarding Say-on-Pay, please contact Greg Schick at (415) 774-2988 or gschick@sheppardmullin.com.

SAY-ON-FREQUENCY RECOMMENDATIONS BY BOARD

DID BOARD'S SAY-ON-FREQUENCY RECOMMENDATION RECEIVE THE MOST SHAREHOLDER VOTES?

Comment

We will be providing periodic blog updates on the results and trends of Say-On-Pay votes as public companies go through the Say-On-Pay process for the first time in 2011. Companies should stay abreast of any trends and practical developments as well as any future regulatory guidance provided by the SEC during this evolutionary phase of Say-On-Pay. 

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988.

Disclaimer

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.

• Say-on-Pay and Say-on-Frequency – The Final Rules clarify that the Say-on-Pay and Say-on-Frequency advisory shareholder votes need to be included in a company's proxy statement only for annual or other shareholder meetings at which directors are being elected.
  
  
  • The Final Rules require a company to include in its proxy materials the current frequency of its Say-on-Pay advisory shareholder vote (e.g., annual, every other year, or every three years) and to also state when the next Say-on-Pay vote will occur. These disclosures are not required in the proxy statement for the first Say-on-Pay and Say-on-Frequency votes.
  • The Final Rules provide an instruction that a company's resolution text for the Say-on-Pay vote must indicate that such vote is to approve the compensation of the company's NEOs as disclosed pursuant to Item 402 of Regulation S-K. While the Final Rules do not mandate specific language for this resolution, the Final Rules do provide a non-exclusive example of a resolution that will satisfy the applicable requirements. The sample resolution text provided in the Final Rules is: "RESOLVED, that the compensation paid to the company’s named executive officers, as disclosed pursuant to Item 402 of Regulation S-K, including the Compensation Discussion and Analysis, compensation tables and narrative discussion, is hereby APPROVED.”  
  • The Final Rules permit a company to exclude a shareholder proposal that would provide a Say-on-Pay vote or seeks future Say-on-Pay votes or that relates to Say-on-Frequency votes, provided the company has adopted a policy on the Say-on-Frequency votes that is consistent with the majority of votes cast in the most recent vote (as opposed to the plurality standard contained in the Proposed Rules).
     
    • Since the majority vote standard is now required, it is therefore possible that no single frequency choice will receive a majority of votes and as a result, such companies may not be able to exclude subsequent shareholder proposals regarding Say-on-Pay matters even if they adopt a policy on frequency that is consistent with the plurality of votes cast.

• Relief for Smaller Reporting Companies – The Final Rules adopted a temporary two-year delayed implementation of the Say-on-Pay and Say-on-Frequency votes for smaller reporting companies (i.e., companies with a public float of less than $75 million). Accordingly, smaller reporting companies are not required to conduct these two shareholder advisory votes until annual meetings occurring on or after January 21, 2013. Smaller reporting companies did not, however, receive an exemption from the Say-on-Golden Parachutes compensation vote.
• Transactions Requiring Say-on-Golden Parachutes Vote and Related Disclosure – A Say-on-Golden Parachutes vote and related disclosure on golden parachute compensation is required to be included in the proxy solicitation in connection with M&A transactions. The Say-on-Golden Parachutes compensation disclosure (but not its advisory vote) is required in connection with other transactions, including Rule 13e-3 going-private transactions and third-party tender offers, so that the golden parachute compensation information is available for shareholders no matter the structure of the transaction. However, the Final Rules now exempt bidders in third-party tender offers from the golden parachute compensation disclosure requirement (although companies filing solicitation/recommendation statements on Schedule 14D-9 in connection with third-party tender offers will be obligated to provide this additional disclosure).
• Compliance date for Say-on-Golden Parachutes Vote and Related Disclosure – All companies, including smaller reporting companies, are required to comply with the Say-on-Golden Parachutes compensation shareholder advisory vote and related disclosure requirements in proxy statements and other schedules and forms initially filed on or after April 25, 2011.
• Form 8-K Disclosure of Frequency Determination – Under existing disclosure rules, companies must disclose the results of shareholder votes within four business days of the vote. The Final Rules now require a company to disclose its decision regarding how frequently it will conduct Say-on-Pay votes in light of the voting results on Say-on-Frequency. Under amended item 5.07 of Form 8-K, this new disclosure will be included in an amendment to the company's prior Form 8-K filing that reported the Say-on-Frequency vote. This amended Form 8-K must be filed no later than the earlier of (i) 150 calendar days after the date of the annual meeting at which the Say-on-Frequency vote took place or (ii) 60 calendar days prior to the deadline for submission of Rule 14a-8 shareholder proposals for the subsequent annual meeting. This is a change from the Proposed Rules which would have required disclosure of such decision either in the Form 10-Q or Form 10-K.

Below is a brief overview of the Final Rules (additional provisions which remain unchanged from the Proposed Rules are described in our October 21, 2010 blog):

SHAREHOLDER ADVISORY SAY-ON-PAY VOTE

• Generally
  
  
  • What: (Final Rule 14a-21(a)). A separate shareholder advisory vote to approve the compensation of NEOs is required to be provided in a company's proxy statement for annual or other shareholder meetings at which directors are being elected (and in which executive compensation disclosure is required to be disclosed under Item 402 of Reg. S-K) at least once every three calendar years.
  • When: A Say-on-Pay vote is required for a company's (other than smaller reporting companies) first annual or other meeting of shareholders occurring on or after January 21, 2011.
    
    
    • Smaller reporting companies - A Say-on-Pay vote will be required for a smaller reporting company's first annual or other meeting of shareholders occurring on or after January 21, 2013.

• Required Disclosures
  
  
  • Item 24 of Schedule 14A; Item 402(b) of Reg. S-K; Form 8-K - Companies are required to disclose in their proxy statement that there is a separate Say-on-Pay vote and to explain the general effect of the Say-on-Pay vote including whether the vote is non-binding (which it almost certainly would be). 
  • Companies will need to describe in their Compensation Discussion and Analysis ("CD&A") section whether, and if so, how their compensation policies and decisions have considered and taken into account the results of the most recent Say-on-Pay vote. 
  • Companies are required to disclose in their proxy statements that contain a shareholder advisory vote on executive compensation the current frequency of their Say-on-Pay vote (e.g., annual, every other year, or every three years) and must also disclose when the next Say-on-Pay vote will occur. These disclosures are not required in the proxy statement for the first Say-on-Pay and Say-on-Frequency votes.
  • In accordance with the existing requirements under Form 8-K, companies are required to disclose the results of the Say-on-Pay vote within four business days of the shareholder meeting. 

SHAREHOLDER ADVISORY SAY-ON-FREQUENCY VOTE

• Generally
  
  
  • What: (Final Rule 14a-21(b)). Companies are required, not less frequently than once every six calendar years, to provide a separate shareholder advisory vote in proxy statements for annual or other shareholder meetings at which directors are being elected (and in which executive compensation is required to be disclosed under Item 402 of Reg. S-K) on whether the Say-on-Pay vote should occur annually, every other year or every three years. Proxy statements need to provide shareholders with four alternative choices: every 1, 2, or 3 years for the Say-on-Frequency vote or for shareholders to abstain from the vote.
  • When: A Say-on-Frequency vote is required for a company's (other than smaller reporting companies) first annual or other meeting of shareholders occurring on or after January 21, 2011.
    
    
    • Smaller reporting companies - A Say-on-Frequency vote will be required for a smaller reporting company's first annual or other meeting of shareholders occurring on or after January 21, 2013.

• Required Disclosures
  
  
  • Item 24 of Schedule 14A; Amendments to Rule 14a-4 and Form 8-K - Companies are required to disclose in the proxy statement that they are providing a separate shareholder vote on the frequency of the Say-on-Pay vote and to explain the general effect of the Say-on-Frequency vote including whether the vote is non-binding (we expect most companies will elect a non-binding vote).
     
    • In accordance with the existing requirements under Form 8-K, companies are required to disclose the results of the Say-on-Frequency vote within four business days of the shareholder meeting. 
    • Companies are also required under amended item 5.07 of Form 8-K to disclose, by filing an amendment to their prior Form 8-K that reported the Say-on-Frequency vote results, their decision on how frequently they will conduct the Say-on-Pay vote in light of the results of the Say-on-Frequency vote. This amended Form 8-K must be filed no later than the earlier of (i) 150 calendar days after the date of the annual meeting in which the vote took place or (ii) 60 calendar days prior to the deadline for submission of Rule 14a-8 shareholder proposals for the subsequent annual meeting.

• Ability to Exclude Shareholder Proposals related to Say-on-Pay or Say-on-Frequency Votes
  
  
  • Amendment to Rule 14a-8 - As an incentive for a company to follow its shareholders' wishes as expressed in the most recent Say-on-Frequency vote, a company will be able to exclude shareholder proposals involving shareholder votes on NEO executive compensation or involving the frequency of such a vote from its proxy statement if: (i) a single frequency choice received a majority of the votes, and (ii) a company adopts a frequency for its Say-on-Pay votes that is consistent with such majority of votes cast in its most recent Say-on-Frequency vote.

SHAREHOLDER ADVISORY VOTE ON GOLDEN PARACHUTE ARRANGEMENTS

• Generally
  
  
  • What: (Final Rule 14a-21(c) and Amendments to Schedule 14A). A golden parachute compensation disclosure is required to be included in the proxy solicitation in connection with M&A transactions and other transactions including Rule 13e-3 going-private transactions and third-party tender offers. A separate shareholder advisory vote on approving NEO golden parachute arrangements will also need to be included in M&A transactions proxy solicitations (but not in connection with other transactions including Rule 13e-3 going-private transactions and third-party tender offers) in which shareholders were being asked to approve the company's corporate transaction. The advisory vote is only cast with respect to the golden parachute arrangements required to be disclosed by the Reform Act with respect to the specific transaction.
  •  When: The separate shareholder advisory Say-on-Golden Parachutes vote and related disclosure is required for M&A and other transaction proxy solicitations initially filed on or after April 25, 2011.

• Required Disclosures – Golden Parachute Compensation Table
  
  
  • Item 402(t) of Reg. S-K - Golden parachute arrangements for NEOs need to be described in proxy or consent solicitations issued in connection with M&A, going-private, third-party tend offers and similar transactions. Bidders in a third-party tender offer (so long as such offers are not also Rule 13e-3 going-private transactions) and foreign private issuers are exempt from the golden parachute compensation disclosure obligations.
  • Companies are required to disclose in their proxy solicitation, in both narrative and tabular form, the golden parachute arrangements of the NEOs. The Final Rules mandate using a specific "Golden Parachute Compensation" columnar table with elements that resemble the Summary Compensation Table. However, companies are permitted to add additional named executive officers and additional columns or rows to the tabular disclosure, so long as such disclosure is not misleading. Note that the Golden Parachute Compensation table would report on the applicable golden parachute compensation arrangements for the NEOs of both the target and acquiring company.
  • The Final Rules also provide that a company can (but does not have to) satisfy the requirement to disclose potential change in control compensation payments (required under Item 402(j) of Reg. S-K) in its annual proxy statement by providing the disclosure required under the new golden parachute compensation disclosure Item 402(t). The company must, however, still include disclosure in accordance with Item 402(j) about payments that may be made to NEOs upon termination of employment outside of a change in control of the company.

• Important Exception
  
  
  • Final Rule 14a-21(c) - As permitted by the Reform Act, a separate shareholder advisory vote on golden parachute arrangements is not required in the M&A proxy solicitation if disclosure of the same golden parachute compensation arrangements had been fully included in a previous Say-on-Pay vote (whether or not the shareholders had previously approved the executive compensation). However, if there have been any changes to such golden parachute arrangements (excluding for this purpose movements in the Company's stock price that had occurred over time), then such changes would trigger the disclosure and shareholder vote requirements for the new/revised golden parachute arrangements in the M&A proxy solicitation. In such case, the required disclosure will include two separate tables with one disclosing all of the golden parachute arrangements and the other table disclosing the new/revised arrangements that are subject to the shareholder advisory vote.
    
    
    • The Final Rules provide that changes that result only in a reduction in value of the total compensation payable will not require a new shareholder vote;
    • The Final Rules clarify that changes in compensation between the time of a regular Say-on-Pay vote and an actual corporate transaction and where such changes result from there being a new NEO, or additional grants of equity compensation in the ordinary course or increases in salary, are deemed to be significant changes to the golden parachute compensation disclosure and will trigger a Say-on-Golden Parachutes vote on such new arrangements.

TECHNICAL CLARIFICATIONS AND TRANSITIONAL ITEMS

• No Requirement to file Preliminary Proxy. The Final Rules provide that any shareholder advisory vote on executive compensation, including Say-on-Pay and Say-on-Frequency votes, will not trigger a preliminary filing of a proxy statement. 
• No Discretionary Broker Voting. The Final Rules reiterate that broker discretionary voting of uninstructed shares will not be permitted for the Say-on-Pay vote or the Say-on-Frequency vote.
• No Added Requirement for TARP Companies.  Companies with indebtedness under TARP already have a current obligation to conduct a shareholder vote on executive compensation and therefore the Final Rules provide that TARP companies will be exempt from having to conduct a Say-on-Pay or Say-on-Frequency vote.

What Next?

Although these executive compensation shareholder votes are only advisory in nature, companies will have to explain whether/how the voting results influences later decisions and actions on executive pay. Moreover, a negative Say-on-Pay vote is presumably something that a company and its executive officers, board of directors and compensation committee will want to avoid. Therefore, as we have previously commented (see for example our blogs from January 20, 2011 "Companies Should Not Take Lightly the Need for Full Compliance with the SEC's Executive Compensation Disclosure Rules", October 21, 2010 "Time to Get Ready for Say-on-Pay as SEC Releases Proposed Rules"), and July 26, 2010 "The Regulatory March to Reform Executive Compensation Practices Takes Another Step Forward"), companies should evaluate their executive compensation processes, arrangements and disclosures and seek to improve them if/as needed. 

In order to better assist shareholders in understanding the executive compensation programs and policies and to improve the likelihood of receiving a positive Say-on-Pay vote, companies should consider including an executive summary in the CD&A that clearly highlights the company's pay and governance practices and which provides a clear link between the company's performance and the resulting pay to its executives. Moreover, companies may want to also consider including a supporting statement with the Say-on-Pay proposal which enumerates the Board’s key reasons for recommending that shareholders approve the compensation of the company's NEOs. 

In preparing for the Say-on-Pay and Say-on-Frequency votes, companies may also want to start evaluating, if they have not yet already done so, the following:

• What Say-on-Frequency to recommend to shareholders and the reasons for the recommended frequency;
• Whether or not to use the sample Say-on-Pay resolution language that was included in the Final Rules and if not then what resolution text will be used instead; and
• Whether or not to include the Item 402(t) golden parachute compensation disclosures in the company's next annual proxy statement.

As Say-on-Pay is new and still evolving, we expect that there will be further interpretative guidance and instructions from the SEC forthcoming throughout this 2011 proxy season.

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988 or Nicole Slattery at (858) 720-7467.

Disclaimer

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.

• Reviewing their existing CD&A and tabular/narrative sections to ensure that they provide clear and comprehensive disclosure;
• Reviewing their golden parachute arrangements and determine if such arrangements are appropriate, defensible and transparent; and
• Examining and confirming full disclosure of perquisites received by the company's executive officers and directors.

Accordingly, and especially in light of Say-on-Pay, compensation committees should consider evaluating their executive compensation programs and disclosures, perhaps utilizing the assistance of its own advisors and legal counsel, from a fresh perspective with an objective of effecting improvements to the maximum extent possible.  Failure to do so could provoke comments from the SEC which could then force the company to have to amend its SEC filings or even subject the company and its officers to more severe consequences.

If you have any questions regarding this information, please contact Gregory Schick at (415) 774-2988 or Nicole Slattery at (858) 720-7467.

Disclaimer

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.

• What: (Proposed Rule 14a-21(a)). A separate shareholder advisory vote to approve the compensation of NEOs would need to be provided in a company's proxy statement for annual or other shareholder meetings (and in which executive compensation disclosure is required to be disclosed under Item 402 of Reg. S-K) at least once every three years. The proxy statement's Compensation Discussion and Analysis ("CD&A") section, executive compensation tables and other executive compensation disclosures, including for example disclosed risk considerations related to the compensation policies for NEOs would all be considered to be part of the executive compensation that is subject to the vote. Smaller reporting companies, while required to conduct a Say-on-Pay vote, would continue to not be required to prepare a CD&A. There is no mandated specific resolution language that will be the subject of the shareholder vote but the vote must be to approve the disclosed NEO compensation.
• When: A Say-on-Pay vote would be required for a company's first annual or other meeting of shareholders occurring after January 20, 2011.

Required Disclosures

• What: (Proposed Item 24 to Schedule 14A; Item 402(b) of Reg. S-K). Companies would be required to disclose in their proxy statement that they are providing a separate Say-on-Pay vote and to explain the general effect of the vote including whether the vote is non-binding.
  
  Companies would also need to describe in their CD&A whether and how their compensation policies and decisions have taken into account the results of the Say-on-Pay vote. Smaller reporting companies would be required to include such a disclosure in their proxy statement only if their consideration of Say-on-Pay vote results was a material factor in understanding their Summary Compensation Table information.

SHAREHOLDER ADVISORY VOTE ON FREQUENCY OF SAY ON PAY VOTE

Generally

• What: (Proposed Rule 14a-21(b)). Companies would be required, not less frequently than once every six years, to provide a separate shareholder advisory vote in proxy statements for annual or other shareholder meetings (and in which executive compensation is required to be disclosed) on whether the Say-on-Pay vote will occur every 1, 2 or 3 years (the "Frequency Vote"). Proxy statements would need to provide shareholders with the four alternative choices of selecting 1, 2, or 3 years for the frequency of the Say-on-Pay vote or to abstain. While the company's board of directors may include a recommendation as to which frequency shareholders should vote for, the Frequency Vote is on the preferred frequency itself and is not a vote to approve or disapprove the board's recommendation.
• When: A Frequency Vote would be required for a company's first annual or other meeting of shareholders occurring after January 20, 2011.

Required Disclosures

• What: (Proposed Item 24 to Schedule 14A; Proposed amendments to Rule 14a-4 and Forms 10-Q and 10-K). Companies would be required to disclose in the proxy statement that they are providing a separate shareholder vote on the frequency of the Say-on-Pay vote and to explain the general effect of the Frequency Vote including whether the vote is non-binding. In accordance with the existing requirements under Form 8-K, companies will be required to disclose the results of the shareholder votes within four business days of the shareholder meeting. Companies would also be required to disclose in their Form 10-Q (covering the period in which the Frequency Vote occurred) or Form 10-K (if the Frequency Vote occurred in the Company's fourth quarter) its decision on how frequently it will conduct the Say-on-Pay vote in light of the results of the Frequency Vote.

Ability to Exclude Shareholder Proposals related to Say-on-Pay or Frequency Vote

• What: (Proposed amendment to Rule 14a-8). In an interesting development, if a company adopts a frequency for its Say-on-Pay votes that is consistent with the plurality of votes cast in its most recent Frequency Vote, then the company will more easily be able to exclude from its proxy statements shareholder proposals involving shareholder votes on NEO executive compensation or involving the frequency of such a vote. Thus, there is an incentive for companies to adopt a frequency of Say-on-Pay votes that is consistent with the results of the non-binding Frequency Vote.

SHAREHOLDER ADVISORY VOTE ON GOLDEN PARACHUTE ARRANGEMENTS

Generally

• What: (Proposed Rule 14a-21(c) and Proposed Amendments to Schedule 14A). A separate shareholder advisory vote on approving NEO golden parachute arrangements would need to be included in M&A or similar transactions proxy solicitations in which shareholders were being asked to approve the company's corporate transaction. However, the advisory vote would only be on the golden parachute arrangements required to be disclosed by the Reform Act with respect to the specific M&A transaction. As noted below, the Proposed Rules would require disclosure of golden parachute compensation information that extends beyond the requirements of the Reform Act. Such additional disclosures, while required, would not be subject to the shareholder vote unless the company voluntarily decided to subject these additional golden parachute arrangements to the shareholder vote. As with the Say-on-Pay vote, there is no specific resolution language and the shareholder vote is not binding on the company or its directors.
• When: The separate shareholder advisory vote on golden parachute compensation arrangements will not be required for M&A proxy solicitations until the effective date of the SEC's final rules.

Required Disclosures – Golden Parachute Compensation Table

• What: (Proposed Item 402(t) of Reg. S-K). Golden parachute arrangements for NEOs would need to be described in proxy or consent solicitations issued in connection with M&A or similar transactions. Covered transactions would also include, among other things, going private transactions and third party tender offers. Moreover, bidders in a third party tender offer may also be required to include target company golden parachute arrangement information in its Schedule TO. Foreign private issuers would be exempt from the golden parachute compensation disclosure obligations.
  
  Companies would be required to disclose in their M&A proxy solicitation in both narrative and tabular form the golden parachute arrangements of the NEOs. The Proposed Rules would mandate using a specific "Golden Parachute Compensation" columnar table with elements that resembles the Summary Compensation Table. The Golden Parachute Compensation table would contain quantitative disclosure of the various elements of all golden parachute compensation (e.g., cash, equity, tax reimbursement, etc) that "is based on or otherwise relates to" the specific M&A transaction and these figures would be separately reported for each NEO along with aggregate totals. Items such as previously vested equity or post-transaction employment agreements would not be required to be reported under this disclosure item because such items are not based on or do not otherwise relate to the transaction. Note that the Golden Parachute Compensation table would report on the applicable golden parachute compensation arrangements for the NEOs of both the target and acquiring company.
  
  Each entry in the Golden Parachute Compensation table would require footnote identification and discussion of the material elements including payment triggering events and the conditions and form of payment. There would also need to be separate discussion of "single trigger" versus "double trigger" items.
  
  The SEC also acknowledged that the new required golden parachute compensation disclosures extend beyond what is technically required by the Reform Act. Therefore, the Proposed Rules make clear that the shareholder vote on golden parachute arrangements only relates to the agreements/understandings that are covered by the Reform Act.
  
  The Proposed Rules also provide that a company can (but does not have to) satisfy the requirement to disclose potential change in control compensation payments (covered under Item 402(j) of Reg. S-K) in its annual proxy statement by providing the disclosure required under new Item 402(t).
• When: The golden parachute compensation arrangements disclosure will not be required for M&A proxy solicitations until the effective date of the SEC's final rules.

Important Exception

• What: (Proposed Rule 14a-21(c)). As permitted by the Reform Act, a separate shareholder advisory vote on golden parachute arrangements would not be required in the M&A proxy solicitation if disclosure of the same golden parachute compensation arrangements had been fully included in a previous Say-on-Pay vote (whether or not the shareholders had previously approved the executive compensation). However, if there had been any changes to such golden parachute arrangements (excluding for this purpose movements in the Company's stock price that had occurred over time), then such changes would trigger the disclosure and shareholder vote requirements for the new/revised golden parachute arrangements in the M&A proxy solicitation. In such case, the required disclosure would include two separate tables with one disclosing all of the golden parachute arrangements and the other table disclosing the new/revised arrangements that would be subject to the shareholder advisory vote.

TECHNICAL CLARIFICATIONS AND TRANSITIONAL ITEMS

• No Requirement to file Preliminary Proxy. The Proposed Rules provide that Say-on-Pay and Frequency Votes will not trigger a preliminary filing of a proxy statement.
• No Discretionary Broker Voting. The Proposed Rules reiterate that broker discretionary voting of uninstructed shares would not be permitted for the Say-on-Pay vote or the Frequency Vote.
• No Added Requirement for TARP Companies. Companies with indebtedness under TARP already have a current obligation to conduct a shareholder vote on executive compensation and therefore the Proposed Rules provide that TARP companies would be exempt from having to conduct a Say-on-Pay or Frequency Vote.
• Transitional Guidance. The SEC acknowledged that its final rules on Say-on-Pay may not be effective before some companies file proxy statements for shareholder meetings which will occur after January 20, 2011. Therefore, the SEC provided some first year transitional relief in the Proposed Rules which can be relied on until the final rules are effective. The transitional relief essentially provides that, with respect to certain enumerated items, the SEC will not object if companies operate in a manner consistent with the Proposed Rules.

What Next?

As noted above, the Proposed Rules contain many requests by the SEC for comments on the provisions of the Proposed Rules. Any comments on the Proposed Rules must be submitted by November 18, 2010. Therefore, companies wishing to influence the outcome of the final regulations are urged to review the Proposed Rules and timely submit any comments. Companies may also wish to begin to evaluate what recommendation, if any, they will make with respect to the Frequency Vote and whether or not to provide the enhanced golden parachute disclosures in their next proxy statement in which there will be a Say-on-Pay vote.

As we have previously commented (see for example our blogs from July 26, 2010 "The Regulatory March to Reform Executive Compensation Practices Takes Another Step Forward" and March 8, 2010 "Proxy Season Heats Up as New Executive Compensation Rules are Effective and SEC Provides New Disclosure Guidance") companies should regularly evaluate their executive compensation processes, arrangements (especially their golden parachute arrangements given the heightened focus on golden parachutes under the Proposed Rules) and disclosures and seek to improve them if/as needed. If a company's shareholders were to reject a company's disclosed executive compensation or the company were to receive a significant number of negative Say-on-Pay votes, then such a result will not be a desirable outcome for the company or its board of directors.

Therefore, in light of Say-on-Pay, a company's compensation committee may want to consider initiating a review of the company's executive compensation arrangements and expected disclosures, perhaps with the assistance of its own advisors and counsel, and consider making necessary changes in order to best prepared for the 2011 Say-on-Pay vote. Implementing, before the Say-on-Pay vote, what are considered best compensation practices, removing or being prepared to explain/justify what may be perceived as overly risky or excessive compensation arrangements, and developing an organized and clear CD&A may help the company in its effort to receive affirmative Say-on-Pay votes. The formal advent of Say-on-Pay is just a few months away and there is no time like the present to start preparing for it.

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988.

Disclaimer

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.

• Director Qualifications and Experience – The SEC issued new interpretations that reiterate its desire for companies to provide fuller disclosure regarding the specific attributes/qualifications of each individual director on a person by person basis. This information would also be required for those directors who are not up for re-election in the case of a classified board. However, the SEC also reiterated that this information need not be provided for directors whose term would not be continuing after the applicable meeting of shareholders.
• Equity Compensation –As we previously reported in our December 18, 2009 blog, the SEC changed the requirements with respect to reporting equity compensation values in the Summary Compensation Table (and Director Compensation Table). That is, the grant date value of the estimated dollar values of equity-based compensation awards (as determined under FASB ASC Topic 718) will now be utilized as compared to the prior requirement of using the annual financial accounting expense recognized for such equity awards. Therefore, a number of new interpretations were provided regarding the reporting of equity compensation awards. For example, an interpretation was issued covering involved how to report the amount of compensation when a named executive officer leaves the company and, in connection with such separation from employment, the company then decides to accelerate vesting of an option grant that had been granted earlier in the same fiscal year. In addition, guidance was issued covering the exclusion of estimated forfeitures in valuing time-based vesting equity awards along with clarifying that an equity award that is forfeited by an executive officer in the year of grant will nevertheless still be included in determining whether such officer is one of the top most compensated executive officers for such year. The SEC also clarified when to report the grant of a performance based equity compensation award if a company's compensation committee retains discretion to reduce the earned value of the award (as often is the case for awards that are seeking to qualify as performance-based compensation under Internal Revenue Code Section 162(m)). And, the SEC's new interpretations addressed the proper reporting of compensation in the proxy's Summary Compensation Table when the settlement of incentive compensation arrangements can or does occur with company stock rather than cash.
• Compensation Consultants - Depending on the underlying facts (see our December 18, 2009 blog), the expanded rules can require a company to disclose additional information regarding fees paid to a company's compensation consultant for other services rendered by the consultant to the company (depending on what the other services were and for what purpose they were performed). The SEC issued new interpretations covering the types of such other services provided by the consultant along with addressing situations where the consultant's services are not customized for a company or are limited to broad-based plans that do not favor executive officers.
• Risk Management - The new rules provide that if risks arising from a company’s compensation policies and practices are “reasonably likely to have a material adverse effect on the company”, then the company must provide disclosure about such policies and practices as they relate to risk management and risk-taking incentives that can affect the company’s risk and management of that risk. A new interpretation was issued stating that such disclosure should be presented together with a company's executive compensation disclosures.
• Reporting of Shareholder Votes - The new rules require accelerated reporting of shareholder votes on Form 8-K within four business days of the shareholder meeting. The SEC provided a new interpretation stating that the end of the shareholder meeting is the triggering event for starting the four day period (such that if the meeting ended on Tuesday, day one would be Wednesday, and the four-business day filing period would end on Monday).
• Disclosure Requirements in Registration Statements - The SEC issued interpretations reiterating that if a registration statement or post-effective amendment is filed after the end of an issuer's fiscal year end but before its Form 10-K is due:
  
  
  • if filed on Form S-1, it must include Item 402 executive compensation disclosure prior to effectiveness
  • if filed on Form S-3, it may forward incorporate by reference to a subsequently filed Form 10-K

If a non-automatic shelf registration statement or post-effective amendment thereto is to be filed after the due date for the Form 10-K, the issuer must either file the definitive proxy statement before the Form S-3 is declared effective or include the officer and director information in the Form 10-K.

REVISED INTERPRETATIONS

• Equity Compensation – The SEC revised an interpretation covering the reporting of "re-load options" (i.e., where the optionee receives a new grant of options upon the exercise of an option) that were granted to a named executive officer. In such case, the grant date fair value of the additional options would need to be reported in the Summary Compensation Table in the aggregate amount. The SEC also has now stated that a company may provide the required valuation assumptions information for equity compensation awards (that would typically be incorporated by a reference to the company's financial statements) by reference to the Grants of Plan-Based Awards Table if the valuation assumptions are reported in such table.

WITHDRAWN INTERPRETATIONS

• Equity Compensation – As a result of the change in reporting equity compensation by switching to using grant date fair value, a number of the SEC's interpretations addressing the prior requirements of annual expense reporting became obsolete and therefore were withdrawn.

As we have mentioned in several of our prior blogs (see for example our December 18, 2009 blog), in addition to complying with the expanded disclosure rules, the SEC has clearly signaled that it will be expecting, and looking for, fuller compliance with its executive compensation reporting regulations along with clearer and more transparent company disclosures in annual proxy statements. Two primary areas that continue to receive greater SEC scrutiny are disclosure of performance targets and compensation benchmarking. Specific disclosure of performance targets which are a material element of compensation, and the actual achievement level against such targets, is required unless the company has a compelling explanation of why such disclosure would cause it competitive harm. And, the SEC has indicated that the competitive harm argument is unlikely to be successful after the company has disclosed the actual bonus amounts and particularly if the performance targets are tied to company-wide financial results that are publicly reported. Similarly, when a company refers to a peer group used for benchmarking purposes, the SEC expects to see disclosure of the names of the peer group companies, how they were selected, and where actual awards fell relative to the benchmark. Therefore, in conjunction with responding to the new disclosure requirements, reporting companies should avoid simply repeating last year's proxy disclosures. Rather, companies should consider re-examining the text and format of their prior /proxy disclosures from a fresh perspective with an objective of effecting improvements to the extent possible. Failure to do so could provoke comments from the SEC which could then force the company to have to amend its SEC filings.

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988.

• FY End Before 12/20/09 - If a company's fiscal year ends before December 20, 2009, its 2009 Form 10-K and related proxy statement are not required to be in compliance with the new proxy disclosure requirements.
• FY End On or After 12/20/09 - If a company's fiscal year ends on or after December 20, 2009, its Form 10-K and proxy statement must be in compliance with the new proxy disclosure requirements if filed on or after February 28, 2010. A preliminary proxy statement filed before February 28, 2010 would also need to comply with the new disclosure rules if its definitive proxy will be filed on or after February 28, 2010. Similarly, if a company files its 2009 Form 10-K before February 28, 2010 and its proxy statement on or after February 28, 2010, the proxy statement must be in compliance with the new proxy disclosure requirements.

With respect to registration statements and the accelerated reporting (on Form 8-K) of results from shareholder meetings:

• Registration Statements – For companies with a 2009 fiscal year that ends before December 20, 2009, any Securities Act or Exchange Act registration statements that are filed before the company's 2010 Form 10-K is required to be filed would not be subject to the Regulation S-K amendments.
• Shareholder Meetings - Any shareholder meeting that takes place on or after February 28, 2010 will be subject to the new Form 8-K accelerated reporting requirements.

The Q&As in the interpretations also provided effective date guidance for: (i) companies that wish to voluntarily comply with the new disclosure rules in its 2009 Form 10-K and related proxy statement (even if not required to do so) and (ii) companies that are going through the IPO process or filing a first registration on Form 10.

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988.

• Compensation Policies and Risk.To the extent that risks arising from a company’s compensation policies and practices are “reasonably likely to have a material adverse effect on the company”, then the company must provide disclosure about such policies and practices as they relate to risk management and risk-taking incentives that can affect the company’s risk and management of that risk. This would cover compensation policies affecting all employees and not just the company’s named executive officers. In a departure from the proposed rules, this new disclosure would have its own section and would not be required to be a part of the Compensation Discussion & Analysis (CD&A) section. However, to the extent that risk considerations are a material aspect of the company’s compensation policies or decisions for named executive officers, the company would be required to discuss them as part of its CD&A. Smaller reporting companies will not be subject to this new requirement to provide disclosure on risk considerations. Moreover, a company will not be required to make an affirmative statement in its disclosures that it has determined that the risks arising from its compensation policies and practices are not reasonably likely to have a material adverse effect on the company.
• Equity Compensation Value Change. The grant date value for the disclosure of the estimated dollar values of equity-based compensation awards, as determined under FASB ASC Topic 718 (formerly referred to as FAS 123(r)), will now be utilized as compared to the current requirement of using the annual financial accounting expense recognized for such equity awards in the Summary Compensation Table and Directors Compensation Table. For performance-based awards, the estimated grant values shall now be calculated based on the probable outcome of the performance condition(s) determined as of the grant date. But, the compensation tables must be annotated with a footnote reporting the maximum value that can be earned under a performance-based award assuming the highest level of the performance conditions is achieved. In transitioning to the new reporting requirements, companies will need to restate the values of equity compensation awards for prior fiscal years in their compensation tables but would not need to change their named executive officers based on the recomputed values.
• Director Qualifications, Legal Proceedings and Board Diversity.The amendments require companies to annually disclose for all directors, and for any nominee for director, the particular experience, qualifications, attributes or skills that led the board to conclude that the person should serve as a director for the company. If an individual is chosen to be a director or a nominee to the board because of a particular qualification, attribute or experience related to service on a specific committee, such as the audit committee, then this should also be disclosed. Companies must now disclose any directorships at public companies and registered investment companies held by each director and nominee at any time during the past five years. In addition, the time period during which disclosure of legal proceedings involving directors, director nominees and executive officers is required has increased from five to ten years and the types of covered legal proceedings has been expanded as well. Companies must also disclose whether, and how, a nominating committee considers diversity in identifying nominees for director. The amendments expressly do not provide a definition for “diversity” and instead companies will be allowed to define diversity in ways that they consider appropriate.
• Board Leadership Structure and Risk Management.Companies will now be required to disclose whether and why it has chosen to combine or separate the principal executive officer and board chairman positions, and the reasons why the company believes that this board leadership structure is the most appropriate structure for the company. If the role of principal executive officer and board chairman are combined, and a lead independent director is designated to chair meetings of the independent directors, then the company must disclose whether and why it has a lead independent director, as well as the specific role the lead independent director plays in the leadership of the company. The board of directors’ role in risk management would also need to be addressed and discussed in the company’s disclosures.
  
  
• Fee Disclosures for Compensation Consultants.If the board or compensation committee has engaged its own compensation consultant and if such consultant provides other non-executive compensation consulting services to the company, then the company must make fee and related disclosures regarding the consultant if the fees for the non-executive compensation consulting services exceed $120,000 during the company’s fiscal year. Even if the board or committee has not engaged its own compensation consultant, fee disclosures will be required if there is a consultant providing executive compensation consulting services and non-executive compensation consulting services to the company, provided the fees for the non-executive compensation consulting services exceed $120,000 during the company’s fiscal year. The amendments do not require disclosure of the nature and extent of additional services provided by the compensation consultant to the company.

• Accelerated Reporting of Shareholder Vote Results.Accelerated disclosure on Form 8-K of results on proposals voted on by shareholders will now be required within four business days of a shareholder meeting rather than the existing practice of providing such disclosures on the next filed Form 10-Q or 10-K.
• Consideration of Proxy Solicitation and Other Potential Reforms is Deferred.The consideration of several proposed amendments governing the proxy solicitation process and other proposed enhanced disclosure requirements will be deferred until a later time.

What to Do Now and SEC Expectations

As we have been commenting in our recent blogs, publicly held companies should examine and revise as necessary their existing compensation/risk management processes and practices, D&O questionnaires, committee charters, organizational structure, etc. in order to be able to prepare the requisite disclosures. The amendments significantly expand the disclosure requirements and it will not be a trivial effort for most companies to adequately comply with these new rules.

In this regard, it is worth noting that the SEC now has greater expectations for executive compensation disclosures. In November 2009, Shelley Parratt, the SEC’s Deputy Director, Division of Corporation Finance, stated in a widely-heard speech that the SEC’s expectations for "quality disclosure are heightened and we will reflect this in our comments." She reiterated that the SEC expects companies and their advisors to understand the disclosure rules and apply them thoroughly. Accordingly, in lieu of making "futures" comments (in which companies can provide information or required disclosures in response letters to the SEC and/or in future filings, as opposed to having to file an amendment to the filing under review), the SEC will now be more likely to compel companies amend their filings if the company has not materially complied with the executive compensation disclosure rules.

Ms. Parratt’s speech echoed a recurring complaint of the SEC when she stated that companies should focus their attention on improving their analysis that is contained in the CD&A and providing disclosure of performance targets if such targets are material to the company’s compensation policies and decisions. Her speech emphasized that the CD&A is to provide the how and why of the specific compensation decisions that were made and that companies need not include elaborate text reciting the framework in which decisions were made or listing out the many tools that were utilized in the decision-making process without discussing how such tools affected the resulting compensation decisions. In summary, Ms. Parratt stated that companies need to make their disclosures "more meaningful and understandable."

Companies should consider taking a fresh look at the many areas touched upon by the amendments especially in this highly charged environment in which front page stories routinely crop up when, among other things, there appears to be a disconnect between executive pay and company performance. Moreover, in view of the escalating scrutiny of and increased expectations regarding executive compensation practices, some boards/compensation committees may wish to consider retaining its own independent expert counsel. Independent decision-making has become an essential ingredient in determining executive compensation. This includes separate and independent director oversight aided by independent compensation consultants. Retaining and utilizing independent counsel, and/or other independent advisors, could enhance both the perception and reality of unbiased determinations of compensation for top management.

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988.

• Compensation Policies. If the risks arising from a company's compensation policies or practices could have a material effect on the company's overall risk exposure, the company's Compensation Discussion & Analysis ("CD&A") would need to include a section discussing: overall compensation policies (covering employees besides the named executive officers), compensation incentives that affect risk-taking, adjustment of compensation in light of risk issues, and the company's assessment of such risks.
• Equity Compensation Value. In a change that likely will be welcomed by companies and investors alike, the grant date value for the numerical disclosure of the estimated values of equity-based compensation awards determined under FAS 123(R) will be used as compared to the current requirement of using the annual financial accounting expense recognized for such awards in the Summary Compensation Table and Directors Compensation Table.
• Director Qualifications. Expansion of the discussion of a director/nominee's experience and qualifications that will more specifically describe the individual's skills and the basis for being qualified to serve on the company's board of directors.
• Leadership Structure and Risk Management. Disclosure of a company's leadership structure and why such structure is the best arrangement for the company. This would include articulating why there was a separation (or integration) of the principal executive officer position and the chairman of the board position along with a discussion about the lead independent director (if any). The board's role in risk management would also need to be addressed.
• Potential Compensation Consultant Conflicts of Interest. Provided that a company’s compensation consultant(s) provided other services to the company, there would need to be disclosure of aggregate fees paid to any such compensation consultants along with a description of such other services. Additionally, the involvement of management in selecting the consultant for non-compensation services and whether the board (or compensation committee) approved the non-compensation services of the consultant would also need to be disclosed.
• Shareholder Vote Results. Accelerated disclosure on Form 8-K of results on proposals voted on by shareholders would be required within four business days of a shareholder meeting rather than the existing practice of providing such disclosures on the next filed Form 10-Q or 10-K.
• Proxy Solicitation and Other Potential Reforms to Executive Compensation. Proposed reforms to proxy solicitation and SEC requests for comments on a variety of other executive compensation reform topics were also contained in the release.

Comments on the proposed amendments may be provided to the SEC on or before 60 days from the date of the proposed amendments' publication in the Federal Register. The SEC is working to adopt final rules in time for the 2010 proxy season.

Given the continuing high level of public and regulatory scrutiny of executive compensation, the SEC proposals will likely draw many comments.And while changes will presumably be made to the rules as currently proposed, some form of the proposals will probably be adopted.  In a related development, on July 16, 2009, the Treasury Department released draft legislation, the "Investor Protection Act of 2009," on Say-on-Pay and heightened independence standards for compensation committees.  The Treasury further released fact sheets on both aspects of the legislation as well (Say-on-Pay fact sheet and compensation committee independence fact sheet).  The draft legislation and new fact sheets follow up on the Treasury's statements in June 2009 on compensation principles, Say-on-Pay and compensation committee member independence (see our June 18, 2009 Blog Article).All of the proposed legislation is consistent with the President's White Paper on financial regulatory reform which was released in June 2009.  Additionally,on July 16, 2009 Congressman Barney Frank issued a statement that the House Committee on Financial Services would begin marking up the legislation as early as next week in response to recent press coverage of the high levels of compensation still being awarded at some of the country's financial institutions.Given the breadth and depth of the SEC's proposed changes and their open-ended request for comments on other executive compensation reform items, along with the Treasury Department's own endeavors to reform executive compensation practices, public companies would be well advised to examine their existing compensation/risk management processes and practices, D&O questionnaires, committee charters, organizational structure and public disclosures. Interested parties may also wish to submit comments to the SEC and perhaps affect the shape the final rules will take. 

For further details on the proposed rules along with representative comments the SEC is soliciting from the public on its proposals, please read the following discussion.

Compensation Polices

In an attempt to create greater accountability at the corporate level, the proposed SEC amendments would require companies to provide investors with more details on the company's overall compensation structure and its relationship to the company’s exposure to various risks. Federal government regulators have made it abundantly clear that they believe that incentive compensation programs at certain financial institutions encouraged excessive risk taking by their executive officers in order to enhance short-term company results (and correspondingly greater compensation payments to top executives) at the expense of long-term growth and prosperity. The view is that such compensation policies played a major role in causing the financial crisis, resulting in the collapse of many companies, and the federal government's dramatic intervention into the private sector in the form of the TARP and stimulus bill. The heightened disclosure of compensation policies required by the proposed amendments is also in response to the view that the compensation of other employees may have become "disconnected" from long-term performance. The desired purpose is to foster better alignment between the incentive compensation of employees and the long-term well-being of the company and to avoid having compensation policies that promote excessive risk-taking by employees.

Effective with the 2007 proxy season, the SEC has required a "principles-based narrative discussion" of a company's compensation program for its named executive officers in the CD&A section. The proposed amendments would expand the scope of the CD&A to include a section discussing how the company's broader compensation policies for its employees (not just the named executive officers) could create incentives that would affect the company's overall exposure to risks and the company's assessment of those risks. The release provides illustrative examples of situations and issues that could merit discussion in this section of the CD&A. If, however, the company determines that the risks arising from its broader compensation policies are not material, then disclosure would not be required.

Representative Comments that the SEC is Requesting:

• Should the scope of the amendments be limited to certain employees at a company or companies of a certain size in a certain industry?
• Should the rules reflect that the cost of tracking and disclosing the nature of the risks may vary across companies or within a company?
• Should a company be required to affirmatively state in its CD&A if it has determined that its broader compensation policies are not reasonably expected to have a material effect on the company?
• Should smaller reporting companies, who do not currently have to provide a CD&A, be subject to these enhanced disclosures on compensation and risk?

Equity Compensation Value

The amendments also propose to change the manner in which stock and option awards are reported on the Summary Compensation Table and Director Compensation Table. The change would require companies to report these awards using their aggregate grant date fair value estimated in accordance with FAS 123(R) instead of reporting the expense amount recognized for financial statement reporting purposes for the fiscal year. This change is in response to comments that the estimated grant date value is more useful to investors than the annual expense amount and also in order to simplify the disclosures. Adoption of this amendment would effectively reverse the SEC's surprise decision in December 2006 to utilize annual expense figures rather than grant date values.

Representative Comments that the SEC is Requesting:

• Should the prior year equity award figures in the Summary Compensation Table be restated to reflect the new valuation method and is there a better approach to preserve year-to-year comparability of equity award compensation amounts?
• Is another method of reporting equity compensation values preferred?

Director Qualifications

The proposed amendments also expand the disclosure requirements for directors and nominees and are intended to provide investors with more information about a director's credentials and possible conflicts of interest. These changes expand both the type of information required to be disclosed as well as the time frame from which the information must be disclosed. A company would need to provide disclosure regarding the specific experience, expertise and skills that qualify the person to serve on the board and committees of the board and articulate why such individual's service on the board will be beneficial to the company. Biographical information would be expanded to include any public company directorships held during the past five years by each director or nominee as compared to the current requirement of reporting only current directorships. The time period from which to disclose legal proceedings involving the director/nominee would be expanded from the last five years to the last ten years. The stated objective of these proposed changes is to help investors determine whether an individual director and the entire board composition as a whole are appropriate choices. In short, the SEC wants companies on an on-going basis to provide a greater justification to investors for why certain individuals are desirable board members.

Representative Comments that the SEC is Requesting:

• Should the rules be amended to compel a discussion of board diversity?
• Should the frequency of the expanded director qualification disclosures occur less often than annually?
• Should the expanded director qualification requirements cover directors on all committees or instead be focused on certain key committees such as the audit, nomination/governance, and compensation committees?
• Should there be any special accommodations for smaller reporting companies?

Leadership Structure and Risk Management

Under the proposed amendments, companies would now be required to disclose their leadership structure and why they think it is the best structure for the company. Companies would also be required to disclose in proxy and information statements the board's role in the risk management process. More specifically, companies would have to disclose whether and why they have chosen to combine or separate the principal executive officer and board chairman positions. In companies where the role of principal executive officer and board chairman are combined and a lead independent director is designated to chair meetings of the independent directors, the company would need to disclose why this structure was chosen and what specific role the lead independent director plays in the company. Even if a company does not utilize one of these particular structures, it would still need to disclose and explain the structure that is in place. 

Companies would also need to disclose the role the board plays in risk management. As an example, companies would need to disclose whether the board implements its risk management function through the board itself or through a committee, such as the audit committee, and the reporting relationships for the company's risk managers. These new disclosures are an effort to address the problems surrounding risk management that are frequently cited as a major factor in creating the on-going economic crisis.

Representative Comments that the SEC is Requesting:

• Should the amendments include more specific disclosures such as how the company determines the number of independent directors on the board?
• Should the SEC make special accommodations for smaller reporting companies?
• Should the SEC require additional disclosures regarding risk management in other registrant filings?

Potential Compensation Consultant Conflicts of Interest

If compensation consultant who helps determine or recommends the amount or form of executive or director compensation also provides other services to the company, the proposed amendments would require disclosure of fees paid to such compensation consultant. The required disclosures would include the nature and extent of the other services provided, the aggregate fees paid for the compensation-related services and the other services, whether the decision to hire the consultant for the other services was reviewed or screened by management, and whether the board or the compensation committee approved the consultant becoming a provider of the other services. The principal purpose of these added disclosures would be to provide investors with information about possible conflicts of interest for the consultant. The concern expressed by some investors is that executive compensation recommendations by the compensation consultant could possibly be affected by the consultant's relationship with management by virtue of providing other services to the company.

Representative Comments that the SEC is Requesting:

• Would the disclosure of additional consulting services and related fees adversely affect the ability of a company to hire consultants?
• Should there be additional disclosures relating to other potential conflicts of interest of compensation consultants?
• Should a minimum threshold amount or percentage of income be established for requiring disclosure of fees?

Shareholder Vote Results

In order to promote more timely disclosure of voting results from shareholder meetings, the proposed amendments would change the time period in which companies are required to disclose voting results. Shareholder voting results would now be reported on a publicly filed Form 8-K within four business days of the shareholder meeting. Previously, the disclosure of shareholder vote results could be reported on a Form 10-Q or 10-K which could result in a gap of several months between the shareholder meeting and the disclosure of voting results. The amendments would provide some relief in the event of a contested election whose results were not certified as final within four business days of the shareholder meeting.

Representative Comments that the SEC is Requesting:

• Could the disclosure of preliminary voting results in a contested election have negative consequences?
• Are there alternative methods, besides Form 8-K, that would more effectively provide voting results to investors?

Proxy Solicitation

The proposed amendments also seek to clarify the manner in which soliciting parties communicate with shareholders. Specifically, the amendments propose to change the proxy solicitation rules so that:

• a "form of revocation" does not include an unmarked copy of management's proxy card that a soliciting shareholder requests be returned directly to management, so that parties seeking to campaign for a certain vote, but who do not wish to solicit a proxy, do not have to meet the full requirements for proxy solicitation;
• disclosure of a substantial conflict of interest by a soliciting party is not limited to parties who are shareholders of the class of securities being solicited and the benefit to that party need not be solely related to or derived from the holding of a security;
• a person soliciting in support of nominees who, if elected, would constitute a minority of the board may seek authority to vote for another soliciting person's nominees in addition to or instead of the issuer's nominees to round out its short slate; and
• the requirement that the proxy statement or form of proxy provide that the shares represented by the proxy be voted "subject to reasonable and specified conditions" will require that "reasonable and specified conditions" be objectively determinable.

Other Potential Reforms to Executive Compensation

The SEC is exploring ways to improve proxy disclosures and in this regard it requested comments on a number of other executive compensation reform topics including the following:

• Should the SEC consider other initiatives to improve disclosures, especially about executive compensation, such as the compensation of every executive, not just the named executive officers?
• Should the SEC amend the rules so that the Compensation Committee report is "filed" rather than "furnished" and therefore subject to greater liability?
• Should any of the narrative or tabular disclosure requirements require additional disclosures about whether or not a company has "hold to retirement" and/or "clawback" provisions?
• Should companies be required to disclose internal pay ratios in order to inform investors of internal pay equity considerations in compensation decisions?
• Should tax gross-up arrangements for any named executive officer also include a disclosure on the savings that accrue to the covered officer?

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988.

• The U.S. Department of the Treasury (“Treasury”) issued a statement outlining the Administration’s expectations and planned legislative proposals for executive compensation reform for publicly held companies.
• The Securities and Exchange Commission (“SEC”) announced it will soon be proposing new expanded compensation disclosure rules that could take effect in time for the 2010 proxy season.
• The Treasury issued regulations providing its much anticipated guidance on standards for executive compensation and corporate governance for TARP recipients.
• The Treasury established an Office of the Special Master for TARP Executive Compensation (the “Special Master”).

• Compensation plans should be tied to performance in order to link the incentives of executives and other employees with long-term value creation. To align with such long-term value creation, performance-based pay should be conditioned on a wide range of internal and external metrics, not just stock price.
• Compensation, including compensation for more than just the top executives, should be structured to account for the time horizon of risks. Similar to the first principle, the objective is to align the compensation to the long-term health of the enterprise.
• Compensation practices should also be aligned with sound risk management. Compensation committees should conduct and publish risk assessments of pay packages to ensure that they do not encourage imprudent risk-taking. Providing greater authority to a company's risk managers may become a by-product of this principle.
• Golden parachutes and supplemental retirement packages should be reexamined so as to ensure proper alignment of the interests of executives and shareholders. Again, the objective is to ensure that poor performance is not rewarded.
• Transparency and accountability in the process of setting compensation should be promoted.

Treasury’s Planned Legislative Proposals

To help promote the fifth principle of transparency and accountability, the Administration will seek legislation to give the SEC the authority to implement two new requirements: (i) shareholder “Say on Pay” and (ii) enhancement of the independence of compensation committees. The Treasury also released two “fact sheets” providing further details on these two initiatives.

The contemplated “Say on Pay” legislation would give the SEC the authority to require non-binding annual “say on pay” votes for public companies. Shareholders would then have the right to, among other things, approve (or disapprove): golden parachute compensation, annual compensation for the top five named executive officers, and executive pay packages as disclosed by the public company in its annual proxy statement.

The contemplated enhancement of the independence of compensation committees would direct the SEC to promulgate rules requiring companies listed on national securities exchanges to meet more exacting standards for independence. In particular, the compensation committee members would need to meet the stricter independence standards required of audit committee members as imposed by the Sarbanes-Oxley Act of 2002. In addition, the compensation committee would have authority to retain counsel and consultants. Further, the SEC will be directed to establish standards regarding the independence of the compensation counsel and consultants used by the compensation committee.

Moreover, the President’s Working Group on Financial Markets will provide an annual review of compensation practices to monitor whether such practices are creating excessive risks. The Treasury is also encouraging experts in the field to conduct reviews to identify best practices, emerging positive and negative trends and call attention to unseen risks.

SEC’s Planned Proposal of Expanded Compensation Disclosure Rules

The SEC announced that it will soon be proposing new expanded compensation disclosure rules which will compel companies to analyze how compensation impacts risk taking and the implications for long term corporate health. Specifically, the SEC will be considering several proposals including requiring public companies to provide fuller disclosure on:

• How a company, and its board, manages risks in its executive compensation program.
• A company’s overall compensation approach and how its incentive structures take into account the potential long term effects on the company.
• Compensation consultant independence and conflicts of interest; and
• Director nominees, including their experience, qualifications to serve on the board or committees, and why a board has chosen its particular leadership structure.

These planned proposals dovetail with the SEC’s June 10, 2009 proposed rule (17 CFR Parts 200, 232, 240, 249 and 274) that is intended to remove impediments so shareholders may more effectively exercise their rights to nominate and elect directors.

Treasury’s Executive Compensation Guidance to TARP Recipients

The Treasury also issued a revised Interim Final Rule 31 CFR Part 30 (“IFR”) providing further guidance on the corporate governance and executive compensation provisions of the Emergency Economic Stabilization Act of 2008 (“EESA”), as amended by the American Recovery and Reinvestment Act of 2009 (“ARRA”). Details of the original executive compensation EESA provisions can be found in our October 21, 2008 Blog Article. The IFR supersedes its two predecessor IFRs that were previously released in January 2009 and October 2008, respectively. The updated IFR implements ARRA's executive compensation provisions which generally replaced the original provisions that were enacted under EESA in October 2008. The new guidance not only clarifies certain details related to ARRA’s executive compensation restrictions and standards, but it also provides additional new standards pursuant to its authority granted by ARRA. Note, the IFR applies not only to public companies but also to privately held TARP recipients.

The IFR's new standards include:

• A prohibition on tax gross-ups to senior executive officers and the next twenty most highly compensated employees;
• A requirement of disclosure and a narrative description of, and justification for, any perquisites, with total value exceeding $25,000, provided to any employee subject to ARRA’s bonus limitations; and
• Mandatory disclosure of any compensation consultant engaged by the company or its compensation committee, including a narrative description of the services provided and the use of any “benchmarking” procedures in the consultant’s analysis.

Below is a listing of other executive compensation items addressed in the IFR, in addition to the three new standards outlined directly above, which generally apply to all TARP recipients:

• Limits on executive compensation that exclude incentives for senior executive officers (“SEO”) to take unnecessary and excessive risks that threaten the value of the TARP recipient;
• Requirement for the recovery of any bonus, retention award, or incentive compensation paid to a SEO or the next twenty most highly compensation employees based on materially inaccurate statements of earnings, revenues, gains or other criteria;
• Prohibition on making any golden parachute payment to a SEO or any of the next five most highly compensated employees;
• Prohibition on the payment or accrual of bonus, retention award, or incentive compensation to SEOs or certain highly compensated employees, subject to certain exceptions for payments made in the form of long-term restricted stock;
• Prohibition on employee compensation plans that would encourage manipulation of earnings reported by the TARP recipient to enhance an employee’s compensation;
• Establishment of a compensation committee of independent directors to meet semi-annually to review employee compensation plans and the risks posed by these plans to the TARP recipient;
• Adoption of a company-wide excessive or luxury expenditures policy;
• Compliance with federal securities rules and regulations regarding the submission of a non-binding resolution on SEO compensation to shareholders; and
• Appointment of a Special Master to approve compensation plans of certain TARP recipients and to provide guidance to other TARP recipients.

Moreover, the IFR also establishes compliance reporting and recordkeeping requirements covering the various executive compensation and corporate governance standards. The principal executive officer and principal financial officer of a TARP recipient must provide certain certifications in their annual report on Form 10-K and to the Treasury (for public companies) and to the primary regulatory agency and Treasury for other entities. Providing false information or certifications may subject the entity or individual to criminal penalties.

While the IFR is effective as of June 15, 2009, i.e., the date the IFR was published in the Federal Register, public comments can be submitted to the Treasury on the topics addressed in the IFR through August 14, 2009.

Treasury’s Special Master for TARP Executive Compensation

The Treasury also announced the appointment of a Special Master for TARP Executive Compensation. In this role, the Special Master will, among other things, have broad authority over the compensation for all executive officers and the 100 most highly paid employees of TARP participants who are receiving "exceptional financial assistance", including the power to reject compensation pay plans deemed excessive. Exceptional financial assistance is deemed to currently cover all entities participating in the Programs for Systemically Significant Failing Institutions, the Targeted Investment Program, or the Automotive Industry Financing Program. The Special Master also has the authority to interpret ARRA's executive compensation requirements and shall review bonus/retention payments made before ARRA's enactment to certain employees of all TARP recipients to ensure that such payments are not inconsistent with ARRA or contrary to public interest. The Special Master has the responsibility and ability to seek reimbursement of those payments which the Special Master has determined do not satisfy these requirements.

The Special Master will apply a set of principles to determine whether the TARP recipients have designed executive compensation to maximize shareholder value and protect taxpayer interests, including whether compensation:

• Avoids fostering unnecessary/excessive risk taking;
• Allows a company to be competitive, recruit/retain valued employees and is able to repay its TARP obligations;
• Is appropriately allocated between types of pay (e.g., salary, long-term incentive pay, retirement), and form of payment, with an emphasis on long-term pay for senior level positions;
• Is performance-based, determined through tailored metrics that provide goals whose attainment is not guaranteed, and which accounts for a greater portion of total compensation for positions with higher levels of responsibility;
• Is comparable to peers; and
• Properly values the employee's overall current/future contributions to the employer.

In summary, the IFR imposes executive compensation requirements that are quite extensive and compliance with all of these rules will likely involve a material change in a TARP recipient's compensatory processes and practices. Moreover, the Administration clearly would like its executive compensation principles to be adopted as best practices for those companies which are not receiving TARP assistance. As “Say on Pay” legislation and enlarged proxy statement disclosures are likely to become a reality, public companies may now want to examine and make changes as appropriate to their existing compensation processes, structures, programs and disclosures in order to be prepared for the impending expansion of executive compensation rules and disclosures.

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988 or Nicole Lee at (415) 774-2998.