Governance & Compliance Insider

The Securities and Exchange Commission issued an order today providing filing relief for companies that are affected by the coronavirus.  In the order, the Commission notes that disruptions to transportation, and limited access to facilities, support staff, and professional advisors as a result of COVID-19, could hamper the efforts of public companies and other persons with filing obligations to meet their filing deadlines. Companies may have an additional 45 days from the original due date to file their Exchange Act reports that are otherwise due between March 1 and April 30.  In the reports, companies must disclose that they are relying on the order and state the reasons why they could not file their reports on a timely basis. As conditions to the filing relief, companies must be unable to meet their filing deadlines due to circumstances related to COVID-19. They must furnish in a report on Form 8-K or Form 6-K, by the later of March 1 or the original filing deadline, (1) a statement that they are relying on the order; (2) a brief description of the reasons why they could not file the report on a timely basis; (3) the estimated date of filing; (4) if appropriate, a risk factor explaining, if material, the impact of COVID-19 on their business; and (5) if the report cannot be filed on a timely basis because of the inability of a third party to furnish a required opinion, report or certification, a signed statement by the third party. Companies may also be exempt from Exchange Act requirements to furnish proxy and other soliciting materials under certain conditions, where the shareholder has a mailing address located in an area where the common carrier has suspended delivery service as a result of COVID-19, and the companies have made a good faith effort to furnish their proxy materials.

The 10-K and proxy season begins in a little over a month for companies with calendar fiscal year-ends.  The following governance and disclosure developments should be considered in the course of preparing these filings. For additional background, see our presentation and supplemental materials for Preparing for the 2019 SEC Reporting Season. Proxy Statement Impact of the government shutdown: During the government shut down, the SEC is operating with a skeleton staff, with no capacity for reviewing preliminary proxy statements or no-action requests. Companies that need to file preliminary proxy materials should continue to file them in accordance with Rule 14a-6(a) of the Exchange Act, at least ten calendar days prior to the date the definitive materials are first sent or given to shareholders.  If companies are not advised by SEC staff within that period that there will be a review, they should proceed with the definitive filing and distribution of proxy materials. While the Division of Corporation Finance has not discussed how no-action requests for shareholder proposals will be handled during the government shutdown, companies should continue to make the submission required by Rule 14a-8(j) via email if they intend to exclude a shareholder proposal.  Given that companies must submit no-action requests no later than 80 calendar days before filing definitive proxy statements, it is likely that the SEC staff will have a chance to review and respond to submissions under Rule 14a-8 once the shutdown ends.  If the current shutdown is still in effect at the time that the proxy statement is filed, a company would have to decide whether it has a basis to exclude the proposal without the benefit of a no-action letter. See this update and this update on the shutdown’s impact on capital markets regulation and this 19-firm memo prepared during the last shutdown. Gender diversity voting policies:  For meetings held after January 1, 2019, Glass Lewis will generally recommend votes against nominating committee chairs (and potentially other nominating committee members) on boards with no female directors.  ISS will do so for meetings held on or after February 1, 2020.  Mitigating circumstances disclosed in the proxy statement may influence their recommendations. Rapidly evolving disclosure of environmental and social programs:  More companies are dedicating sections of their proxy statements to describing these initiatives, or referring to applicable disclosure on their websites or in their responsibility reports, while being careful not to incorporate by reference these materials into their filings. Expanding duties for compensation committees: These committees are overseeing broader issues of human capital management beyond director and executive officer compensation, sometimes in response to allegations of sexual harassment and other misconduct, followed by investor questions.  Semler Brossy reports that one-third of DJIA (Dow Jones Industrial Average) 30 companies have a board compensation committee with broader responsibilities, e.g., leadership development and/or other HR areas - many of which signal their breadth in their name, such as Talent & Development Committee or Human Resources Committee. Updated tax policy discussions in the CD&A: Companies historically may have disclosed that they use best efforts to obtain tax deductions for executive compensation above the $1 million cap under Section 162(m) of the Internal Revenue Code.  Since the exemption for performance-based compensation has been eliminated under the Tax Cuts and Jobs Act, with limited grandfathering for compensation payable pursuant to a written binding contract in effect on November 2, 2017, this disclosure now should be updated. CEO pay ratio in year two: Companies may keep the median employee from last year, unless there were significant changes to (i) the employee population, (ii) employee compensation arrangements or (iii) the original median employee’s circumstances, so that the company reasonably believes its pay ratio disclosure would significantly change.  In cases (i) and (ii), the median employee should be re-identified.  In case (iii), the company may use another employee whose compensation is substantially similar to the original median employee based on the compensation measure used to select the original employee.  If the same median employee is used, briefly disclose the basis for the reasonable belief. Say-on-frequency for smaller reporting companies: A non-binding say-on-frequency vote is due for those companies that had their last vote in 2013, including most smaller reporting companies.  Shareholders may cast an advisory vote on whether to hold the advisory vote on executive compensation ("say-on-pay") every year, every two years or every three years.  Per Rule 14a-21 of the Exchange Act, include (i) a statement that the vote concerning the frequency of the say-on-pay vote is being provided as required pursuant to Section 14A of the Securities Exchange Act of 1934, as amended; (ii) a description of the general effect of the say-on-frequency vote, such as whether it is non-binding; and (iii) the current frequency of the say-on-pay vote and when the next say-on-pay vote will occur.  Emerging growth companies ("EGCs") are exempted from say-on-pay and say-on-frequency votes.  The SEC also expanded the definition of "smaller reporting company" this year.  See discussion below. Guidance for equity compensation plan proposals: The SEC updated its guidance related to equity compensation plan proposals, see Section 161 of the Proxy Rules and Schedules 14A/14C C&DIs.  Among the clarifications provided: Companies should be prepared to disclose all material terms of a plan, even when the proposal is for an amendment of an existing plan.  Furthermore, a New Plan Benefits Table (listing benefits or amounts that will be received by each of the named executive officers and certain groups under the proposed plan) will only be called for if the plan is: (i) a plan with set benefits or amounts (e.g., director option plans); or (ii) one under which some grants or awards have already been made subject to shareholder approval. Annual Report on Form 10-K Disclosure simplification:  As a result of the SEC’s Disclosure Update and Simplification rulemaking, certain 10-K disclosure can be eliminated, because the information is  outdated or duplicative of information already included in the financial statements in accordance with GAAP or in the MD&A when material to the business. Part I, Item 1, Business: Companies are no longer required to disclose: three years of segment level financial information, amounts spent on R&D financial information by geographic area risks associated with foreign operations and a segment’s dependence on foreign operations facts indicating why performance in certain geographic areas may not be indicative of current or future operations (but consider for the MD&A) reference to the SEC’s Public Reference Room, physical address and phone number (but disclose the SEC website, a statement that SEC filings are available there, and the company’s website) Part II, Item 5, Market for Registrant’s Common Equity: Companies are no longer required to disclose: high and low sales prices for common equity traded over the last two fiscal years (but disclose trading symbols for each class of common equity traded) frequency and amount of cash dividends declared restrictions that currently or are likely to materially limit a company’s ability to pay dividends on its common equity (including restrictions on subsidiaries to transfer funds) Part II, Item 7, MD&A: Companies should discuss changes in financial condition and results of operations based on geographic area, if they are material to an understanding of the business. Part IV, Item 15, Exhibits: Companies are no longer required to provide a ratio of earnings to fixed charges as an exhibit. Update those risk factors:  Not only should companies consider new and emerging risks, they should review the status of existing risks.  An abstract discussion may not be sufficient if an existing risk has materialized.  Earlier this year, as reported here, Altaba (formerly Yahoo! Inc.) agreed to pay a $35 million penalty to settle charges that it misled investors by failing to disclose one of the world’s largest data breaches thus far.  Among its violations, Yahoo's post-breach disclosure in quarterly and annual reports was too general, stating that the company faced only the risk of, and negative effects that might flow from, data breaches.  The company failed to disclose the actual breach or its potential business impact and legal implications. Continue to mind the GAAP: In a recent SEC cease-and-decease order discussed here, ADT was fined $100,000 for failing to give “equal or greater prominence” to the most directly comparable GAAP measures in accordance with Item 10 of Regulation S-K.  The company highlighted non-GAAP measures in the headlines and bullets summaries of two earnings releases, without disclosing the GAAP measures until later in the earnings releases. Leasing and revenue recognition accounting standards: Public entities besides EGCs must adopt the leasing accounting standard (FASB ASC Topic 842) for annual reporting periods beginning after December 15, 2018, including interim reporting periods within that reporting period.  For calendar year-end companies, they will adopt the standard on a modified retrospective basis on January 1, 2019, with an initial application date of January 1, 2017.   Section 11200 of the SEC Financial Reporting Manual clarifies that filing a registration statement with an earlier comparative period (eg, January 1, 2016) does not change the date of initial application. Last year, public entities adopted the revenue recognition accounting standard (FASB ASC Topic 606) for annual reporting periods beginning after December 15, 2017, including interim reporting periods within that period.  SEC Chief Accountant Wes Bricker has indicated that revenue recognition disclosure will be a top issue for comment this season, and the SEC staff has encouraged companies to refine and supplement their annual disclosures included in subsequent quarterly filings. Areas of judgment, such as identification of performance obligations and the application of principal vs. agent guidance have been the most frequently discussed topics in consultations with the Office of the Chief Accountant.   Section 11100 of the SEC Financial Reporting Manual addresses certain disclosure issues related to the adoption of ASC 606.  For instance, for companies that adopted ASC 606 using the full retrospective approach, they do not need to apply the standard when reporting selected financial data in the 10-K for periods prior to those periods that are retroactively adjusted, but they must provide information regarding comparability of data presented pursuant to Instruction 2 to the Item 301. Updates to the 10-K cover page were made in connection with rulemaking for smaller reporting companies and inline XBRL reporting (see our Preparing for the Proxy Season presentation for a markup). No delivery of hard copies of proxy materials to the NYSE, if the hard copies have been filed in EDGAR.  Nasdaq had abolished this requirement earlier. More companies qualify as “Smaller Reporting Companies:” During 2018, as discussed here, the SEC expanded the definition of “smaller reporting company” to include (i) those companies with public float of less than $250 million as of the last business day of their second fiscal quarter, and (ii) those companies with less than $100 million of annual revenues and either no public float or public float of less than $700 million.  As a result, additional companies now qualify to provide scaled disclosure in this year’s Form 10-K and proxy statement.  If and until the SEC makes corresponding amendments to the definitions of “accelerated and “non-accelerated” filers, smaller reporting companies with public float of $75 million or more will continue to be accelerated filers that must comply with shorter filing deadlines and provide an auditor’s attestation of management’s assessment of internal control over financial reporting required under Sarbanes-Oxley Act Section 404(b). And coming up for future 10-Qs and 10-Ks: Effective for quarters beginning after November 5, 2018 (which means Q1 2019 for calendar companies), amended Rules 8-03(a)(5) and 10-01(a)(7) under Regulation S-X require quarterly (vs annual) analysis of changes in stockholders’ equity and the amount of dividends per share for each class of shares for “the current and comparative year-to-date [interim] periods, with subtotals for each interim period.”   These changes were adopted as part of the Disclosure Update and Simplification rulemaking discussed above. A discussion of critical audit matters, which are related to accounts or disclosures that are material to the financial statements, and involved especially challenging, subjective, or complex auditor judgment, will be included in audit reports for fiscal years ending on or after June 30, 2019 for large accelerated filers and in audit reports for fiscal years ending on or after December 15, 2020 for all other companies to which these requirements apply.  The new requirement does not apply to emerging growth companies. Inline XBRL, which allows filers to embed financial data into the body of an SEC filing, rather than attaching the data as an exhibit, must be implemented as early as fiscal periods ending on or after June 15, 2019 for large accelerated filers; fiscal periods ending on or after June 15, 2020 for accelerated filers and fiscal periods ending on or after June 15, 2021 for all other filers. And coming up for future proxy statements: Effective for proxy statements filed during fiscal years beginning on or after July 1, 2019 (July 1, 2020 for smaller reporting companies and emerging growth companies), companies must describe any practices or policies that they have adopted regarding the ability of employees, officers or directors to engage in hedging transactions.  Companies may either disclose the full policy, or a "fair and accurate" summary of the policy.  Summaries must include the categories of persons and the categories of transactions specifically permitted or disallowed.  Companies that have not adopted hedging policies must disclose that fact or state that hedging transactions are permitted.

ISS released its annual update of frequently asked questions on its US Compensation Policies on December 20, 2018 (preliminary updates had been released in November). The updates are effective for shareholder meetings occurring on or after February 1, 2019. There are nine new or materially updated questions, which are summarized below: #19 Will any of the quantitative pay-for-performance screens change in 2019?  No.  The screens will continue to use GAAP/accounting performance measures, but ISS will display Economic Value Added (EVA) measures on a phased-in basis over the 2019 proxy season and will continue to explore their future use to add insight to financial performance.  (EVA can measure a company's residual wealth by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis.) #21 Given the use of TSR in ISS' quantitative screen, does ISS prefer companies use TSR as an incentive program metric?  While it recognizes investors' preference for objective and transparent metrics, ISS does not endorse or prefer the use of total shareholder return (TSR) or any specific metric in executive incentive programs. #42 How does ISS analyze "front-loaded" awards intended to cover future years?  ISS is unlikely to support grants that cover more than four years (ie, the grant date plus three future years), and for these types of grants, commitments not to grant additional awards over the covered period should be firm.  Usual pay-for-performance considerations will be more closely scrutinized. #47 Which problematic practices are mostly likely to result in an adverse recommendation?  Additional problematic pay practices that are likely to result in adverse vote recommendations on compensation committee members and/or say on pay proposals now include: (1) excessive termination payments (not just change in control payments) exceeding three times base pay and annual bonus, and (2) a "good reason" termination definition that presents windfall risks. #48 How does ISS evaluate "Good Reason" termination definitions?  ISS will scrutinize "Good Reason" definitions to ensure that the circumstances are reasonably viewed as an adverse constructive termination, and to determine whether there is a potential windfall risk.  Circumstances reflecting potential performance failures, such as bankruptcy or delisting, will be considered problematic. #50 If a company becomes a "smaller reporting company" under the SEC's revised definition, how will ISS assess reduction in compensation disclosure?  ISS notes that smaller reporting companies (SRCs) are still required to hold say on pay votes, and so while they may use scaled compensation disclosure requirements, SRCs should continue to provide sufficient disclosure to enable investors to make an informed say on pay vote.  This means that SRCs should think carefully before eliminating CD&As, and at minimum, ensure that there is sufficient narrative for shareholders to meaningfully assess compensation philosophy and practices. #59 How would ISS view any compensation program changes made in light of the removal of 162(m) deductions?  While shifts away from performance-based compensation to discretionary or fixed pay elements did not make the list of problematic pay practices most likely to result in an adverse recommendation, ISS will still consider these shifts to be problematic pay practices and will view them negatively. #67 How does ISS apply its policy around "excessive" levels of non-employee director pay?   If ISS determines that a NED’s pay is a quantitative pay outlier (see FAQ below), it will perform a qualitative evaluation of the company’s disclosed rationale to determine if concerns are adequately mitigated.  The updated FAQs list a number of circumstances that will typically mitigate concern around high non-employee director (NED) pay, including onboarding grants, special payments related to corporate transactions or special circumstances, and payments for specialized scientific expertise as may be necessary in certain industries.  As a reminder, last year, ISS had announced a policy to recommend against board members responsible for approving NED pay when there is a recurring pattern of excessive pay magnitude without a compelling rationale in two or more consecutive years.  ISS subsequently updated its methodology to identify pay outliers, and in consideration of the updates, ISS had postponed issuing adverse recommendations until meetings occurring on or after February 1, 2020. #68 What is ISS' methodology to identify non-employee director pay outliers?  The updated FAQs clarify that the methodology identifies pay outliers above the top 2-3% (vs the top 5%) of all comparable directors within the same two-digit GICS group and index grouping (eg, S&P 500).  The revised methodology acknowledges that there are pay premiums for non-executive chairs and lead independent directors, and in limited instances, the methodology also makes allowances for narrow distributions of NED pay, where there is not a pronounced difference in pay between the top 2-3% of directors and the median director.

A recent SEC consent order against The Dow Chemical Company reminds companies that when evaluating whether or not to disclose a payment or benefit to an executive as a perk in a proxy statement, the fact that the item has a tangential business purpose, or is convenient for the company, is insufficient grounds to exclude the item as a perk.  In order to be excluded as a perk, the item must be "integrally and directly" related to the performance of the executive's duties.  Examples of items that typically should be classified as perks include country club memberships for mixed business and personal use, commuting expenses, and personal guests who join a business flight on the corporate jet. While companies may perceive individual perks as insignificant or as justifiable business expenses, these items can be significant in the aggregate, in hindsight and through a regulatory lens.  The consistent failure to disclose perks over a period of years may result in Commission sanctions and negative publicity, particularly for larger public companies and for companies who for a variety of reasons are the subject of closer Commission scrutiny. As background, on July 2, 2018, the SEC entered into a consent order against Dow, settling claims that from 2011 through 2015, the company did not adequately evaluate and disclose approximately $3 million in executive perks as "other compensation" in its proxy statements.  These authorized but undisclosed perks included personal use of the Dow aircraft and other expenses.  The consent order notes that though Dow applied procedures regarding the evaluation and disclosure of its executives' perks, it did not follow the Commission's standard regarding disclosure of perks, which provides that: • An item is not a perquisite or personal benefit if it is integrally and directly related to the performance of the executive’s duties. • Otherwise an item is a perquisite or personal benefit if it confers a direct or indirect benefit that has a personal aspect without regard to whether it may be provided for some business reason or for the convenience of the company, unless it is generally available on a non-discriminatory basis to all employees. Instead, the consent order finds, Dow incorrectly applied a standard whereby a business purpose related to the executive’s job was sufficient to determine that a benefit would not be a perquisite that required disclosure. Notably, the consent order also sanctions Dow for its disclosure controls.  According to the order, Dow did not adequately train employees in key roles, including those tasked with drafting the CD&A section of the proxy statement and compiling the executive compensation tables, to ensure that the proper standard was applied for perks disclosure.  Dow also had inadequate processes and procedures to ensure proper reporting of perks.  In addition to a $1.75 million penalty, the consent order requires Dow to hire an independent consultant for one year to review and make recommendations on Dow's policies, procedures, controls and training related to the evaluation of whether payments and other expense reimbursements should be disclosed as perks under securities laws.  

The SEC announced that it has voted to amend the definition of "smaller reporting company," or "SRC," expanding the population of companies that qualify for a range of scaled (reduced) disclosure requirements. The rules will become effective 60 days after publication in the Federal Register. Examples of scaled disclosure include that SRCs, in their annual reports on Form 10-K, are not obligated to include risk factors, and selected and supplementary financial data. They may include only two years of income statements (vs three years) and a comparison of two years (vs three years) of financial results. In their proxy statements, SRCs are not required to include a CD&A, CEO pay ratio and certain executive compensation tables. They may include fewer NEOs, and only two years of compensation in the Summary Compensation Table. Under the new definition, companies with a public float of less than $250 million (vs $75 million) will qualify as SRCs. A company with no public float or with a public float of less than $700 million will also qualify as an SRC if it had annual revenues of less than $100 million (vs $50 million) during its most recently completed fiscal year. Commission staff estimates that 966 additional companies will be eligible for SRC status in the first year under the new definition. The SEC released the following summary of the amendments to the definition of an SRC:   Criteria Previous SRC Definition Revised SRC Definition Public Float Public float of less than $75 million Public float of less than $250 million Revenues Less than $50 million of annual revenues and no public float Less than $100 million of annual revenues and no public float, or public float of less than $700 million For purposes of determining whether or not it is an SRC, a reporting issuer (vs. a non-reporting issuer filing its first registration statement) must measure its public float annually, on the last trading day of the second fiscal quarter of the previous fiscal year. Qualifying issuers are then eligible to use scaled disclosure rules for the first quarterly report on Form 10-Q for the fiscal year following the determination. Newly eligible SRCs may "early adopt" those rules for the quarterly report immediately following the determination. Once a company fails to qualify as an SRC, it may continue to report under SRC disclosure requirements through the end of that fiscal year. However, in order to re-qualify as an SRC, the company must meet more stringent qualification thresholds. The subsequent qualification thresholds, set forth in the table below, are set at 80% of the initial qualification thresholds in the table above. Criteria Previous SRC Definition Revised SRC Definition Public Float Public float of less than $50 million Public float of less than $250 million Revenues Less than $40 million of annual revenues and no public float Less than $80 million of annual revenues, if it previously had $100 million or more of annual revenues; and Less than $560 million of public float, if it previously had $700 million or more of public float. It is worth noting that a company may qualify as an SRC, but still be an accelerated filer. The amendments do not change the threshold in the “accelerated filer” definition that requires, among other things, that filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting. However, the SEC staff has begun to formulate recommendations to the Commission for possible additional changes to the “accelerated filer” definition to reduce the number of companies that qualify as accelerated filers. In addition to amendments to the definition of "smaller reporting company," the SEC also adopted amendments to Rule 3-05(b)(2)(iv) of Regulation S-X, in order to increase the net revenue threshold in that rule from $50 million to $100 million. As a result, companies may omit financial statements of businesses acquired or to be acquired for the earliest of the three fiscal years otherwise required by Rule 3-05 if the net revenues of that business are less than $100 million.

As companies prepare their Form 10-K and proxy statement disclosures, they will be challenged with disclosing the impact of the Tax Cuts and Jobs Act on performance results for the purposes of financial reporting as well as for compensation measurement. Here is a short list of issues to be aware of. Form 10-K Disclosure Implications of Tax Reform: Sections in the MD&A likely to be affected by tax reform include the discussion of operating results and financial condition and discussion of critical accounting estimates. Companies also are adding or modifying their risk factors to acknowledge the impact of the Tax Cuts and Jobs Act. In the MD&A, companies are required to describe any “known trends or uncertainties that have had or that the company reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.” There are comparable requirements for known trends or uncertainties impacting liquidity and capital resources. Companies should be prepared to assess the potential impact of tax reforms including: Reduction of top corporate tax rate from 35% to 21% beginning in 2018 Capital expenditure deductions: Expensing of new and qualified property placed in service after September 27, 2017, through 2022 Limit on net interest deductions to 30% of EBITDA Net operating loss (NOL) deduction limited to 80% of taxable income with indefinite carryforward; carrybacks generally eliminated R&D expenditures paid or incurred after 2021 must be capitalized and amortized over a five-year period Adoption of a territorial tax regime: foreign source portion of a qualified dividend received by a 10% U.S. corporate shareholder is exempt from U.S. tax Deemed repatriation: 15.5% tax on post-1986 foreign earnings held in cash and an 8% rate on all other post-1986 earnings To the extent that companies use reasonable estimates of the tax reform impact in their disclosure in accordance with SAB 118, they may want to caution readers that they are in the process of determining the actual impact, and that their reasonable estimates are based on provisional amounts that may be adjusted upon obtaining, preparing, or analyzing additional information. Proxy Disclosure Implications of Tax Reform: Changes to Internal Revenue Code Section 162(m) will eliminate deductibility of compensation for “covered employees” (including now the CFO) over $1 million, even for qualified, performance-based compensation. However, arrangements in place before November 3, 2017, and that are not materially modified will be grandfathered; IRS guidance is forthcoming. Disclosure and governance considerations include: CD&A Disclosure: 162(m) deductibility will still be a relevant discussion for past awards and grandfathered awards and for distinguishing what’s deductible vs not deductible. CD&A Disclosure: Discuss tax reform impact on performance results, and whether those results are adjusted to exclude the impact of tax reform for compensation purposes (e.g., revaluation of deferred tax asset or deferred tax liability based on new corporate tax rate may result in a big non-cash gain or loss in Q4 of 2017). CD&A Disclosure: Elimination of 162(m) deductibility is a significant change for compensation programs going forward and may impact compensation design. D&O questionnaires: Continue to confirm that compensation committee members qualify as “outside” directors for purposes of certifying grandfathered awards and for certifying vesting of grandfathered performance awards. Covered employees: A “covered employee” will now be anyone who has ever been the CEO, CFO, or one of the three most highest compensated officers in any fiscal year beginning after December 31, 2016. Thus, the new rule is essentially “once a covered employee, always a covered employee.” If possible, employers should not structure one-off payments that would cause an individual to become one of the three highest compensated officers in a particular year, when he or she typically would not be one in other years. In addition, employers should track “covered employees” and their compensation arrangements.

At last Friday's ABA annual meeting, Bill Hinman (with the standard disclaimer that he is speaking for himself and not on behalf of the SEC) confirmed that the SEC will not be delaying implementation of the CEO pay ratio rule, which will require most public companies to report the pay ratio in their 2018 proxy statements, for the first fiscal year beginning on or after Jan. 1, 2017.  (Foreign private issuers, MJDS filers, emerging growth companies and smaller reporting companies are exempt from the rule.)  Bill Hinman is the Director of the SEC's Division of Corporation Finance. Director Hinman also mentioned that the Division will be issuing additional guidance on the CEO pay ratio rule in the near future.  This earlier blog entry includes a summary of the SEC's previous guidance on implementing the CEO pay ratio rule. In a recent Compensation Standards survey, Liz Dunshee reported on trending practices in pay ratio preparation.

The SEC's semi-annual update of its rulemaking docket was released on July 20. Overall, the SEC has cut its rulemaking agenda by about half under the Trump administration. A number of long-anticipated Dodd-Frank rulemakings on executive compensation disclosure are missing from the docket: Pay Versus Performance Listing Standards for Recovery of Erroneously Awarded Compensation (Clawbacks) Disclosure of Hedging by Employees, Officers and Directors Incentive Compensation at Financial Institutions. Likewise, the Universal Proxy rulemaking was missing. Still on the docket of proposed rulemakings: Amendments to the XBRL Program Business and Financial Disclosures required by Regulation S-K Guide 3 Bank Holding Company Disclosure Reporting of Proxy Votes on Executive Compensation and Other Matters Concept Release on Possible Revisions to Audit Committee Disclosures Rulemaking to Simplify Regulation S-K Provisions Governing Non-Financial Disclosures

For U.S. and Canadian companies with annual meetings to be held between September 16, 2017, and January 31, 2018, the window for alerting Institutional Shareholder Services (ISS) about changes to self-selected peer groups used for executive compensation benchmarking closes this Friday, July 21st, at 8:00 pm EDT. Information on self-selected peer groups may influence ISS as it constructs the peer groups that it uses in its pay for performance analysis in its voting reports. According to the ISS press release, companies that have made no changes to their previous proxy-disclosed executive compensation benchmarking peers, or companies that do not wish to provide this information in advance, do not need to participate. For companies that do not submit changes, the proxy-disclosed peers from the company’s last proxy filing will automatically be factored into ISS’ peer group construction process. More information on ISS’ peer group selection process, including a link to the form for submitting peer group changes, is available here.

This week, during his opening remarks at the 2017 National Conference of the Society for Corporate Governance, SEC Commissioner Michael Piwowar remarked on prospects for repealing or delaying the CEO pay ratio rule. Under the rule, most public companies must disclose the median of the annual total compensation of all employees (including non-U.S., part-time, temporary and seasonal workers), except for the CEO; the annual total compensation of the CEO; and the ratio of the two amounts, as calculated under proxy rules. The disclosure must be prepared for fiscal years beginning on or after January 1, 2017, which would be disclosed in 2018 proxy statements. Emerging growth companies, smaller reporting companies and foreign issuers are not subject to the rule. Commissioner Piwowar expressed his support for repealing the rule, which would require Congressional action. In terms of delaying effectiveness of the rule, he stated that public commentary would determine whether that alternative is feasible in light of the associated costs and benefits of implementing the rule. Though the latest comment period on the rule has ended, he urged interested parties to continue to submit comment letters describing specific reasons why the rule is burdensome, as well as proposed fixes. During the latest comment period, the SEC received approximately 180 unique comments, with 150 of those comments in favor of the rule. Given the approaching 2018 proxy season, we advise companies not to count on a repeal or delay of the rule. Companies should continue preparing for the CEO pay ratio disclosure, and keep in mind that there is significant latitude for how the ratio may be calculated, in accordance with Item 402(u) of Regulation S-K and related guidance in C&DIs 128C.01-128C.05. In particular: The median employee, which must be identified once every three years absent a significant change, may be identified from a survey of the entire employee population, a statistical sample or other reasonable method. A de minimis exemption allows companies to exclude non-U.S. employees who account for 5% or less of their employees, including employees whose inclusion would result in a violation of foreign privacy data laws. If certain employees are excluded, then all employees from that jurisdiction must be excluded. Companies may use a consistently applied compensation measure (“CACM”) other than annual total compensation to identify the median employee, as long as the CACM reasonably reflects the annual compensation of employees. For example, total cash compensation could be a CACM unless the company also distributed annual equity awards widely among its employees. Companies may select a determination date within three months prior to the end of their fiscal year, in order to determine employee population from which to identify the median. In applying the CACM to identify the median employee, companies are not required to use a compensation period that includes the determination date. Nor are they required to use a full annual period. As an example, the SEC states that a company may use annual total compensation from its prior fiscal year so long as there has not been a change in the registrant’s employee population or employee compensation arrangements that would result in a significant change of its pay distribution to its workforce. Workers whose compensation is determined by an unaffiliated third party may be excluded from the pay ratio calculation. This population may include leased workers, independent contractors who determine their own compensation, and even workers whose minimum level of compensation is set by the company. Companies should consider testing alternative methodologies in order to assess the quality and consistency of results. While there is considerable latitude to design a pay ratio methodology, companies should let reason be their guide and be prepared to explain the decisions that they make. Companies are required to describe in their proxy statements the methodology used, as well as any material assumptions, adjustments and estimates. Not surprisingly, CEO pay ratios have varied significantly depending on the companies surveyed and the methodology. The AFL-CIO’s annual report on CEO pay calculated a CEO-to-worker-pay ratio of 347-to-1 for 2016, based on the average total compensation package for 400 of the S&P 500 CEOs of $13.1 million last year, and the average annual cash income only (excluding fringe benefits) for America’s 100,525,000 rank-and-file workers of $37,632. In contrast, a 2016 Mercer study found the ratio among respondents to be less than 200-to-1.

The House passed the Financial CHOICE Act on Thursday as part of the new administration’s bid to overhaul Dodd-Frank. It is not expected to get through the Senate in its current form, but it does provide an interesting read. While current disclosure requirements have become too lengthy and cumbersome in many respects, the proposed change to Say-on-Pay voting frequency requires a materiality determination that may prove difficult for companies to implement. Currently, public companies are required to provide their shareholders with an advisory vote on executive compensation no less than once every three years. Most companies hold the vote annually. The Financial CHOICE Act would modify this requirement so that the vote is held “[e]ach year in which there has been a material change to the compensation of executives of an issuer from the previous year.” So, each year the issuer would have to determine if there has been a material change to executive compensation when deciding what proposals are put before shareholders at the annual meeting. I expect many issuers would continue to hold an annual vote to seek feedback from their shareholders even if there was no material change in compensation. However, given the high profile nature of a negative say-on-pay result, would issuers shy away from the advisory vote in a year of poor company performance (absent an obviously material change to executive compensation)? Will an issuer’s determination not to include the advisory vote bring on another wave of proxy disclosure litigation? Could an issuer determine not to hold a say-on-pay vote for multiple years in a row? Fewer say-on-pay advisory votes may not be problematic for issuers with strong corporate governance and shareholder engagement. However, for other issuers, say-on-pay advisory votes provided shareholders with a powerful (albeit imprecise) means of communicating their displeasure to the Board of Directors.

Companies frequently wrestle with perks in their proxy executive compensation disclosure. Whether an item constitutes a perk often requires judgment based on the facts and circumstances,¹ and disclosure may elicit intense, public scrutiny over what amounts to a relatively small percentage of an executive’s total compensation package.² From time to time, the SEC issues a cautionary tale that perks need to be accounted for and reported with care. The SEC recently announced that Miles Nadal, the former CEO of marketing company MDC Partners, has agreed to pay $5.5 million to settle charges that his perks were not properly disclosed to shareholders. While MDC Partners disclosed certain perks received by Mr. Nadal, including an annual allowance of $500,000, it failed to disclose payments for personal use of private airplanes, charitable donations in Mr. Nadal’s name, yacht and sports car expenses, cosmetic surgery, and a wide range of other perks totaling an additional $11.285 million from 2009 through 2014. The SEC order notes that MDC Partners, which agreed to a $1.5 million settlement of the matter earlier this year, understated Mr. Nadal’s perks by an average of almost 300% each year. While MDC Partners’ example is an egregious one, companies should verify that they have implemented internal controls that are capturing the full range of perks and potential perks, particularly where there is temptation to omit or mischaracterize these items, and that they have implemented disclosure controls that ensure the accurate reporting of these items. 1  In its adopting release for the “Executive Compensation and Related Person Disclosure,” Release Nos. 33-8732A, 34-54302A, File No. S7-03-06 (Aug. 29, 2006), the SEC established a two-step analysis for whether an item constitutes a perk: An item is not a perquisite if it is “integrally and directly related” to the performance of the executive’s duties, even if there is an element of personal benefit, so no disclosure would be required. If an item is not integrally and directly related to the performance of the executive’s duties, and it confers a direct or indirect benefit that has a personal aspect, then the item is a perquisite, unless it is generally available on a non-discriminatory basis to all employees. It does not matter whether the item may be provided for some business reason or for the convenience of the company. 2  Under Item 402(c)(2)(ix) of Regulation S-K, perquisites or other personal benefits paid to the named executive officers in the proxy statement must be disclosed in the summary compensation table, unless their total value is less than $10,000. Each perquisite or personal benefit must be identified by type, and each one that exceeds the greater of $25,000 or 10% of the total amount of perquisites and personal benefits must be quantified and disclosed in a footnote. Perquisites and other personal benefits are to be valued based on their aggregate incremental cost to the company.  

While passage in the House seems likely, the Financial Choice Act may undergo significant changes before it may pass in the Senate. Here is a summary of certain governance and executive compensation provisions that are included in the discussion draft: Prohibit Universal Proxy Ballots. Currently, companies are not required to use a universal proxy ballot in the event of a proxy contest, so shareholders receive one ballot listing candidates nominated by the board of directors and separate ballot(s) listing candidates nominated by the shareholder proponents. The Financial CHOICE Act would prohibit the SEC from requiring that companies use a universal proxy ballot. Modernize Shareholder Proposal Thresholds. The Financial CHOICE Act would increase share ownership thresholds for submitting shareholder proposals, from ownership of 1% of outstanding shares or $2,000 for one year, to 1% of outstanding shares for three years; increase resubmission thresholds; and prohibit proposals by a proxy other than the shareholders. Amend Frequency of Say-on-Pay Votes. Currently, under the Dodd-Frank Act, non-binding shareholder votes approving executive compensation must occur at least once every three years. The Financial CHOICE Act would amend the frequency to “each year in which there has been a material change to the compensation..." Require proxy advisory firms to register with the SEC and to provide companies with an opportunity to review and provide meaningful comment on draft recommendations. The registration application would include a certification that the firm has the financial and managerial resources to consistently provide proxy advice based on accurate information. The firm would be required to disclose the procedures and methodologies used in developing proxy voting recommendations, its organizational structure, whether or not it has a code of ethics, any potential or actual conflict of interest, and its policies and procedures to manage conflicts of interest. The registration would be updated as there are material changes, and at least on an annual basis. Repeal CEO Pay Ratio Disclosure. The Financial CHOICE Act would repeal the section of the Dodd-Frank Act which requires companies to disclose the ratio of pay between CEOs and the median employees. Acting SEC Chairman Michael S. Piwowar’s has requested an expedited review of unanticipated challenges to implementing the CEO pay ratio disclosure rule. Repeal Incentive-Based Compensation Disclosure by Covered Financial Institutions. The Financial CHOICE Act would repeal the Dodd-Frank provision which requires enhanced disclosure and reporting of incentive-based compensation by covered financial institutions. This Dodd-Frank Act provision targets excessive compensation and compensation that could lead to material financial loss. More broadly, President Trump has issued an executive order mandating that the Department of the Treasury review financial regulations, including the Dodd-Frank Act. Repeal Disclosure of Hedging Policies. The Financial CHOICE Act would repeal the Dodd-Frank requirement that companies disclose whether employees or directors may engage in hedging transactions in the company’s equity securities. Limit Clawbacks. Under the Dodd-Frank Act, companies that haven’t developed and implemented compensation clawback polices cannot be listed on national securities exchanges and associations. The Financial CHOICE Act would limit the scope of the clawback rule to current and former executives who had “control or authority over the financial reporting that resulted in the accounting restatement.” Pay vs. Performance Disclosure. The future of the pay versus performance provision is uncertain because it isn’t addressed by the Financial CHOICE Act or Hensarling’s memo. Section 953(a) of Dodd-Frank requires companies to disclose the relationship between executive compensation actually paid and the financial performance of the company.

Companies that permit the grant of early exercise incentive stock options (“ISOs”) do so primarily to limit the impact of the alternative minimum tax (“AMT”). However, due to fairly counterintuitive tax regulations, structuring options in this fashion can expose optionees to negative tax consequences in the event of a disqualifying disposition. Read more about the tax effects of early exercise ISOs and how the tax results compare to alternate structures in our recent eUpdate here: www.dorsey.com/newsresources/publications/client-alerts/2017/04/unexpected-risks-of-early-exercise-isos

Last Friday, ISS released new and updated FAQS on U.S. Equity Compensation Plans, as summarized below. These FAQs provide new and updated guidance on ISS’s evaluation of equity compensation plan proposals, including treatment of performance-based awards in burn rate calculations, bundling of plan amendment proposals, updates to ISS’s Equity Plan Scorecard (EPSC) policies, and the EPSC as it applies to newly public companies. Since 2015, ISS has evaluated proposals for equity compensation plans and certain amendments to these plans using the EPSC. The ESPC analysis is based on three pillars: Plan cost ("shareholder value transfer" or SVT), relative to the company's market and industry peers, Plan features, and The company's historical grant practices, including its 3-year average burn rate relative to market and industry peers. ISS scores proposals according to factors under each of these three pillars, using its proprietary model. Proposals may receive a maximum of 100 total points, with a threshold of 53 points required to receive a favorable recommendation (absent egregious factors). Summary of New and Updated FAQs 19. If a company grants performance-based awards, how will the shares be accounted for the purposes of calculating burn rate? Both time- and performance-based awards will be counted in the year in which they are granted for the burn rate calculation, but performance-based awards will be counted in the year in which they are earned if the company provides a table of awards granted and earned each year for the past three years, either in the 10-K or proxy statement. There’s a sample table in the FAQ. The aggregate of performance-based awards from all plans to all participants must be disclosed, and not just awards for NEOs. For performance awards that are subject to additional time vesting, the shares generally will be counted at the end of the time-vesting period if the number is disclosed. ISS advises companies to continue to make the additional disclosure, so that ISS may capture performance awards going forward and to provide a clear view of the year-to-year status of the performance award program. 28. How does ISS evaluate an equity plan proposal seeking approval of one or more plan amendments? If the proposed amendments do not request additional shares (or other modifications deemed to potentially increase cost), ISS will make a recommendation based on an analysis of whether the amendments are deemed to be “overall beneficial or contrary to shareholders’ interests.” If the proposed amendment is bundled with a material new share request (or are deemed to potentially increase cost), or this is the first time shareholders may vote on the plan, then ISS generally will support the amendments if there is a passing EPSC score, unless the amendments represent a “substantial diminishment to shareholders’ interests.” ISS will generally support proposals seeking approval of performance measures for Section 162(m) tax deductibility purposes, unless they are bundled with other plan amendments. For ISS’s treatment of bundled amendments, see FAQ #30. 30. How are proposals that include 162(m) reapproval along with plan amendments evaluated? ISS encourages companies to unbundle plan amendments from proposals seeking 162(m) reapproval, since the latter are generally supported by ISS (see FAQ #28). ISS will analyze bundled amendments to determine whether they are, on balance, positive or negative with respect to shareholders' interests. ISS may consider both an EPSC score and/or the balance of positive and negative impacts from the bundled amendments. 32. How does ISS view a plan amendment to increase the tax withholding rate applicable upon award settlement? This type of amendment is generally viewed as an administrative change neutral to shareholders' interests. However, if the plan contains a liberal share recycling feature (such as recycling of shares tendered as payment for an option exercise, shares withheld to cover taxes, shares added back that have been repurchased using stock option exercise proceeds, and stock-settled awards where only the actual shares delivered are counted against the plan reserve), then a company can mitigate ISS’s concern by providing that only the number of shares withheld at the minimum statutory rate may be recycled, even if the tax withholding is at a higher rate. See also, Nasdaq Doesn’t Require Shareholder Approval of Equity Compensation Plan Amendments to Increase Tax Withholding. 36. What changes were made to the EPSC policy for 2017? Effective for meetings as of Feb. 1, 2017, the following adjustments will apply to EPSC evaluations: Payment of dividends on unvested awards (new factor): Full points will be earned if the equity plan expressly prohibits, for all award types, the payment of dividends before the vesting of the underlying award. Accrual of dividends that are only payable upon vesting is allowed. No points will be earned if this prohibition is absent or incomplete (i.e. not applicable to all award types). Minimum vesting terms (updated factor – see also, FAQ #47): Full points are awarded only if the equity plan specifies a minimum vesting period of one year for all equity awards. Also, no points will be earned if the plan allows for the administrator to reduce or eliminate the one-year vesting requirement. Companies are permitted to carve out 5% of equity awards granted under the plan, which do not have to be subject to the minimum vesting requirement. Burn rate data: For companies with between 33 and 36 months of trading history at the applicable quarterly data download date, the EPSC model index will be based on whether the company has disclosed three years of burn rate data. Special Cases models apply for companies with 32 or fewer months of trading history. Factor scoring adjustment (see also, FAQ #42 and 43): Scoring for certain EPSC factors has been adjusted, though ISS does not provide specifics under its proprietary model. 41. How will equity plan proposals at newly public companies be evaluated? Newly public companies, including recent IPOs, spinoffs, and bankruptcy-emergent companies, may be evaluated under an EPSC model that includes fewer factors. In addition to these FAQS, ISS also released new and updated FAQs on U.S. Executive Compensation Policies and updated Pay-for-Performance Mechanics (which details ISS’s new Relative Pay and Financial Performance Assessment).

Over the last few months, the SEC has obtained a string of cease and desist orders against SEC reporting companies, both domestic and foreign, to enforce an often overlooked rule adopted under Dodd-Frank.  Rule 21F-17 provides that “[n]o person may take any action to impede an individual from communicating directly with the [SEC] staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement … with respect to such communications”. Many practitioners thought little about this rule until this summer.  In recent cease and desist orders involving Health Net, BlueLinx and Anheuser-Busch InBev, the SEC has made clear that it believes that a confidentiality clause violates Rule 21F-17 if, read on its face, it would prevent an individual from voluntarily communicating with the SEC regarding potential securities law violations (something that is not “required by law”) or if the clause would require the individual to obtain anyone’s consent or provide notice to anyone in order to engage in such communications.  In other words, the SEC now views “standard” confidentiality clauses included in employment, separation, confidentiality and other agreements and policies entered into with employees and other individuals as violating U.S. federal securities laws unless they include a specific carve out allowing whistleblowing. In recent months, the SEC has imposed fines ranging from $250,000 to more than $6 million on companies using such clauses in their agreements, and required such companies to take remedial actions, including informing current and former employees of their right to communicate with the SEC regarding potential securities law violations.  In several cases, the SEC did not allege that any of the affected persons was a whistleblower or had been impeded from being a whistleblower, just that the language used in the agreements was impermissible.  The SEC has also taken the position in recent actions that any purported waiver of an individual’s right to obtain a whistleblower award from the SEC is impermissible. While the cease and desist orders have, to date, been limited to SEC reporting companies, Rule 21F-17 does not appear limited to public companies.  Accordingly, private companies subject to U.S. jurisdiction should also consider their compliance with Rule 21F-17. Because the offending language is language that many consider “standard” for employment, separation, confidentiality and other agreements, as well as corporate governance policies such as codes of conduct and ethics, many companies will need to modify their corporate governance policies and their existing and template agreements to comply with the new interpretations.  We have developed language for confidentiality clauses and corporate governance policies that is intended to comply with the SEC’s new interpretations, and have worked with a number of companies to implement compliance regimes.  For further information or for assistance in complying with Rule 21F-17, please contact the author or your other Dorsey contacts.

ISS has published an executive summary of 2017 updates to its benchmark proxy voting policies for the Americas, EMEA, and Asia-Pacific regions.  The updated policies will generally be applied to shareholder meetings on or after February 1, 2017. U.S. policy changes are summarized below, and companies should keep them in mind as they consider policies on director compensation, dividend and vesting policies for stock awards, and shareholder rights to amend bylaws.  For companies contemplating IPOs, governance structures that have a material adverse impact on shareholder rights, including multi-class shareholder structures, generally will lead to recommendations against director candidates.  It’s worth noting that in certain situations where ISS finds a practice problematic, it will result in ongoing (versus one-time) recommendations against directors (see the last two policies described below). In December 2016, ISS will release a complete set of updated policies, and it will release updated Frequently Asked Questions ("FAQ") documents on certain U.S. policies, including the Equity Plan Scorecard. Non-Employee Director Pay:  While ISS does not evaluate stand-alone non-employee director (“NED”) plans according to its Equity Plan Scorecard he EPSC model, these plans do receive a standard cost evaluation for Shareholder Value Transfer (SVT).  Under the updated policies, NED pay proposals will be evaluated across “a broader range of factors and more nuanced consideration of director pay.”  ISS will assess advisory proposals seeking shareholder approval of NED pay, and certain NED equity plan proposals that are determined to be relatively costly, considering the following, additional qualitative factors: The relative magnitude of director compensation as compared to companies of a similar profile; The presence of problematic pay practices relating to director compensation; Director stock ownership guidelines and holding requirements; Equity award vesting schedules; The mix of cash and equity-based compensation; Meaningful limits on director compensation; The availability of retirement benefits or perquisites; and The quality of disclosure surrounding director compensation. This policy update is consistent with recent judicial scrutiny of director compensation.  In Calma v. Templeton, the Delaware Chancery Court denied Citrix’s motion to dismiss the plaintiff’s breach of fiduciary duty claim against the Citrix board of directors, and furthermore, held that director compensation decisions would be judged by the heightened entire fairness standard (versus the deferential business judgment rule), where the director compensation program did not include “meaningful limits.” Dividends and Minimum Vesting for Stock Awards:  ISS added a factor on dividend payments on unvested awards.  ISS will award full points if the equity plan expressly prohibits dividend payments for all award types before the vesting of the underlying award.  Accrual of dividends payable upon vesting is acceptable.  No points will be earned if this prohibition is absent or incomplete (i.e. not applicable to all award types).  Notably, a company's general practice of not paying dividends until vesting, if it is not memorialized in the plan document, is insufficient to earn full points. The minimum vesting factor was also updated so that an equity plan must specify a minimum vesting period of one year for all award types under the plan in order to receive full points for this factor.  No points will be earned if the plan allows for individual award agreements that reduce or eliminate the one-year vesting requirement. Restrictions on Shareholder Amendments to Bylaws:  ISS will make ongoing recommendations against governance committee members if the company's charter imposes undue restrictions on shareholders' ability to amend the bylaws.  These restrictions include but are not limited to a prohibition on the submission of binding shareholder proposals or ownership/holding requirements for such shareholder proposals that exceed those in the SEC’s Rule 14a-8. IPOs with Multi-Class Shareholder Structures:  If prior to or in connection with a company's public offering, the company or its board adopted bylaw or charter provisions materially adverse to shareholder rights, or implemented a multi-class capital structure in which the classes have unequal voting rights, ISS will generally recommend withhold or against votes on directors individually, committee members, or the entire board (except new nominees, who should be considered case-by-case).  Unless the adverse provision and/or problematic capital structure is reversed or removed, ISS will recommend a vote case-by-case on director nominees in subsequent years.  

On October 19th, the SEC released five new Compliance and Disclosure Interpretations (“CDIs”) relating to the upcoming “Pay Ratio Disclosure” requirements in Item 402(u) of Regulation S-K. Item 402(u) Pay Ratio Disclosure requirements, mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, require each covered public company to make annual disclosure of the ratio of its principal executive officer’s total annual compensation to the total annual compensation of an individual whose compensation is determined to be the median compensation of all of the company’s employees. Read our complete summary here:  https://www.dorsey.com/newsresources/publications/client-alerts/2016/10/new-cdis-help-issuers