IN THIS ISSUE NOVEMBER 2016

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1 IN THIS ISSUE NOVEMBER 2016 Insights on proxy access and disclosure from the SEC Division of Corporation Finance s director 2 Consider how Brexit will impact disclosure by SEC-reporting public companies 7 RECENT DEVELOPMENTS Shareholder proxy access, institutional ownership increased in Contact Us: info@merrillcorp.com Subscribe to future issues of DIMENSIONS Copyright 2016 Merrill Communications LLC

2 Insights on proxy access and disclosure from the SEC CorpFin Division s director By DIMENSIONS staff Among the better ways to gain insight into what the SEC is planning are the speeches and other public addresses given by SEC commissioners and high-level staff members. Keith Higgins, Director of the SEC s Division of Corporation Finance, recently conducted an open discussion at the annual meeting of the American Bar Association s Business Law Section in Boston. While Mr. Higgins addressed a wide variety of subjects related to SEC disclosure, we have selected a few topics of interest to discuss here. An audio recording of the full discussion is available. Proxy access dominated 2016 exclusion requests Director Higgins stated that during the 2016 proxy season, proxy access was the most common topic by a wide margin for shareholder proposals that CorpFin staff considered for exclusion under SEC Rule 14a-8. Sixty of the no-action requests from companies concerned proxy access, far more than the next most common set of subjects (environmental topics; 27 of the requests). There were fewer requests on executive compensation proposals than in previous years. The focal point of requests involving proxy access was SEC Rule 14a-8(i)(10), which allows a company to exclude a shareholder proposal if it has already substantially implemented the essence of the proposal. CorpFin received 44 no-action requests related to proxy access under what is commonly referred to as the (i)(10) exclusion. In response to 40 of those requests, the staff allowed the company to exclude proposals from its proxy materials. The types of proxy-access proposals, Mr. Higgins explained, fell into two categories: proposals for the company to adopt a proxy-access bylaw, and proposals demanding amendments to an existing bylaw. The most common type of proposal was seeking the adoption of a 3% NOVEMBER 2016 DIMENSIONS 2

3 ownership threshold with a 3-year holding period for the stock, which would allow shareholders meeting those requirements to nominate up to 25% of the board (but no fewer than two directors). CorpFin staff did not agree that 5% constitutes substantial implementation CorpFin staff allowed companies that had already adopted a 3%/3 years proposal, with a 20% or 25% nomination capacity, to exclude the proposals under the substantial implementation rationale. It did not matter if aspects of the company s adopted proposal differed from what the proponent had wanted. Our view was that those [company] proposals had met the essential objective of the proposal to adopt a proxy-access bylaw, Mr. Higgins said. For an example of a shareholder proposal that a company was not allowed to exclude under Rule 14a-8(i)(10), he cited a request to change specific provisions of the company s proxyaccess bylaw most importantly, by lowering the ownership threshold from 5% to 3%. CorpFin staff did not agree with the company that a 5% proxy-access bylaw constitutes substantial implementation of a proposal seeking a 3% threshold. The nonexcluded shareholder proposal sought to remove the limits on aggregation, taking out the post-meeting holding period and allowing the counting of recallable loan shares in calculating ownership. After no-action relief was denied, the company eventually amended its plan to 3%, including recallable loan shares. CorpFin staff then agreed that the company had substantially implemented what the shareholders had proposed. Mr. Higgins discussed at some length the denial of H&R Block s no-action request under Rule 14a-8(i)(10). While the company already had a proxy-access bylaw, a shareholder/proponent sought changes in limited aggregation, the number of board nominees that can be proposed, the use of loan shares, and limits on renomination. H&R Block argued that it had substantially implemented that proposal, pointing out that it already permitted proxy access for shareholders meeting the standard 3% and 3 years threshold. Nonetheless, the company s request for exclusion did not really focus on the modifications to the existing bylaw, and no-action relief was denied. Mr. Higgins emphasized that when the proponent of a proxy proposal wants a vote on specific items in a company s proxy-access bylaw, the company must do more than merely argue that it already has standard bylaw features (e.g., 3% ownership, 3-year holding period, for 20% of the board). CorpFin expects to see more shareholder proposals targeted at specific features of proxy-access bylaws. CorpFin expects to see more shareholder proposals targeted at specific features of proxy-access bylaws. It will be tough, he indicated, acknowledging that when a shareholder wants specific NOVEMBER 2016 DIMENSIONS 3

4 changes in a proxy-access bylaw, an especially rigorous analysis is needed before the staff can conclude that the proposal has already been substantially implemented. Not sure that we have ever done that before, but obviously [it is] something that we will think about in the off season, he concluded. Regulation S-K concept release; comment letters; structured data Another area covered in the discussion were the comment letters received during the summer on the Regulation S-K concept release. (For our review of selected comments, see the October 2016 issue of DIMENSIONS.) The vast majority of commenters supported requiring more sustainability disclosure, either generally or on specific topics, Director Higgins pointed out. This is a topic that is not going away, but it is going to be a challenge for the Commission because of the diversity of different things that apply across all industries. Establishing and updating sustainability standards across 79 separate industries is a pretty daunting task, especially given the controversial nature of the topics. Nevertheless, he hinted at future SEC rulemaking on these issues: It is an area that we should all pay attention to. Comment letters about the MD&A section particularly the potential use of structured data to improve disclosure delivery and presentation led to the implication that implementing commenters suggestions might be easier if the SEC had a structured taxonomy for the text portions of Form 10-K. For example, narrative discussions could be block-tagged. Results of operations, liquidity, capital resources, contractual obligations, all of the headings you could block-tag that, Mr. Higgins explained. And then somebody who wanted to take a look at an industry and wanted to look at the capital-resources discussion across industries could do it. These are things we are thinking about as we try to reimagine how we can make disclosure more accessible and easier for shareholders to get. Inline XBRL Companies might think of [Inline XBRL] as another way to characterize what the instance document is. A June 2016 SEC order, which lets companies use Inline XBRL instead of filing a separate document with XBRL-tagged financial data, gives issuers the ability to integrate XBRL data within their HTML filings through March Director Higgins indicated that the SEC is working on a proposal for Inline XBRL which is broader than the recently adopted order. He also confirmed that the order allowing voluntary use of Inline XBRL does not change anything about the liability regime or whether it is furnished or filed, whether it is subject to disclosure controls or procedures. Companies might think of it as another way to characterize what the instance document is. He sought to reassure filers that may be reluctant to use Inline XBRL, because they fear liability or are unclear on whether it is subject to internal controls over financial reporting (see, e.g., Guide to Internal Control over Financial Reporting). Nothing has changed except the location of NOVEMBER 2016 DIMENSIONS 4

5 this tagged information. It has always been filed. It has never been furnished. The Commission has always believed it is subject to disclosure controls and procedures, and that the XBRL information itself is not subject to ICFR. That is what the rule is now, and the order did not purport to change anything on that front. Disclosures on board diversity in the pipeline According to a speech by SEC Chair Mary Jo White, Mr. Higgins noted, the SEC staff is working on recommendations to improve diversity disclosure and to focus on race, ethnicity, and gender. He told the lawyers in the audience that they should watch this space, adding that we are pretty far along in our thinking. New rule on hyperlinks; expect more Mr. Higgins discussed SEC Release No , which requires companies to include a hyperlink to each exhibit identified in the exhibit index in any registration or report that must include exhibits under Item 601 of Reg. S-K. Companies must also file these registrations or reports in HTML format. (For details of the rule, see the October 2016 DIMENSIONS.) It makes a lot of sense to require hyperlinks, Mr. Higgins said. We do not think it is costly. He observed that the release requires hyperlinks in only the final registration statement that is declared effective. The SEC is seeking comments on whether it ought to require hyperlinks in any of the earlier filings. A small number of companies still file in ASCII format, but they will now have to use HTML. He added that the hyperlinking requirement may eventually be broadened: I think this could be expanded requiring internal hyperlinks in the table of contents. Non-GAAP disclosures: crossing a horse and a donkey During the past year, the SEC staff has intensified its scrutiny of non-gaap measures in disclosures (see the July 2016 issue of DIMENSIONS). The staff s activities on that front have included a revised set of Compliance & Disclosure Interpretations (C&DIs) to clarify the SEC s position on non-gaap measures. We did not set out to wipe non-gaap off the face of the planet, said Mr. Higgins. Our goal was to curb what we viewed as troubling practices that had developed over the past several years. We have always commented on non-gaap, so this should not come as any huge surprise. The C&DIs list eight examples of disclosures that, in the view of CorpFin staff, fail the equal-orgreater-prominence requirement of Regulation G. This rule governs not only the placement and style of presentation but also subtler issues, such as the balance of coverage in the discussion of non-gaap and GAAP numbers. He itemized some of the topics addressed by the CD&Is: non-gaap measures that exclude normal recurring cash operating expenses which are necessary to run a company s business cherry-picking of data for non-gaap measures transparency when a company is changing how it calculates non-gaap measures individually tailored recognition and measurement methods Mr. Higgins offered frank words of caution about the practice of concocting a novel non-gaap measure that uses both a GAAP measure and a company s own method of recognition and NOVEMBER 2016 DIMENSIONS 5

6 measurement. We are deeply suspicious of those, particularly in the revenue area, which is where it has been most prominent. We are giving these things some thought we are not just firing these out. Other practices that the CorpFin staff frowns on include the use of per-share data for liquidity purposes and income-tax expense presented as a performance measure. The subtle prominence issues remain the more difficult ones, he added. A company may say we had record non-gaap results and go on about everything that drove the great non-gaap results and then briefly say we had a GAAP net loss of $75 billion. Those are the types of things we will be looking at. The SEC staff has a team that focuses on non-gaap measures, which are scrutinized at the AD (Assistant Director) Group level. The staff does not send comments to filers until a specialized group has thoroughly evaluated the non-gaap measures under review. We are giving these things some thought we are not just firing these out. Different industries do have different non-gaap-related things, so we are [also] mindful of that. In a jocular spirit, Mr. Higgins regaled the meeting attendees with a few suspiciously creative non-gaap measures that have surprised even his own staff: Earnings excluding losses from acquired businesses until those businesses generate income Earnings excluding all R&D expense for products not currently generating revenue Earnings excluding all selling and marketing expenses Attendees asked about how to handle some specific scenarios with non-gaap numbers that would pass the prominence tests. His responses indicate that there is not always a clear answer in these situations, which depend on facts and circumstances. One example showed that many video-game companies choose not to present a hybrid revenue number; instead, they present their GAAP revenue, then show the deferred revenue. We are not against disclosures of deferred revenue, Mr. Higgins said. We think that is good disclosure. We encourage companies to do that. It is just that when you are crossing a horse and a donkey, you are getting a made-up number, which we were troubled by. EDITOR S NOTE: A universal proxy ballot, which would include the names of all the nominees for the board of directors, may be on the way. The SEC has just proposed requiring that parties in a contested election use universal proxy cards. Shareholders could vote by proxy for their preferred combination of board candidates, as if they had attended the meeting and voted in person. The SEC also proposed amendments to Rule 14a-4(b), which would require proxy cards to include an against option for board elections when that vote has a legal effect and also enable shareholders to abstain in an election governed by a majority voting standard. Here is a link to the proposing release, Rel NOVEMBER 2016 DIMENSIONS 6

7 Consider how Brexit will impact disclosure by SEC-reporting public companies Abstracted from: Brexit: Disclosure Implications For SEC Reporting Companies By: Mark Bergman and David Lakhdhi Paul Weiss Rifkind Wharton & Garrison, London, England Corporate Governance Advisor Vol. 24, No. 5, Pgs. 1-7 Ask a raft of questions. Brexit, the United Kingdom s withdrawal from the European Union was approved in a June 2016 referendum. It will significantly affect the disclosure obligations, especially the MD&A and risk factors, of domestic companies and foreign private issuers that report to the SEC, attorneys Mark Bergman and David Lakhdhir warn. Management s attention to Brexit and the resulting political, economic, and monetary uncertainties should trigger numerous questions. These include how much of the company s business is in the United Kingdom; how much of its revenues and expenses are denominated in pounds; what duties would apply to UK/EU trading without a pact; how much it has to reduce investments or hiring; how much of its business is retail and hence vulnerable to lower consumer confidence; to what degree its UK operations depend on EU workers; and how harmful interrupted information transfers would be. Junk the boilerplate in MD&A. Brexit s impacts are difficult to foresee, but management should try to give investors as much guidance as possible, as soon as possible, and should not presume that extensive publicity has made the investors aware of those impacts. The required MD&A disclosure of known trends and uncertainties must not just be generic, the authors advise. Tailor disclosures to the company and its financials; make them industry-specific as well as company-specific; and disclose whether the company is in the United Kingdom, substantially exposed to its economy or currency, or otherwise vulnerable to Brexit-induced macroeconomic changes. Bank rates may float. Brexit might affect how central banks, including the US Federal Reserve, will time their interest-rate increases. It may very well influence how foreign-exchange rates will fluctuate and whether financial-services firms in the United Kingdom can keep the so-called passport that permits them to operate throughout the European Union. Make risk factors shipshape as well. Management guidance on Brexit s impacts should extend to risk factors. Here again, the authors remind, boilerplate is inadequate. Courts have frequently said that meaningful risk factors address the company s particular facts and situations. Moreover, management should regularly re-evaluate Brexit-related risk factors in NOVEMBER 2016 DIMENSIONS 7

8 light of new data, since courts have also said that unchanging risk factors are liable to turn into boilerplate. Brexit could also require disclosure of an altered environment for financing (if companies need liquidity sooner than anticipated or if they see chances to lock in low-interest-rate funding) or for M&A activity (which could be used to establish an EU presence for passporting or other purposes). Underwriters and M&A counterparties due diligence will certainly involve Brexit considerations. Treat disclosure of plans as a tender task. Companies having substantial exposure to EU markets via the United Kingdom may be eager to reassure their shareholders that they have made contingency plans for handling Brexit but reluctant to disclose those plans that could greatly affect their workers and other stakeholders. Management has to strike a delicate balance, the authors caution, because selective disclosure could violate Regulation FD. Companies reporting to regulators in both the United States and the United Kingdom must also obey the latter s rules. According to a pre-referendum statement by the UK Financial Reporting Council, a company ought to tell shareholders if it deems Brexit to be a principal risk. The United Kingdom requires companies to consider materiality when they disclose principal risks and uncertainties in the strategic report within the annual report; the UK regulators encourage companies to disclose the range of possible outcomes and unlike in the United States the mitigating factors, if any. Abstracted from Corporate Governance Advisor, published by Wolters Kluwer Law & Business, 4025 W. Peterson Avenue, Chicago IL To subscribe, call (800) ; or visit NOVEMBER 2016 DIMENSIONS 8

9 RECENT DEVELOPMENTS Shareholder proxy access, institutional ownership increased in 2016 During the 2016 proxy season, shareholders intensified their crusade for more proxy access; ownership by institutional investors in public companies grew to 70%; and more than 260 public companies failed to exceed the voting benchmark of 70% support from shareholders for say-on-pay proposals. These are three of the findings from an annual survey conducted jointly by PricewaterhouseCoopers s Governance Insights Center and Broadridge Financial Solutions, which processes shareholder communications and proxy voting for public companies. In the third edition of ProxyPulse: 2016 Proxy Season Review, PwC and Broadridge present data from 4,200 annual shareholder meetings that took place between January 1st and June 30 th, Shareholder proxy access continues to blaze a trail through public companies According to the report, the adoption of proxy-access bylaws among the S&P 500 has skyrocketed, from just 1% of the companies in 2014, to 40% in Other major findings from the 2016 proxy season include the following: Proxy-access proposals continue to win support. More than half (60%) of the 69 shareholder proposals that came up for a vote were supported by a majority of the voting shareholders. Institutional shareholders favor proxy access; retail investors do not. While 60% of the votes from institutional investors approved of proxy-access proposals, most of the votes (85%) from retail investors were opposed. Activism continues to wield significant influence. The New York City Boardroom Accountability Project submitted proxy-access proposals to 72 companies; more than two-thirds of those companies agreed to adopt a proxy-access bylaw before the annual shareholders meeting. Directors approve of proxy access, but not the current eligibility standard. Although most of the surveyed directors say that they view proxy access favorably, only a minority of them (20%) think that 3% ownership over a 3-year holding period should be the standard threshold for eligibility. More than half favor a more rigorous standard, 5% over at least 5 years. Despite the push, proxy access had not been used for board nominations as of June The average shareholder support for nominated directors was 96% among the surveyed companies during the 2016 proxy season. Between January and the end of June, 22,560 directors were nominated, and only 382 did not win majority support from shareholders. NOVEMBER 2016 DIMENSIONS 9

10 Low say-on-pay support correlates with director unpopularity Shareholder support for say-on-pay averaged 90% at large- and mid-cap companies, 88% at small-cap companies, and 83% at micro-cap companies. The ProxyPulse survey finds that weak support for say-on-pay can be associated with weak support for directors. At nearly onequarter of the surveyed companies where say-on-pay won less than 70% of shareholder votes, at least one director also received less than 70% of the shareholder votes. According to PwC and Broadridge, this correlation between say-on-pay support and director popularity is promoting more direct dialogue between directors and investors about executive compensation and a change in director mindset about such communications. Of the surveyed directors, 77% think it is either somewhat or very appropriate to include shareholders in discussions about executive compensation. Institutional investors own about 70% of public companies At the 4,200 public companies included in the ProxyPulse survey, ownership by institutional investors rose from 68% of shares in 2015 to 70% in Institutional ownership at mid-cap companies is highest (77% of shares), followed by ownership at large-cap companies (72%) and small-cap companies (68%). Only 33% of the shares in micro-cap companies are owned by institutional investors. Proposals on board leadership fail; proposals on board declassification succeed The survey also considered shareholder proposals on board leadership and board declassification among the surveyed companies. ProxyPulse reports that 44 shareholder proposals in the 2016 proxy season sought to split the role of chair and CEO, down from 57 such proposals in Just three proposals succeeded in 2015; none won majority support from shareholders in By contrast, all 38 proposals on board declassification most of which came from management received a majority of shareholder support. NOVEMBER 2016 DIMENSIONS 10