Compensation and Corporate Governance Disclosure and Proxy Solicitation

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1 Compensation and Corporate Governance Disclosure and Proxy Solicitation SEC Publishes Proposed Rules to Expand Disclosure Regarding Compensation and Corporate Governance Matters and to Clarify Proxy Solicitation Rules SUMMARY The SEC has published the full text of rules that would expand disclosure of compensation and corporate governance matters. The proposals also clarify issues relating to the solicitation of proxies and the granting of proxy authority and would mandate prompt reporting of shareholder voting results on Form 8-K. The new rules for compensation and corporate governance disclosure would require the company to: discuss how its overall compensation policies may affect the company s risk management practices or risk taking incentives, if the risks arising from those compensation policies may have a material effect on the company, which could require a focus on compensation practices within a specified business unit or units; report stock-based awards on a grant-date fair value basis, rather than the current financial statement reporting basis; describe the specific qualifications of the company s director nominees; describe the board s overall leadership structure, why the structure is appropriate for the company and whether and why the company has chosen to combine or separate the Chairman and CEO positions; discuss the role of the board in the company s risk management process; disclose the fees and services provided by compensation consultants that provide noncompensation-related services to the company; and report the results of a shareholder vote on Form 8-K, as opposed to Forms 10-Q or 10-K. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 The enhanced disclosure requirements would apply to companies that have a class of equity securities subject to SEC proxy rules, including investment companies registered under the Investment Company Act of 1940, but not to foreign private issuers. The changes to the proxy solicitation rules would: clarify that providing a form of revocation (which makes the exemption from the proxy rules for solicitations by non-management parties unavailable) does not include the furnishing of an unmarked duplicate copy of management s proxy card if the duplicate is to be returned directly to the company; codify recent SEC staff guidance that facilitates the rounding out of short slates for which proxies are solicited by non-management parties; clarify that any conditions imposed by a soliciting party as to whether the shares for which voting authority is sought must be objectively determinable ; and clarify that information regarding the identity and interests of participants in a solicitation must be on file with the SEC when the solicitation begins. Should the proposal be adopted, the Commission anticipates that the changes would be effective for the 2010 proxy season. EXPANDED COMPENSATION DISCLOSURE Compensation Discussion and Analysis A company s Compensation Discussion and Analysis currently focuses on the compensation of the company s principal executive officer, principal financial officer and the three most other highly compensated executive officers (the named executive officers ). The proposed rules would require that the Compensation Discussion and Analysis also describe how the company s overall compensation policies and practices for employees may affect the company s risk management practices or risk taking incentives to the extent the risks arising from those compensation policies may have a material effect on the company. No disclosure is required unless the materiality threshold is met, and no disclosure is required of the individual compensation of anyone other than a named executive officer. Although the Commission emphasizes that determining situations that require the additional disclosure will depend on the particular company and its compensation policies, the proposed rule contains a nonexhaustive list of situations that may trigger such disclosure if material. The list includes, among other things, the existence of compensation policies: at a business unit of the company that carries a significant portion of the company s risk profile; at a business unit where compensation is structured significantly differently than it is at other units within the company; at business units that are significantly more profitable than others within the company; -2-

3 at business units where compensation expense is a significant percentage of the unit s revenues; and that vary significantly from the overall risk and reward structure of the company, such as bonuses that are awarded upon accomplishment of a task, while the income and risk to the company from the task extend over a significantly longer period of time. Similarly, the proposed rule does not contain any specific issues that a company must discuss and analyze, but rather, includes a set of illustrative examples that companies should consider addressing if such policies or practices have the potential to create risks that are material to the company. These examples include: the general design philosophy of the company s compensation policies for employees whose behavior would be most affected by the incentives established by the policies, as such policies relate to or affect risk taking by those employees on behalf of the company, and the manner of their implementation; the company s risk assessment or incentive considerations, if any, in structuring its compensation policies or in awarding and paying compensation; how the company s compensation policies relate to the realization of risks resulting from the actions of employees in both the short term and the long term, such as through policies requiring claw-backs or imposing holding periods; the company s policies regarding adjustments to its compensation policies to address changes in its risk profile; material adjustments the company has made to its compensation policies or practices as a result of changes in its risk profile; and the extent to which the company monitors its compensation policies to determine whether its risk management objectives are being met with respect to incentivizing its employees. In each case, the appropriate level of detail in the disclosure would depend on the particular facts at the reporting company and within its various business units. Summary Compensation Table Under the proposal, Item 402 of Regulation S-K would be modified to revise the way stock and option awards are reported on a company s Summary Compensation Table and Director Compensation Table. Such awards would be required to be disclosed based on their fair value on the grant-date, computed in accordance with Financial Accounting Standards Board Statement of Financial Accounting Standards No. 123 (revised 2004) Share-Based Payment ( SFAS 123R ). Under the existing disclosure requirements, established in 2006, these awards are disclosed based on the value recognized for financial statement reporting purposes pursuant to SFAS 123R. The Commission now believes that using the full grant-date fair value calculation would be more useful and informative than the existing financial statement recognition method because investors may consider compensation decisions made during the fiscal year which usually are reflected in the full grant date fair value measure, but not the financial statement recognition measure to be material to voting and -3-

4 investment decisions. 1 In addition, the Commission noted that aggregate grant-date fair value reporting of stock and option awards would, unlike the financial statement recognition model, take into account the incremental fair value of options repriced during the fiscal year. In a potentially significant change, the Commission requests comment on whether the new grant-date disclosure should reflect awards made after year-end but that relate to services performed in the prior fiscal year. Under the current rules, the Grants of Plan-Based Awards Table only includes awards made during the fiscal year; awards made after the year-end are excluded, even if they relate to services performed in the prior year. If the change proposed by the Commission is adopted, the Summary Compensation Table would better reflect the compensation paid for services performed during the relevant fiscal year. We expect commentators to support this approach. The Commission has proposed two additional, related changes to Item 402. First, the proposal would delete the requirement to report the full grant-date fair value of each individual equity award in the Grants of Plan-Based Awards Table and the corresponding footnote disclosure to the Director Compensation Table as duplicative. Second, Instruction 2 to the salary and bonus columns of the Summary Compensation Table would be amended to exclude the amount of salary or bonus forgone at a named executive officer s election pursuant to a program under which non-cash compensation may be received in lieu of annual compensation. Instead, the non-cash compensation would be reported in the column applicable to the form of award elected. The Commission proposed the latter change to ensure that the compensation disclosed in the Summary Compensation Table for each named executive officer would properly reflect the form of compensation ultimately received by such officer. If the proposed change to the method of reporting stock-based awards from a financial statement recognition basis to a grant-date fair value basis is adopted, it may affect which executive officers are identified as the named executive officers for proxy disclosure purposes. Recognizing this, the Commission is considering requiring compensation for the prior two years for the named executive officers in 2010 proxy statements to be restated to reflect the new method of reporting. This requirement to restate would apply even if the named executive officer would not have been a named executive officer in the prior two years based on the grant-date fair value methodology. Consistent with this approach, the Commission indicates that issuers would not need to re-determine the named executive officers for the prior two years. The Commission seeks comment on this proposed transition method. ENHANCED CORPORATE GOVERNANCE DISCLOSURES The Commission has also proposed a number of amendments to Items 401 and 407 of Regulation S-K, as well as to certain reporting forms under the Securities Act of 1933 and the Securities Exchange Act of 1 See Release No (July 10, 2009), available at: -4-

5 1934, in each case designed to improve the manner in which companies disclose information to their shareholders regarding certain corporate governance matters. Director Qualifications Under the proposal, Item 401 of Regulation S-K would be amended to require additional disclosures about directors or director nominees. In particular, companies would be required to discuss the specific experience, qualifications, attributes or skills that qualify that person to serve as a director for the registrant at the time that the disclosure is made, and as a member of any committee 2 that the person serves on or is chosen to serve on (if known), in light of the registrant s business and structure. This disclosure would apply not only to director nominees proposed by the company s board of directors, but also to director nominees nominated by other shareholders. The proposed rule further provides that, if material, this disclosure should cover more than the past five years, and include information about the person s risk assessment skills, particular areas of expertise, or other relevant qualifications. These required disclosures would be in addition to the current requirement that companies briefly describe the business experience during the past five years of each director nominee. The proposal also includes two additional changes to Item 401. First, the Commission has proposed requiring the disclosure of each directorship held by any person who was a director or nominee during the preceding five years, even if that person no longer serves on the other board. Under the current rule, directors and nominees for director are required to disclose only their current directorships. 3 Second, the Commission proposes to extend the period in which directors and nominees would be required to disclose their involvement in certain legal proceedings from five to ten years. 4 Each of the changes noted above would apply to a company s proxy and information statements filed on Schedules 14A and 14C, annual reports filed on Form 10-K, and any registration statements on Forms 10, S-1, S-4 and S-11. In addition, the Commission has proposed requiring that these enhanced disclosures also apply to proxy statements filed by management investment companies that are registered under the Investment Company Act. Finally, Forms N-1A (used by open-end management The proposed rule would cover all board committees, not just standing committees such as the audit, compensation and nominating committees. The SEC requests comments on whether the proposed rule should extend to just standing committees. If not narrowed, the rule would apply to, among other committees, special litigation committees, committees established to approve security offerings and committees established to consider business combinations. The proposed rule, like the existing rule, only requires such disclosure of directorships of companies with a class of securities registered pursuant to Section 12 of the Exchange Act, or subject to the requirements of Section 15(d) of that Act, or any company registered as an investment company under the Investment Company Act of The list of legal proceedings required to be disclosed by Item 401(f) of Regulation S-K includes, among other things, a conviction in a criminal proceeding or being named in a pending criminal proceeding (excluding traffic violations and other minor offenses), and certain civil or administrative actions taken in respect of violations of federal or state securities or commodities laws. -5-

6 investment companies), N-2 (used by closed-end management investment companies) and N-3 (used by separate accounts, organized as management investment companies, which offer variable annuity contracts) would each be amended to include the expanded narrative disclosure regarding director and director nominee qualifications and the additional disclosure for past directorships. New Information About a Company s Leadership Structure and the Board s Role in Risk Management The proposed rules would require additional disclosure about a company s leadership structure and the board s role in the risk management process. These changes would require disclosure about the company s leadership structure and why company believes the structure is appropriate given its specific characteristics or circumstances. These new provisions would also require companies to disclose whether and why they have chosen to combine or separate the Chairman and CEO positions. If these positions are combined, the company must disclose whether it has a lead independent director and what specific role that director plays in the leadership of the company. Registered investment management companies would be required to include similar disclosure, except that the fund must disclose whether its board chair is an interested person of the fund, as defined in Section 2(a)(19) of the Investment Company Act, and, if so, whether it has a lead independent director and what specific role that director plays in the leadership of the fund. Reporting companies and registered investment management companies would also be required to disclose the extent of the board s role in the company s risk management and the effect that this role has on the entity s leadership structure. The SEC indicates that this disclosure would address how the board implements and manages its risk management function and might address whether the risk management personnel report directly to the board or a board committee. These disclosures would apply to apply to a company s proxy and information statements filed on Schedules 14A and 14C, and would also be reflected in the statements of additional information filed as part of registration statements on Forms N-1A, N-2 and N-3. Compensation Consultant Disclosures Item 407 of Regulation S-K currently requires disclosure of any role played by compensation consultants in determining or recommending the amount or form of executive and director compensation, the identity of those consultants, whether they are engaged directly by the compensation committee, the nature and scope of their assignment, and the material elements of the instructions or directions given to them. The proposed rules would make two changes regarding disclosure about the activities of compensation consultants and their affiliates. First, the proposed rule would provide an exemption from the existing disclosure requirements where the consultant s role in determining or recommending executive or director compensation was limited to consulting on any non-discriminatory broad-based plan that is generally available to all salaried employees (such as 401(k) and health insurance plans) in which executives and -6-

7 directors may participate. This exemption would apply only so long as the compensation consultants limited their services to these types of broad-based plans; the exception would be lost if the consultants provide any other services, including other services relating to executive or director compensation. Second, the proposal would expand the disclosures required when the consulting services include not only a role in determining the amount or form of compensation for executives or directors but also other services to the company during the most recently completed fiscal year. The required additional disclosure would include: the nature and the extent of all additional services provided; the aggregate fees for the additional services and the aggregate fees for determining or recommending the amount or form of executive and director compensation; whether the decision to engage the compensation consultants or their affiliates for the other services was made, subject to screening, or recommended, by management; and whether the compensation committee or the board approved the other services of the compensation consultants or their affiliates. The Commission believes that these new disclosures will improve investors ability to assess incentives a consultant may have in advising on executive compensation. In announcing the proposed rule, the Commission noted that the fees generated by such additional services, such as benefits administration, human resources consulting and actuarial services, could, in some cases, exceed the fees earned by the consultant for executive compensation services. Expedited Voting Results Currently, companies must disclose the results of a shareholder vote in their next filing on either Form 10-Q or Form 10-K. Consequently, disclosure is delayed by up to three months following the shareholder vote. To prevent such delays, the proposed rule would require the vote to be reported in a Form 8-K. The Form 8-K would need to be filed within four business days after the day on which the meeting ended. In the case of contested director elections, however, if the voting is not definitively determined at the end of the meeting, the company would be required to disclose only the preliminary voting results within four business days after such results are determined, and subsequently file an amended Form 8-K within four business days after the final results are certified. CLARIFYING PROXY SOLICITATION RULES Communications by Non-Management Parties Shareholders and other non-management parties are generally exempt from the proxy solicitation rules so long as they are not seeking proxy authority on their own or another s behalf and do not have a substantial interest in the subject matter of the solicitation. The proposed rules clarify that providing -7-

8 shareholders with an unmarked duplicate copy of management s proxy card does not disqualify the soliciting person from the exemption if the person requests that the card be returned directly to the company. The exemption is unavailable to persons who furnish or request a form of revocation of proxy. 5 The proposing release states that this clarification would aid efforts by persons not seeking proxy authority to facilitate voting by shareholders sharing their views on matters submitted for shareholder approval such as in a just vote no campaign without having to incur the costs and efforts of conducting a fully-regulated proxy solicitation and provide shareholders a convenient opportunity to indicate their votes after hearing those views without having to request another proxy card from management. In addition, the proposed rules would clarify that the substantial interest requirement applies whether or not the soliciting person is a shareholder, and that the substantial interest does not have to be derived from stock holdings. This clarification is consistent with the Commission s stated intent to limit the exemption solely to disinterested persons. Rounding Out Director Nominee Slates The proposed rules would codify recent SEC staff guidance that facilitates the rounding out of short slates for which proxies are solicited by non-management parties. 6 Rule 14a-4(d)(4) currently permits a person soliciting support for a short slate to round out the slate by seeking authority to vote, in addition, for some of the registrant s nominees, even though such nominees had not given the consent, otherwise required, to be named in the soliciting person s proxy statement. The proposal would broaden this rule to allow the non-management parties to round out their short slates with nominees from any other person s proxy statement. 7 The Commission stated that the current rule effectively advantages the company s nominees, who may be voted on more than one proxy card, while the non-management nominees may only be voted on one proxy card. If the soliciting party is seeking authority to vote for nominees named in one or more non-management persons proxy statements, such person must represent in its proxy statement that: it has not agreed and will not agree to act, directly or indirectly, as a group or otherwise engage in any activities that would be deemed to cause the formation of a group as determined under the Exchange Act with any such other non-management person(s); and The proposed rule would effectively reverse a 2004 decision by the U.S. Court of Appeals for the Second Circuit. Mony Group, Inc. v. Highfields Capital Mgmt., L.P., 368 F.3d 138 (2nd Cir. 2004) (holding a duplicate of management s proxy card, when included in a mailing opposing a proposed merger, was a form of revocation under Rule 14a-2(b)(1)). A short slate is a group of nominees who, if elected, would constitute a minority of the board of directors. See Eastbourne Capital, L.L.C., SEC No-Action Letter (Mar. 30, 2009) and Icahn Associates Corp., SEC No-Action Letter (Mar. 30, 2009) at -8-

9 it has not acted and otherwise will not act as a participant in any solicitation by any such other non-management person(s). The proposed rule would not alter the current requirements that the party rounding out its short slate: seek authority to vote in the aggregate for the number of director positions then subject to election; represent that it will vote for all the nominees named in such other proxy statements, other than those nominees specified by the soliciting party; provide shareholders an opportunity to withhold authority with respect to any other nominee named in such other proxy statements by writing the name of that nominee on the form of proxy; and state on the form of proxy and in the proxy statement that there is no assurance that the nominees named in such other proxy statements will serve if elected with any of the soliciting party s nominees. Requiring Objectively Determinable Conditions Rule 14a-4(e) requires that a proxy provide that the shares represented by the proxy will be voted subject to reasonable specified conditions. This requirement was intended to ensure that a shareholder, prior to granting the legal power to someone else to vote his or her shares, understood any of the conditions under which the proxy would be voted. The proposed rules would amend Rule 14a-4(e) to clarify that any conditions imposed by a soliciting party as to whether the shares will be voted must be objectively determinable. The Commission indicates that a condition that the proxy holder conclude in his or her discretion the advisability of voting would not be objectively determinable, while a condition that the proxy holder make a filing with the SEC seven days before the meeting date would be objectively determinable. Availability of Disclosures Rule 14a-12 permits a party to make a solicitation to shareholders before furnishing them with a proxy statement if each written communication includes either the identity of the participants in the solicitation and a description of their direct or indirect interests or a legend advising security holders where they can obtain that information. The proposed rules would clarify that if a legend is used, the information regarding the identity and interests of participants in a solicitation must be filed under Schedule 14A no later than the time the first soliciting communication is made. IMPLICATIONS The SEC s proposals may have a number of effects on a company s existing governance practices. These include: changes to the executive officers who are named in the proxy and whose compensation details are disclosed; -9-

10 expanded discussions at a company s nomination committee; limiting the services performed by compensation consultants; increased pressure to create a lead independent director, and potentially, separate the CEO and Chairman positions; and potentially significant increases in the time required to prepare, complete and process directors and officers questionnaires. The Effect on the Identity of Named Executive Officers The proposed new requirement to report stock-based awards on a grant-date fair value basis, rather than the current financial statement recognition basis, could significantly alter the total reported compensation of the company s executive officers, and therefore could affect the identity of the most highly compensated executive officers (other than the principal executive officer and principal financial officer) included in the relevant disclosure documents. In the case of issuers subject to the recently adopted TARP standards for compensation and corporate governance, 8 changes in the named executive officers could have a significant impact on their compensation practices. Impact on Nominating Committees Nominating committees are often provided an array of information on director nominees and candidates for board and board committee membership. In light of the new director disclosure requirements, it may be advisable for a nominating committee to explain more fully its rationale for recommending a director nominee or a director to serve on a particular committee. Use of Compensation Consultants In light of the proposed disclosures concerning additional services provided by compensation consultants or their affiliates, companies could further limit the additional services provided by compensation consultants that provide advice on executive or director compensation or require compensation committee pre-approval of those services, similar to what is currently done for non-audit services of independent auditors. In any event, companies should consider putting in place procedures to track the services provided by, and the fees paid to, compensation consultants in order to prepare for the proposed disclosures. The Effect on Board Independence Reporting companies who have not yet done so are likely to feel pressured to consider appointing a lead independent director and to define the specific role such person will play in the leadership of the company. The proposed rule changes may also result in more issuers choosing to split the CEO and Chairman positions. 8 The interim proposed rule is discussed in our Memorandum to Clients, dated June 11, 2009, entitled Treasury Implements TARP Compensation and Corporate Governance Standards. -10-

11 Implications on Directors and Officers Questionnaires The proposed requirements of additional information about directors and director nominees, including enhanced disclosure with respect to such person s business qualifications, previous directorships and legal proceedings, can be expected to lead companies to significantly expanded directors and officers questionnaires. The revised questionnaires will require additional time and expense not only to complete, but also to incorporate into the company s disclosure documents. SUMMARY Comments on the proposed rules are due by September 15, Sullivan & Cromwell LLP will be submitting a comment letter on the proposed rules. In the proposing release, the Commission indicated that, should these amendments be adopted, the Commission anticipates that the changes would be effective for the 2010 proxy season. * * * Copyright Sullivan & Cromwell LLP

12 ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance and corporate transactions, significant litigation and corporate investigations, and complex regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 700 lawyers on four continents, with four offices in the U.S., including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Jennifer Rish ( ; rishj@sullcrom.com) or Alison Alifano ( ; alifanoa@sullcrom.com) in our New York office. CONTACTS New York John E. Baumgardner, Jr baumgardnerj@sullcrom.com Robert E. Buckholz, Jr buckholzr@sullcrom.com H. Rodgin Cohen cohenhr@sullcrom.com Joseph B. Frumkin frumkinj@sullcrom.com David B. Harms harmsd@sullcrom.com Richard R. Howe hower@sullcrom.com John P. Mead meadj@sullcrom.com James C. Morphy morphyj@sullcrom.com Robert W. Reeder III reederr@sullcrom.com Glen T. Schleyer schleyerg@sullcrom.com Max J. Schwartz schwartzma@sullcrom.com Marc R. Trevino trevinom@sullcrom.com Washington, D.C. Janet T. Geldzahler geldzahlerj@sullcrom.com Eric J. Kadel, Jr kadelej@sullcrom.com Robert S. Risoleo risoleor@sullcrom.com Palo Alto Scott D. Miller millersc@sullcrom.com -12- DC_LAN01:

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