SEC Adopts Enhanced Compensation and Corporate Governance Proxy Disclosure Rules

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Friday, January 15, 2010

SEC Adopts Enhanced Compensation and Corporate Governance Proxy Disclosure Rules for 2010 Proxy Season

A Practical Approach to What Companies, Boards and Compensation Committees Need to Do Now

Welcome and Introduction

• Welcome• Today’s subject: SEC’s new enhanced

disclosure rules and what companies, Boards and Compensation Committees need to do now– Review of rule changes– Provide practical analysis of how to comply:

analysis and disclosure

New Rules Are Effective on February 28

• Proposed rules were issued in July 2009

• New rules are generally effective as of February 28, 2010– Apply to definitive proxy statements and 10-Ks filed after that date– Except for companies with FY end before December 20, 2009

• Preliminary proxy filings before Feb. 28 must include disclosure if it is expected that the definitive will be filed after Feb. 28

• Registration statements for non-reporting companies filed after December 20, 2009 must comply in order to be declared effective on or after Feb. 28

Disclosure Drives Behavior

• Compensation and governance under the microscope• Underlying philosophy: Sunlight is the best

disinfectant• Likely intended to affect substantive policies• Designed to advance shareholder empowerment

trend

Federal Policymakers Take Control of the Governance Agenda in 2008-09

• Government takes equity stakes in Citigroup, GM, GMAC, AIG, Bank of America, Chrysler

• Intense focus on executive compensation– TARP firms hold mandatory Say on Pay votes– Pay Czar cuts pay for executives at top TARP firms, an

average of 50%– Legislation to require Say on Pay votes

• SEC proposes new proxy access rule• SEC and NYSE eliminate broker discretionary voting

Legislative Developments

• Senator Schumer’s “Shareholder Bill of Rights”– Would direct SEC to establish proxy access– Would also make other fundamental changes in corporate

governance—declassification, mandatory independent chair– Mandatory Say on Pay votes

• Similar bill by Rep. Gary Peters• Senator Dodd’s Financial Reform Bill

– Covers majority voting, declassification, proxy access, independent chairman, clawbacks, Say on Pay, golden parachutes, and independent consultants and counsel

Topics

• Analyzing and disclosing pay risk• Revised equity grant disclosure• New disclosure regarding compensation consultant

services and fees• New disclosure regarding corporate governance• Questions/Answers

Pay Risk: A Practical Approach to Analysis and

Disclosure

Pay Risk: A Practical Approach to Analysis and Disclosure

Pay Risk: A Practical Approach to Analysis and Disclosure

• What triggers disclosure under the new rules?

• What information must be disclosed?• Policies that may mitigate or balance

incentives• Steps to take now

What Triggers Disclosure?

• Disclosure is required where “risks arising from the registrant’s compensation policies and practices for its employees are reasonably likely to have a material adverse effect on the registrant”

• Applies to compensation policies and practices for all employees, not just executives

What Triggers Disclosure?: Examples

• The trigger is designed to be principle-based, varying based on facts and circumstances, but the final rules include a non-exclusive list of examples where disclosure may be triggered:– Compensation policies and practices at a business unit that

either (1) carries a significant portion of the company’s risk profile, (2) has a significantly different compensation structure than other units; (3) is significantly more profitable that other units; or (4) pays compensation expense as a significant percentage of the unit’s revenues

– Compensation policies and practices at a company vary significantly from the company’s overall risk and reward structure (e.g., where bonuses are awarded based on performance while the related income and risk to the company are spread over a significantly longer period of time)

What Information Must Be Disclosed?

• The disclosure will be located in a separate section of the proxy, rather than as part of the CD&A

• If disclosure is not triggered, the rules do not require a company to state affirmatively that is has made a determination that its compensation practices and policies are not reasonably likely to have a material adverse effect on the company

• If disclosure is triggered, a company must “discuss the registrant’s policies and practices of compensating its employees, including non-executive officers, as they related to risk management and risk-taking incentives.”

What Information Must Be Disclosed? (continued)

• Principles-based rule, but the final rules include examples of issues companies may need to address if disclosure is required:– General compensation policy design philosophy;– Method for conducting risk assessment;– Use of “clawbacks” and holding periods;– Adjustment process to address changes in risk

profile;– Compensation policy changes relating to changes

in the company's risk profile; and– Monitoring of compensation policies.

Policies That May Mitigate or Balance Incentives

• Policies or practices that mitigate or balance incentives may be considered in determining whether compensation practices are “reasonably likely to have a material adverse effect” on the company

• Appropriate Performance Metrics: • Balance financial vs. non-financial goals and individual vs. company-wide

goals;• Vary goals applicable to long- and short-term awards; • Implement longer-term performance objectives and vesting conditions;• Increase the range of performance over which incentives are paid.

• Appropriate Pay Mix: • Create a balance of short-term and long-term incentives, cash and equity

incentives and incentive compensation vs. base pay.

• Limited Non-Performance Payouts: • Limit the size of sign-on bonuses and other payouts that do not reflect

performance;• Limit severance and change-in-control payouts to avoid perverse incentives.

Policies That May Mitigate or Balance Incentives (continued)

• Appropriate Equity Incentives: • Balance grants of options/SARs and stock awards; • Limit the size of equity grants; • Implement longer vesting periods; • Implement stock ownership and holding guidelines that link executive and

shareholder interests.

• Compensation Consultant: Engage a compensation consultant to assess compensation policies and compare these policies to those of peers and of the broader industry.

• Deferred Payments: Defer annual incentive awards and build-in permissible adjustments based on subsequent results or discoveries.

• Remedial Measures: Reserve availability of “clawbacks,” payout caps and discretion to adjust awards, including in connection with extraordinary or unanticipated company events.

• Positive Company Culture: Encourage emphasis on long-term value creation.

Steps to Take Now

• Assess Risk Policies. Review existing risk management policies, determine if broader or more detailed policies are needed and implement as appropriate.

• Assess Risk Profile. Identify components of the company’s known risk profile that may be impacted by compensation decisions and confirm that compensation policies mitigate rather than exacerbate these risk factors.

• Coordinate Oversight. Harmonize functions of audit and compensation committees and ensure that controls are in place to verify attainment of performance goals. Confirm that risk managers are not compensated based on the performance of the units they oversee.

Steps to Take Now (continued)

• Revisit Compensation Programs. Review compensation agreements, plans and programs to ensure that incentives encourage desirable behavior linked to long-term value.

• Revise Compensation Policies. Revise compensation agreements, plans and programs as needed to ensure that they provide proper incentives.

• Document Risk Assessment Process. Describe steps taken to assess risk and implement risk-monitoring and mitigating procedures.

Enhanced Equity Award Disclosure

Enhanced Equity Award Disclosure

Enhanced Equity Award Disclosure

• Companies must now report equity awards at aggregate grant date fair value (in accordance with FASB ASC Topic 718) on the Summary Compensation Table and Director Compensation Table

• Disclosure is required for awards granted during the fiscal year (rather than grants based on services performed during the fiscal year, even if granted after fiscal year end)– The SEC suggests that post-fiscal year end

awards be analyzed in the CD&A

Enhanced Equity Award Disclosure (continued)

• The new rule may affect who is a named executive officer

• The value of performance-based awards must be reported based on the probable outcome of the performance conditions, as of the grant date– The maximum possible value of awards must be reported in a

footnote

• The SEC’s proposed changes eliminating the reporting of full grant date fair value in the Grants of Plan-Based Awards Table were not adopted in the final rules

• Companies must re-calculate awards on a grant date fair value basis for current named executive officers for 2008 and 2007, but companies are not required to re-compute who would have been a named executive officer in those prior years

Enhanced Compensation Consultant Disclosure

Enhanced Compensation Consultant Disclosure

Enhanced Compensation Consultant Disclosure

• Board compensation consultants• Company compensation consultants• Exempt services

Board Compensation Consultants

• Disclosure is triggered if the board (or compensation committee) engages a consultant (or an affiliate) who provides: – (1) advice on the amount or form of executive and/or director

compensation, and – (2) non-executive compensation consulting services for fees

in excess of $120,000 annually

• If triggered, the company must disclose:– Aggregate fees paid for compensation and non-

compensation consulting services– Whether the decision to engage the consultant for non-

compensation services was made or recommended by management

– Whether the board approved the non-compensation services

Company Compensation Consultants

• Disclosure is triggered if the board (or compensation committee) has not engaged its own consultant, and the company engages a consultant (or an affiliate) who provides:

– (1) advice on the amount or form of executive and/or director compensation, and

– (2) non-executive compensation consulting services for fees in excess of $120,000 annually

• Disclosure is not required with respect to the company’s consultant where the board and management have separate compensation consultants, regardless of whether the management consultant participates in board meetings

– Disclosure may still be triggered with respect to the board’s consultant if the conditions for disclosure are met

• If triggered, the company must disclose:– Aggregate fees paid for compensation and non-compensation consulting

services

Exempt Services

• Disclosure is not required where:– The consultant’s only role in consulting on

compensation is related to broad-based plans that do not discriminate in favor of executives or directors of the company

– The consultant’s services are limited to providing information that is not customized to the company or is customized based on parameters not developed by the consultant (e.g., survey data)

• However, the consultant may not provide advice or recommendations in connection with the information provided

Disclosure About Board Leadership Structure

Trends in Board Leadership Structure

• Enron, WorldCom, SOX and the aftermath– Audit committees must consist only of independent directors– Listed company boards required to have a majority of

independent directors– Boards to meet in regularly scheduled executive session

without management– Certain mutual funds must have independent chair

• Financial crisis leads to high profile CEO departures, and separation of Chair and CEO roles– Major financial firms, such as Citigroup, Bear Stearns,

Washington Mutual, Wachovia and Wells Fargo split the Chair and CEO roles

– Stockholders strip Bank of America CEO Ken Lewis of his Chairman title

Trends in Board Leadership Structure (continued)

• In 2008, NACD study: 73% of directors on boards with independent chair said company greatly benefited; 7% said not

• In 1998, 16% of S&P 500 companies had non- executive chairmen

• By 2008, 39% had non-executive chairs– 45% at S&P 1500

• However, most non-executive chairs are not completely independent (usually former CEO or other related party– According to Spencer Stuart, in 2004, 7.6% of all non-

executive chairmen were designated as independent, rising to 13% in 2007 and 16% in 2008

14a-8 Stockholder Proposals

• Before 2009, most stockholder proposals sought a lead independent director– In the 2009 proxy season, there was fault line shift from proposals

for lead independent directors to proposals for separate independent board chairs

• In 2009, 43 proposals sought independent chairs vs. 34 in 2008– Support is also up: 35% in 2009 vs. 28% in 2008– Approximately 45% of S&P 1500 have already separated the CEO

and board chairs– RiskMetrics and other proxy advisory firms will recommend in favor

of separation proposal, with limited exceptions• Political and regulatory support

– Pending legislation would mandate independent board chair– SEC proposed disclosure rules would focus disclosure on this issue

New SEC Disclosure Rules about Board Leadership Structure

• New rules mandate disclosure of – whether and why it has chosen to combine or

separate the Chairman and CEO positions– why company has determined its leadership

structure is appropriate given its specific characteristics or circumstances.

• If Chairman and CEO positions are not split, more disclosure is required:– Disclosure as to whether or not registrant has a

lead independent director, and – Disclosure of the specific leadership role of lead

independent director

Company Must Make A “Determination” that Board Leadership Structure is “Appropriate”

• A “determination” should lead to actual and meaningful board deliberation and discussion

• SEC has not provided guidance about what “appropriate” means in this context

• Of course, board discussion on these topics may suggest ways to improve leadership structure and board function

The New Default Structure?

• The SEC’s presumption appears to be that a split Chairman and CEO is, in general, a more appropriate leadership structure– Potential for inherent conflict of interest;

board is to act independently of the CEO– Effective chair of a public company board

involves substantial duties that are inconsistent with a full-time job managing the company

Structure “Appropriate Given the Company’s Specific Characteristics and Circumstances”

• What specific characteristics and circumstances might make a combined Chairman/CEO appropriate?– It ain’t broke– Confusion, duplication, inefficiency, and cost– Disruptive to strip CEO of his Chairman title; separation

should be done as part of succession– Controlled companies– Chairman temporarily assumes CEO role

• What specific characteristics and circumstances might make it appropriate to have a combined Chairman/CEO and no lead independent director?

• Disclosure will change behavior• Analogy to SOX disclosure regarding absence of financial

experts

Enhanced Director and Nominee Disclosure

Disclose Qualifications of Directors and Nominees

• Company to briefly discuss, for each director or nominee:– specific experience, qualifications, attributes or

skills– that led the Board to conclude that the person

should serve as a director– at time disclosure is made– in light of registrant’s business and structure

• Regarding board service, not committee service, unless expertise qualifying individual for a committee is the reason for nomination to the board

Expanded Disclosure of Directorships and Legal Proceedings

Expanded biographical information shall include: • All public company directorships held in past five years

– This is designed to reveal past board experience, and professional or financial relationships that might pose potential conflicts of interest

• Legal proceedings over previous ten years, instead of five years • Disclosable legal proceedings expanded to include:

– Judicial or administrative orders, judgments or findings alleging violations of

• Securities law or regulations, or commodities laws• Laws regarding financial institutions or insurance

companies• Mail or wire fraud, or fraud related to a business entity• Excludes settlements of private civil litigation

– Disciplinary sanctions or orders imposed by a stock, commodities or derivatives exchange or other SRO

Director Diversity

Disclosure of the Nominating Committee’s process for identifying and evaluating nominees must address:

• Whether, and if so, how, the nominating committee (or board) considers diversity in identifying nominees for director; and

• If the nominating committee (or the board) has a policy with respect to the consideration of diversity

– Describe how the policy is implemented; and– How the nominating committee (or the

board) assesses the effectiveness of its policies.

Definition of Diversity

• Companies are free to define as they consider appropriate

• A definition of diversity can include differences of:– Viewpoint– Professional experience– Skill– Other individual qualities or attributes that

contribute to board heterogeneity.• Need not be limited to concepts of race,

gender and national origin

Disclosure of the Board’s Role in Risk Oversight

New SEC Disclosure Rules Focus on the Board’s Role in Risk Oversight

Proxy and Information Statements must disclose:

– The extent of the board’s role in risk oversight• How does the board administer its oversight function

– The effect that the Board’s role has on the board leadership structure.

The Board’s Risk Oversight Process

• How does the board use its board committees in administering it risk oversight?

• What role does the full board play?• How does the board, or board committee, receive

information on risk and risk management from management?

• Should a standing risk committee be formed?• How much of this should you disclose?

8-K Reporting of Voting Results

8-K Reporting of Voting Results

• Voting results must be reported within 4 business days after the meeting

• If result is not known (matter is contested, or too close to call), file preliminary results in 4 business days, and final within 4 business days after results are known

• Failure to file within required time period can affect S-3 eligibility

Questions and Comments?

Speakers

John M. Newell, Latham & Watkins, Partner, Corporate Department (San Francisco)+1.415.395.8034 ⎜

[email protected]

David M. Taub, Latham & Watkins, Partner, Tax Department (Los Angeles)+1.213.891.8342 ⎜

[email protected]

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