Considerations for Directors in the 2014 Proxy Season and Beyond

As we begin 2014, calendar-year companies are immersed in preparing for what promises to be another busy proxy season. We continue to see shareholder proposals on many of the same subjects addressed during last proxy season, as discussed in our post recapping shareholder proposal developments in 2013. To help public companies and their boards of directors prepare for the coming year’s annual meeting and plan ahead for other corporate governance developments in 2014, we discuss below several key topics to consider.

1. Executive compensation.

Executive compensation continues to be a hot button issue with investors and the public. The reaction to the recent “pay ratio” proposals issued by the Securities and Exchange Commission (“SEC”) is just one indication of this. The proposals, which would require disclosure about the ratio between CEO and average worker pay, generated over 100,000 comment letters and were the subject of widespread coverage in the press. The pay ratio disclosures will not apply for the 2014 proxy season, but if the SEC adopts final rules in 2014, we expect that calendar year companies will have to provide their first pay ratio disclosures in the 2016 proxy statement.

Even in this environment, however, support for company-sponsored say-on-pay proposals remained high during the 2013 proxy season, with votes averaging approximately 91% and almost 98% of Russell 3000 companies receiving majority support for their say-on-pay. Additionally, as in prior years, negative voting recommendations from the two main proxy advisory firms, Institutional Shareholder Services (“ISS”) and Glass, Lewis & Co. (“Glass Lewis”), had a significant impact on support for say-on-pay proposals. In 2013, the most common reasons for negative say-on-pay recommendations from ISS and Glass Lewis were pay-for-performance “disconnects” and compensation practices the proxy advisory firms view as “problematic.” For 2014, ISS is changing its pay-for-performance analysis to emphasize long-term performance by evaluating alignment between a company’s total shareholder return and CEO pay using only a three-year period, rather than one- and three-year periods.

Despite widespread support for say-on-pay, companies and their compensation committees need to remain vigilant in preparing for 2014 say-on-pay votes, even at companies where say-on-pay received significant shareholder support last year. Companies that opted for triennial say-on-pay will hold their second votes in 2014, along with smaller companies (those with public floats below $75 million). Companies with triennial say-on-pay votes, in particular, will need to evaluate their compensation practices and CD&A disclosures against a landscape that has evolved over the past three years.

During this time, one constant that has remained is the importance of linking pay to performance. Boards and compensation committees need to be focused on this issue, both in making compensation decisions and changes to compensation programs, and in explaining the company’s compensation practices to shareholders. Companies that provide supplemental pay disclosures (such as disclosures about realized or realizable pay) should take care to make sure those figures fairly present the compensation of senior executives. They should be aware that this is an area where SEC officials are focused, as the SEC considers additional executive compensation rulemaking under the Dodd-Frank Act (discussed below).

With shareholders having a greater voice on matters like executive compensation, proactive and ongoing dialogue with major shareholders is critical (as discussed below) so companies can understand shareholder concerns about their compensation practices and determine how best to address them, and so companies can explain their practices to shareholders. As in prior years, companies also should evaluate their pay practices against those of peer companies and the policies of the major proxy advisory firms. Likewise, companies should review the voting guidelines of their institutional investors, many of which have their own policies with respect to executive compensation (and other matters).

2. Shareholder engagement.

Executive compensation is just one area where shareholders have been seeking greater dialogue with companies and their boards of directors. Although executive compensation has been a driving force in the trend toward enhanced engagement, over the past several years, companies and their boards have been communicating about a growing spectrum of issues, ranging from governance to sustainability, with a greater variety of shareholders that now extends well beyond traditional “activists.” In a December 2013 speech, SEC Chair May Jo White observed that the “landscape has unquestionably changed” for shareholder activism in the United States, and that “the board of directors is—or ought to be—a central player in shareholder engagement.”

While we expect that shareholders will continue to seek greater input on matters involving the companies in which they invest, from the board’s perspective two things have not changed. The first is the core principle that shareholder engagement should occur on an ongoing basis. Regular outreach is critical to developing and maintaining good relationships with long-term shareholders, to understanding their views and to helping them understand the plans and views of the board and management. The second principle is that boards of directors need not—and should not—reflexively implement every change or “good governance” practice that shareholders suggest. Indeed, directors have a fiduciary duty to exercise independent judgment in making decisions that they believe are in the best interests of the company and its shareholders. Accordingly, while the views of shareholders are among the important factors that the board should evaluate as part of its decision-making process, at the end of the day, on matters within its discretion, the board must exercise its own informed judgment. Once the board reaches a decision, the company should consider how best to communicate the board’s decision to shareholders.

To promote effective shareholder engagement, the board, through its nominating/governance committee, should oversee the company’s efforts in this area. In practice, this means that the board should understand what the company is doing to communicate with shareholders, and participate in engagement efforts as appropriate. It should know who the company’s shareholders are and have an understanding of their views on major issues relevant to the company, as well as their voting policies where applicable. Individually, directors should participate in dialogue with shareholders on issues where board-level involvement is appropriate. For example, when dealing with matters like executive compensation and board leadership structure, the expectation among many large shareholders is that they will interface directly with board members. Of course, companies and their boards should be mindful of Regulation FD in communicating with shareholders, but it should not be an impediment to shareholder engagement. Finally, boards and management should endeavor to anticipate areas where the company may receive criticism from activist shareholders so the company can communicate effectively with the investor community on these issues. For example, if significant changes in strategy or executive compensation are planned, an effective communications program covering the reasons for and corporate benefits of the changes should be a focus of the board approval process.

3. Board composition issues.

As the business and regulatory environment for public companies has become more challenging, boards increasingly have been asking themselves whether they have the optimal mix of skills and experience to meet those challenges, and shareholders have been asking this question as well. Nominating/governance committees, as well as shareholders, have become more focused on whether the board includes the “right” directors—directors who individually have skills sets that are relevant for the company’s business, including industry knowledge, and who as a group can apply their collective experience to oversee the company most effectively.

In 2013, the issues of board diversity and director tenure gained greater attention, due in part to efforts in the United States and abroad to increase the percentage of women on boards. Related to this, institutional investors and other commentators in the United States have started to focus on director tenure because of their concern that long-term board service may impact director independence and hinder efforts to achieve greater board diversity. In the United Kingdom, a presumption already exists that directors serving for more than nine years are not independent, although under the “complain or explain” regime in place there, companies may explain why they have determined that any such directors are independent. While boards should be attuned to the need for gender and racial diversity, diversity in the broadest sense—that is, a diversity of backgrounds and experiences—is critical to the larger issues of board composition and director succession planning, which should be high priorities for boards of directors.

A recent Ernst & Young study on board diversity at S&P 1500 companies confirms what many have observed: there are more women joining boards, but change has been slow. As of 2013, 85% of S&P 1500 board seats were held by men. The study also demonstrates why the next several years present an opportunity to move the needle on this issue: public company boards consist heavily of long-serving directors who are likely to step down over the next decade. According to the study, as of 2013, about 45% of S&P 1500 board seats were held by individuals who had served for ten years or longer, and 27% of these seats were held by individuals age 68 or older.

The extent of turnover anticipated on public company boards over the next decade or so highlights the importance of succession planning at the board level. The board should take a proactive approach to succession planning by evaluating the composition of the board regularly, looking at the skills and experience represented on the board and identifying additional attributes that would be helpful, considering retirements that are on the horizon, and engaging in targeted recruiting to identify new director candidates. As an initial step, we encourage nominating/governance committees to use a matrix to map the skills and experience of current directors and to pinpoint where additional or deeper expertise may be appropriate. The goal of the board succession planning process should be a “curated board” whose composition reflects a deliberate, thoughtful selection process that produces the “right board” for the company, given the company’s current circumstances and its longer-term strategic and operating plans. Succession planning should cover not just new directors, but also committee chairs and board leadership, so that the board has a “pipeline” of directors who can fill key roles on the board.

4. Oversight of strategy and risk.

Strategy and risk continue to be two key areas that are top of mind for public company boards, and areas where many directors say they would like to spend more time. Ongoing board-level attention to strategy has become even more critical in the past year or so, as shareholder activists have begun casting a wider net and focusing on strategy and operations, as well as related risks. Well-advised boards understand that strategy and risk are integrally related, and these boards are focusing on risk issues—risk appetite, and oversight of risk assessment and risk management—as a core element of the strategic planning process.

The board is responsible for overseeing and understanding the company’s strategy, from development through execution by management. Boards should be comfortable that they have an appropriate level of involvement in strategy, and that they are spending the time they want on strategic planning issues. At many companies, board-level discussions about strategy are no longer reserved for the annual strategic retreat or for times when the company is contemplating a major change of course. Instead, time at board meetings is set aside throughout the year to brief the board on strategy issues, including updating the board on implementation of the company’s strategy. This can provide the board with a deeper, more current understanding of how the company is performing relative to its own strategic plan, in addition to keeping the board apprised of industry and other macro factors that may impact strategy. Making strategy a recurring agenda item will assist directors in engaging in informed evaluation of strategic planning issues. As part of the strategic planning process, the board should take a holistic picture of risk by considering the risks that are inherent in the company’s business and strategy and talking with management about how it is managing these risks and how management plans to do so going forward as the company executes its strategic plan.

Focusing on risk as part of strategic oversight is one component of risk oversight. Smart risk oversight starts with establishing a structure for the board to oversee risk that pairs oversight and engagement at the full board level with involvement from the audit committee and other appropriate board committees, which often oversee risks in their respective areas of expertise. Boards use a variety of risk oversight structures, and the “right” structure for a particular board is one that provides the board with visibility into the major risks facing the company—both current and anticipated—and how management is monitoring and managing those risks. Senior management should brief the board on a regular basis about its approaches to risk assessment and risk management, and should seek input from directors about whether they are receiving the amount and kind of information they need to effectively perform risk oversight. Care should be taken to prioritize risks, communicate their expected impact and avoid “information overload.” The risks facing a company change over time, so identifying and monitoring emerging risks should be an important part of a company’s risk assessment and management processes, and the board should be kept appropriately informed about these risks. For example, we expect that a recent, highly-publicized data breach at one of the country’s largest retailers will prompt continued dialogue in many boardrooms about what companies are doing to address cyber risks and liabilities. Many boards already are focused on strategy and risk, including risks in the information technology space. It is also important that companies communicate clearly and concisely to investors about what they and their boards are doing in these areas.

5. Developments impacting the audit committee’s work.

Audit committees have remained busy over the past few years, even as a spotlight has been directed at compensation committees in the wake of the Dodd-Frank Act. In 2014, audit committees can expect to hear more about regulatory changes that are underway at the Public Company Accounting Oversight Board (“PCAOB”), and they should consider whether there are enhancements that can be made to existing disclosures—including the audit committee report—to provide shareholders, regulators and the public with additional understanding of what the audit committee does.

In August 2013, the PCAOB proposed two audit standards that will, if adopted, significantly change the model for the outside auditor’s report included in the annual report on Form 10-K and dramatically expand the auditor’s responsibilities in reporting on disclosures outside the financial statements. The first standard would require disclosure in the audit report about the auditor’s tenure and about “critical audit matters” encountered during the audit, such as matters involving the most difficult, subjective and complex auditor judgments. The second standard would require the auditor to evaluate “other information” in the Form 10-K, including Management’s Discussion and Analysis, exhibits and disclosures incorporated by reference from the proxy statement. Based on this evaluation, the auditor would have to report on whether the information contains any material misstatements or material inconsistencies relative to information in the audited financial statements. The public comment period on these proposals closed in December 2013, and it will be important to follow PCAOB plans with respect to these proposals. The PCAOB has said it anticipates scheduling a roundtable in the first half of 2014 to discuss the proposals.

Also in December, European Union officials reached agreement on proposed legislative changes addressing the audit sector, which include a requirement that auditors produce more detailed audit reports, with a required focus on information that is relevant to investors. These proposals also would require public companies to rotate their auditors every ten years, with possible extensions of up to ten years if the engagement is put out to bid and up to 14 years for companies that have “joint audits” by more than one audit firm. In the United States, even though the PCAOB has issued a concept release soliciting comment on the issue, PCAOB officials have remarked that the PCAOB currently has no plans to pursue mandatory audit firm rotation.

According to the PCAOB, the goal of its proposals relating to the auditor’s report is to provide investors with more useful information. Consistent with this goal, audit committees also should take a fresh look at the audit committee report and consider whether the report or other proxy disclosures about their work could provide more meaningful disclosure about their activities. A trend toward greater transparency in audit committee reports is already underway, with one survey of 2013 proxy disclosures from Fortune 100 companies concluding that many of these companies “exceed the minimum disclosure requirements.” In November 2013, a group of leading governance organizations, including the National Association of Corporate Directors, issued a report concluding that public company audit committee reporting can be strengthened in some ways. The report urged public company audit committees “to voluntarily and proactively improve their public disclosures” and emphasized the importance of providing more relevant—not just more—disclosure that is tailored for the company. Factors that audit committees could consider addressing in the audit committee report include the scope of the audit committee’s duties, the committee’s role in selecting, overseeing and evaluating the outside auditor, the tenure of the outside auditor, and the committee’s pre-approval of audit and non-audit services. Audit committees should review the recommendations in the November 2013 report to help inform their approach in the upcoming proxy statement and determine whether some or all of the recommendations should be applied to their reports. Audit committees would need to take some actions associated with the recommendations soon, in advance of inclusion in the audit committee report. As companies prepare the Form 10-K and proxy statement, they also may wish to undertake an assessment of all their audit committee-related disclosures, which often appear in a number of places throughout these filings, to determine whether the disclosures can be revised in order to provide investors with a more comprehensive, easily accessible picture of the audit committee’s work.

6. D&O indemnification and insurance.

For individuals serving as directors and officers of public companies, exposure to investigations and lawsuits remains real. In the past few years, public companies have faced an uptick in shareholder litigation, as well as record levels of enforcement activity in areas such as the Foreign Corrupt Practices Act. In 2013, shortly after the appointment of SEC Chair Mary Jo White, the SEC announced that it would begin moving away from its practice of allowing defendants to “neither admit nor deny” alleged wrongdoing in settlements with the SEC and that it would instead seek admissions of wrongdoing in certain circumstances. The SEC already has applied this policy in a handful of high-profile settlements, prompting discussion about the impact it will have on companies’ D&O insurance.

In this environment, outside directors, in particular, are understandably concerned about liability and they remain focused on whether their companies’ indemnification and insurance will protect them. While a number of companies have modernized their indemnification provisions in recent years and some now conduct regular reviews of their D&O insurance policies, too often these protections do not receive sufficient attention until someone truly needs them and the time for addressing any gaps in coverage has passed. Those who work with boards of directors—including in-house counsel, corporate secretaries and risk managers—can prevent this situation by being proactive and regularly reviewing the company’s indemnification and insurance to make sure they remain state of the art and poised to respond to the latest developments.

This is especially critical for D&O insurance because changes in the external environment—such as the rise over the past several years in investigation costs and litigation from M&A transactions—often warrant changes to a company’s D&O insurance program. The D&O insurance market evolves to respond to these types of changes, and new coverage features often become available. Due to the complexity of policy language and the issues involved, expert advice from qualified professionals is important in obtaining a thorough understanding of a company’s D&O insurance program. More and more boards of directors are seeking comprehensive analyses of their companies’ D&O insurance, undertaken with the assistance of experts, in connection with the purchase or annual renewal of coverage.

7. Management succession planning and development.

Like strategy and risk, management succession planning, and corporate talent development generally, are areas where many directors say they would like to spend more time, and in our experience, many directors have acknowledged that there is room for improvement in these areas.

Many public company boards have stepped up their succession planning and talent development oversight activities in recent years, but these efforts generally have focused on developing ordinary course and emergency succession plans for the CEO. This is critical, because the board needs to reach consensus on how to address both planned transitions like retirements, and unexpected, “hit-by-the-bus” scenarios. However, succession planning is not just about the CEO and it is not just about succession, in the sense of identifying a replacement for the CEO. Rather, it implicates broader issues of leadership talent development, and “bench strength,” that reach down below senior management. Without a robust “pipeline” of talent well below the CEO level, boards will face challenges in finding strong future candidates for the top position.

In light of this, many boards are now looking at talent development more broadly, with the goal of “building a bench” of individuals that the company can draw on to fill senior management positions when the need arises. The CEO necessarily will play the most important role in this process, as the person who has day-to-day contact with many of the individuals in the talent “pipeline.” As part of their job duties, the CEO, working together with other senior management, should be responsible for developing a talent pool by identifying high-potential people within the company and making sure that they have access to appropriate professional experiences that will allow them to develop into viable candidates for senior management positions.

If the board has delegated primary responsibility for CEO succession planning to an independent committee—such as the compensation or nominating/governance committee—that committee could take the lead in overseeing management development. The full board should be briefed, and the views of all directors sought, as part of the periodic reports made by that committee to the board. As part of their oversight function, the committee and the full board should endeavor to develop an understanding of the skills and experience that are represented on the senior management team, and of what the CEO and other senior management are doing to develop these skills and experience at more junior levels. Additionally, up-and-coming members of management should have exposure to the board, both in board meetings and in less formal settings, so board members have an opportunity to observe managers directly and begin developing relationships with them.

8. Upcoming regulatory developments.

Moving into 2014, there are several developments on the regulatory front that will impact companies and their boards.

a. Compensation committee independence. The deadline is approaching for companies to have compensation committees that meet new, heightened stock exchange independence criteria. In anticipation of this deadline, which is the earlier of the first annual meeting after January 15, 2014 or October 31, 2014, boards will need to add an independence assessment for compensation committee members to their annual director independence assessments. In making an affirmative determination that compensation committee members are independent, boards at both NYSE and NASDAQ companies must consider all relevant factors, including whether a compensation committee member receives any consulting, advisory or other compensatory fees from the company, and whether the committee member has any affiliate relationships with the company, its subsidiaries or any affiliate of a subsidiary. As a result of recent rule changes, NASDAQ will not prohibit directors from serving on the compensation committee if they receive fees from the company. Instead, the board need only consider any such fees as part of the independence assessment.

b. Conflict minerals reports. Although a legal challenge to the SEC’s conflict minerals rules is ongoing, the rules remain in effect for now and affected companies will need to file their first disclosures on new Form SD no later than June 2, 2014. (The annual filing deadline is May 31, but companies have until the next business day if that deadline falls on a weekend or holiday.) The Form SD must include conflict minerals information for the calendar year 2013, and the extent of the information required will vary depending on companies’ circumstances. Companies that have concluded a reasonable “country of origin” inquiry and have no reason to believe that their products contain conflict minerals from the Democratic Republic of the Congo or adjoining countries (or that reasonably believe their conflict minerals came from recycled or scrap sources) must disclose their determination and the nature and results of their inquiry on Form SD. Companies that cannot reach this conclusion must take additional steps that involve conducting due diligence on the source and chain of custody of their conflict minerals, preparing a conflict minerals report to file with the Form SD (unless they determine, as a result of their due diligence, that the conflict minerals did not originate in the Congo or adjoining countries or that they came from recycled or scrap sources), and obtaining an independent private sector audit of the conflict minerals report in most circumstances. Meanwhile, as companies move forward with this work, oral arguments in the next stage of the legal challenge to the rules took place on January 7, 2014. Previously, in July 2013, the U.S. District Court for the District of Columbia had granted the SEC’s motion dismissing a challenge to the rules filed by a group of business organizations.

c. Executive compensation rulemaking. The pay ratio disclosure mandated by the Dodd-Frank Act (discussed above) is just one of four executive compensation provisions in the statute that require SEC rulemaking. In 2014, the SEC expects to propose rules on the remaining three, which will require companies to: (1) adopt and disclose “clawback” policies; (2) provide disclosure about whether they permit employees and directors to engage in hedging; and (3) provide disclosure about the relationship between compensation “actually paid” to executives and a company’s financial performance. SEC Chair Mary Jo White has indicated that completing these rules is a high priority, and proposals are expected in 2014. In the wake of the rulemaking delay and ongoing investor focus on executive compensation, many companies have acted voluntarily to adopt clawback policies and policies that restrict hedging and pledging of company stock, and to provide disclosure about these policies in their proxy statements. With respect to the pay-for-performance disclosure, SEC officials have suggested that the SEC plans to bring some consistency to the varied approaches companies have been taking to realized and realizable pay by adopting a definition of compensation “actually paid” to executive officers that uses realized pay.