Proxy Season 2009

This post from Marc Rosenberg is based on a client memo by partners at Cravath, Swaine & Moore LLP.

The outlook for proxy season 2009
This proxy season will be significantly affected by the credit crisis and the ensuing global economic turmoil. Investors and politicians have joined in an outcry over a perception of excessive executive pay, reckless risk-taking by management and inadequate board oversight at some companies. Prosecutors have launched investigations at numerous financial institutions, perceived abuses have been widely reported in the media, and Congress is seeking to reform compensation practices and give shareholders the right to vote on executive compensation.

Management and boards will be well-served at this time to reassess their compensation and governance policies and practices, as well as how they communicate with their investors. A strategic and well-analyzed response by a company and its board to these unprecedented conditions will be crucial to managing this challenging proxy season successfully.

Prepare for investor and regulatory scrutiny of executive compensation
Compensation practices undoubtedly will be an area of sharp focus this proxy season. The number and variety of shareholder proposals addressing compensation practices and policies is increasing. In particular, we are seeing an increase in proposals related to “say on pay,” “pay for performance,” “clawback” of executive pay in the event of a financial restatement and elimination of a variety of “poor pay practices” (e.g., tax gross-ups on executive perks or excise payments triggered by golden parachute payments and payment of dividend equivalents on unearned performance awards). Variations of each of these proposals have been endorsed by proxy advisor RiskMetrics (formerly ISS), an influential source of voting advice for institutional investors. RiskMetrics has also aligned its position on compensation policies and proposals for all public companies with the standards set for institutions selling equity to the federal government under the Emergency Economic Stabilization Act (“EESA”). The EESA requires, among other things, that financial institutions receiving assistance under it agree to stringent limitations on executive compensation.

In this environment, companies will have to think hard about which programs work well to incentivize desired behavior and clearly explain their analysis, or they risk shareholders withholding votes or voting against compensation committee members. We believe this trend is likely to continue to affect those issuers that do not proactively address these types of issues. Indeed, several companies have already announced their intent to give shareholders a vote on executive pay or attempt to assuage them with a compensation survey. Management and compensation committee members will have to be prepared to review, and perhaps modify, compensation practices that are no longer consistent with evolving corporate norms, pose undue risk or simply cannot be justified in the current climate as having any reasonable business purpose. At the same time, companies must prepare to defend vigorously those compensation programs that legitimately and appropriately incentivize management to contribute to the long-term health and profitability of the corporation. These programs will be scrutinized (and vocally criticized if perceived as excessive) by the investing public, advisors to institutional investors and the media. There will be a significant public relations aspect to this effort that will require the coordination of the compensation committee with personnel responsible for investor and media relations, corporate governance and executive compensation. Without meaningful communication with investors about the rationale for total executive compensation, opportunity targets, vesting periods, payment accelerations, dividend equivalents, perquisites and gross-ups, companies are likely to receive unwanted media attention and face challenges at the annual meeting, in director elections and in proxy seasons to come.

In the near term, there are several measures management and boards can take to prepare for effectively communicating with investors and the public generally on compensation issues. First, senior risk officers and compensation committee members should analyze collaboratively the impact of recent economic events and the risks posed by conduct that may be incentivized by the compensation program. Second, the company should reexamine its Compensation Disclosure & Analysis, considering whether, in light of current circumstances, it adequately addresses, for example: (1) the justification of compensation programs and policies, such as perks, long-term employment contracts, severance agreements and internal pay disparity; (2) benchmarking methodologies and selection of peer groups; (3) the method by which compensation plans would operate to pay severance to a departing executive; and (4) how equity compensation might be impacted when the stock price has fallen precipitously. Finally, companies should reevaluate the existence of conflicts of interest for their compensation consultants and/or the compensation committee, considering what, if any, agreements are in place, whether their independence may be impaired by the provision of multiple services and whether disclosure of the company’s practice with regard to the use of such consultants makes sense.

Anticipate changes in expectations for directors and the governance structure
Beyond cumulative voting and majority vote requirements for directors that have been widely proposed in prior years, this year we expect an increase in the number of, and support for, governance-related proposals, as well as a greater number of votes withheld from and against directors who are perceived to have failed to respond to such proposals. One of the most common governance-related shareholder proposals this year calls for an independent board chair or, alternatively, separating the roles of the chief executive and the board chair. RiskMetrics reports that about 67% of institutional investors view the combined role as either unacceptable or acceptable only with good governance provisions and satisfactory rationale. Consistent with its position in prior years, RiskMetrics generally will recommend in favor of proposals requiring that the board chair position be filled by an independent director, unless the company has a “counterbalancing governance structure” with an independent lead director and established governance guidelines. The company must also not have underperformed relative to its peers and applicable index in both one- and three-year total shareholder returns, have a board that is at least two-thirds independent, have entirely independent key committees and not have any problematic governance or managerial issues (such as perceived egregious compensation practices or multiple related-party transactions).

In addition, with momentum that began last proxy season, we believe shareholders will continue to seek additional rights. This year, like last, investors are seeking to give a relatively small number of shareholders the ability to call a special meeting. However, this year shareholders are proposing by-law amendments that would enable an even smaller percentage (10% vs. 25%) of shareholders to call such meetings. We believe RiskMetrics is likely to recommend in favor of such proposals. Likewise, shareholders are seeking to expand their rights by proposing, with the support of RiskMetrics, that corporations eliminate or require shareholder approval of poison pills. RiskMetrics, consistent with its position in prior years, will recommend withholding or voting against an entire board of directors if the board adopts or renews a poison pill without shareholder approval or does not commit to a future vote on it. This year, however, RiskMetrics has distinguished between traditional takeover defense pills and “net operating loss” pills that are used to preserve a tax benefit. RiskMetrics has now added flexibility to its policy on net operating loss pills, stating that it will consider several characteristics of such pills proposed by management before deciding whether they are acceptable. Finally, and with the endorsement of RiskMetrics, shareholders are seeking to rescind supermajority vote requirements for amendments to by-laws and/or charters.

In this environment in which many companies have been weakened by the economic crisis and rendered vulnerable to takeover, it is particularly critical that directors carefully consider the costs and benefits of the company’s takeover defenses. Moreover, before the proxy season is in full swing, company representatives should consider carefully communicating with certain institutional investors and shareholder proponents. Good faith communication can be educating to company officials and shareholder proponents alike. It can also generate goodwill that may make the annual meeting and future disagreements potentially less adversarial. In addition, if the company implements or intends to implement any governance or other relevant changes sufficiently in advance of the annual meeting that will affect RiskMetrics’s recommendation, it would make sense to publicize those changes to obtain, to the extent possible, the benefit of the recommendation the company is seeking.

Assume proxy access will resume momentum in 2009
The proxy access debate has clearly taken a back seat to compensation and board oversight issues, particularly with the dismissal of Bebchuk v. Electronic Arts, in which the Southern District of New York dismissed Harvard Law School professor Lucian Bebchuk’s case seeking to compel Electronic Arts to include in its proxy a proposal that would allow a 5% shareholder to place in the company’s proxy a proposal to amend the corporate by-laws as long as it was not contrary to law and did not relate to matters of ordinary business. Proxy access, however, may pick up steam early next year if it becomes the subject of legislation, as some would like, and becomes an SEC priority after the expected resignation of SEC Chairman Cox once President-elect Obama takes office. Proxy access was a high-priority item addressed at the confirmation hearings last summer for each of the three new SEC Commissioners. Shareholders’ focus on proxy access may also build on the Delaware Supreme Court’s ruling earlier this year in CA v. AFSCME Employees Pension Plan that has been interpreted as allowing a shareholder proposal to amend the company’s by-laws to provide for reimbursement of costs associated with a successful election of a shareholder-nominated director if it gives the board discretion consistent with the exercise of its fiduciary duties.

Anticipate that certain social issues will continue to have a place in the proxy
As in prior years, we are seeing repeat proposals from activist shareholders that often get enough votes to avoid exclusion under Rule 14a-8(i)(12). For example, we are seeing proposals this year calling for (1) disclosure of charitable or political contributions, (2) reports on environmental policies and/or the company’s response to global warming and (3) adoption of healthcare reform principles. Depending on the proponent, the circumstances of the proposal and the company’s willingness to make certain additional disclosures, we have had success in negotiating withdrawal of many of these proposals where the company is prepared to engage in a serious dialogue at senior levels of the organization and make certain concessions. This proxy season will pose new challenges and magnify preexisting ones. The way in which companies and their boards modify their governance and compensation practices, make meaningful disclosure to shareholders and manage investor communication will have a significant impact on how they emerge.

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